Facebook Financial Analysis – Potential Manipulation?
“Surprise, surprise!” as Private Gomer Pyle use to say. We knew, even before this pre-IPO analysis, that Facebook was bound to disappoint. Between their terrible implementation of critical financial concepts, an extremely inflated valuation, and too much hype over substance for too long, this was the killer trifecta. Online social interaction is an impressive thing but this is going overboard with delusions of grandeur. We wanted to see a Facebook financial analysis that told the whole story so we made one ourselves.
We used the Business Ferret key financial metrics to generate the analysis below. These metrics give a complete, historic picture of Facebook’s finances, as well as an accurate prediction of future performance. Some of what we found won’t surprise you, but one little trick with Facebook’s net trade cycle in 2011 makes the rest of their finances suspect.
Facebook has had tremendous real revenue growth, but that growth has been slowing since 2009.
Their revenue is really the only salient point of the argument for the high valuation but, in the end, it doesn’t pan out. In fact, all of the post-IPO brew-hah-hah has been focused on the slowing revenues, which, as we’ll see, is actually good for the company.
The average sustainable revenue growth has only been 7% over the last 4 years and the company has grown real revenue growth at 17 times that pace.
Facebook’s need for working capital is like a homeless person at a smorgasbord; the company is literally eating the balance sheet alive and rapidly reducing cash flow.
Some good news! Facebook has good control of its pricing policy and has been pushing the positive pricing actively.
In 2008, the company experimented with low pricing for high margins but realized what a disastrous concept that is. After working harder and harder for less and less money, they corrected course and ended up in a good position today.
Facebook gets great marks on control of operating expenses.
Increasing gross profit margins resulted in expanding net income margins and dollars.
It’s the least they can do in the face of their extreme stock value.
Facebook is a classic example of how misleading EBITDA can be (we call it “EBITduh!”).
Net income is way up and EBITDA is way up … but cash flow is flat and threatening to decline. In fact, if it were not for a financial trick that Facebook employed in 2011 (see Net Trade Cycle below), the cash flow would have tanked, dropping to a negative $100 million. This is not good, yet no one has noticed.
This proves how careless the average stock investor actually is.
Adjustments to cash flow showed the same issue: the cash flow peaked in 2010 and started to decline again. Allowing for the net trade cycle trick implemented in 2011, Facebook has had only one year of positive cash flow, 2010.
This cash flow should not afford such an astronomical valuation!
In 2011, Facebook actually showed a turn towards production of working capital excess cash. Removing the financial trick implemented in 2011 eliminates this positive trend and would have put it on track for needing working capital cash of $100 million, not an excess of $73 million.
In other words, the company really needs more and more cash in working capital, not less and less.
Yes, Facebook has $4 billion in cash but this is way too much sitting around. If the cash need is $100 million, $1 billion in cash holding would be quite sufficient!
The average return on assets for Facebook is around 12%. With a more efficient use of capital, however, that could increase to 32%.
A company like Facebook, with such a lofty stock valuation, has no excuse to ever be allocating capital inefficiently.
For most of the last five years, Facebook has fallen short on financing its working capital.
The excess occurred finally in 2010 and 2011 but, with the net trade cycle adjustment in 2011, the working capital would not produce an excess.
As mentioned before, Facebook uses too little debt financing and holds too much cash balances. Equity is very expensive yet Facebook uses around 75% equity to finance its capital structure.
Capital is scarce for all companies – misuse it and you will lose it.
Here’s that financial trick we’ve been talking about.
The net trade cycle had been fairly stable up to 2010 at around a positive 62 days. But in 2011, the net trade cycle curiously declines over 16 days resulting in an increase in cash flow for the year of an additional $162 million.
The majority of this improvement happened by shortening the collections of the accounts receivable (AR). The timing is suspect but the important question is if this change is sustainable.
If this shorter AR collection period is not sustainable then Facebook would have manipulated its finances before its IPO.
Cost of Capital and Economic Value Added for Facebook
For every year over the last five years the cost of capital has exceeded the return on assets. This means that Facebook has not created value over and above its book equity – only the investors did by paying too much for the stock.
In fact, the company has never created enough spread between their cost of capital and return on assets to justify its book equity value, based on its own numbers!
In the last two years, if the company used its capital (debt, equity, and cash) efficiently and correctly it would have been able to hurdle its cost of capital with its adjusted ROA … but still not enough to even come close to the IPO value.