The pending Facebook public offering is the pinnacle of the Web 2.0 IPOs that have priced during the past year. The company is the poster child for a successful global business with almost one billion users. In 2011, Facebook generated almost $4B of revenue with an operating margin exceeding 47%. Wall Street analysts are forecasting revenue growth of more than 30% in 2012. Most importantly, the Facebook business model is sound with higher barriers to entry – scale and user engagement. The IPO, which is scheduled to be priced on May 18, will value the company at almost $100B and raise $5B of cash for the company. At the proposed IPO pricing, Facebook will have a larger market value than McDonalds (MCD), Citigroup (C) or Disney (DIS). Moreover, if the stock price appreciates by the same percentage on the first day of trading as did its closest peer LinkedIn (LNKD), Facebook will have the fifth largest market capitalization after Apple (AAPL), Exxon Mobil (XOM), IBM (IBM) and General Electric (GE).
The level of buzz surrounding Facebook’s IPO only happens once or twice per decade. Offerings that have created similar excitement include: Google (2004), Amazon (1997), Microsoft (1986) and Apple (1980). Each of these companies created new markets, garnered a disproportionate percentage of their industry’s profits and were led by young visionary founders. Even though the robust revenue trend for each of these companies kept up with the initial hyped expectations, the stocks were volatile. For example, Amazon rose almost 7,000% in its first four years as a public company before losing more than 90% of its value over the next two years despite growing its revenues from $150 million to $3.2 billion over those six years (66% CAGR).
Investors, both individual and institutional, have flocked to the recent round of internet related IPOs, commonly referred to as Web 2.0 businesses. Redwood anticipates that the underlying demand for Facebook’s offering will be enormous. If just 2% of Facebook daily users purchase 100 shares each, they could buy all of the publicly offered shares without any purchases by institutional investors. Companies like Groupon (GRPN) and Zynga (ZNGA) earned multiple billion dollar valuations despite their businesses generating minimal profits, having limited material barriers to entry, and only existing for a few years.
While almost all of the Web 2.0 companies are more developed and have better business models than the first round of internet IPOs (Web 1.0 companies) that went public during the technology bubble more than a decade ago, the stock performance of both Web 2.0 and Web 1.0 IPOs has been disappointing. The following two tables compare some of the most well known offerings from both time periods. In both groups, most of the IPOs’ stock prices jumped significantly on the first day. However, investor excitement quickly gave way to the reality that stock performance is ultimately connected to the underlying fundamentals of a business and the valuation of the stock. Web 1.0 business models were based on non-financial metrics such as “eyeballs” and “stickiness”. These companies quickly spent their IPO proceeds and headed to bankruptcy or irrelevancy. Web 2.0 companies are generating material revenues but still generally lack profitability. Moreover, just about all of these stocks are expensive on any valuation metric. Given general investor skittishness combined with attractive valuation of more established companies, Web 2.0 companies could experience additional volatility in the coming months.
Thus far, Redwood has elected to not to participate in the Web 2.0 IPO activity. The portfolios do, however, own a few premiere Web 1.0 companies that have been able to cross the chasm and develop sustainable business models that balanced growth and profitability. These include Google (GOOG), eBay (EBAY) and Stamps.com (STMP). One key differentiator between these companies and the recent IPOs is their attractive valuations. GOOG trades with a P/E of 13x, eBay at P/E of 15x and Stamps.com at 17x – all three at reasonable levels given each company’s growth and profitability characteristics. Other Web 2.0 or 1.0 stocks could become attractive portfolio candidates but these companies will need to demonstrate improved fundamentals and lower stock valuations.
Web 2.0 IPOs
Businesses: Well Known by Customers, Consumer Facing, User Generated Content, Social
Strengths: High Revenue Growth, High GM%, Significant Scale
Challenges: Extremely High Valuations, Competition, Unclear Long-Term Profitability
Average Change from IPO Price to 5/4/2012: -21%
Web 2.0 Companies: LinkedIn, Pandora Media, Groupon, Agnie's List, Zynga, Yelp
Web 1.0 IPOs
Businesses: Unknown to Customers, Internet Centric, Read-Only Content
Strengths: Vision, Creativity
Challenges: No Revenue Model, Too Early Stage to be Public Companies, Unsustainably High Valuations
Average Change from IPO Price to 5/4/2012: -95%
Web 1.0 Companies: Theglobe.com, Marketwatch.com, VALinux, FreeMarkets, Webmethods