Facebook Q1 16A – Painful splits.

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A stick in the eye for corporate governance.  

• A great set of results was marred by the timely announcement of a share split that further strengthens the founders’ grip on the company to the detriment of all other owners.
• Q1 16A revenues / adj-EPS were $5.4bn / $0.77 compared to consensus at $5.3bn / $0.62.
• Although revenues beat by 2.5%, EPS beat by 23% mostly due to a lower tax rate but also due to expenses growing more slowly than revenues.
• The outlook for profit and cash flow has also improved as the company stated it should be able to keep expenses within the current plan despite revenues faring better than expected.
• With 1.65bn MaU’s and 1bn daily users on mobile devices, Facebook still has all the makings of the biggest ecosystem of them all.
• The good news is that the company has recognised this (see here) and is moving full steam ahead to make the most of the opportunity that it has.
• The combination of this opportunity and the superb execution of Sheryl Sandberg’s organisation keeps me confident that there is much more to come from this company.
• However there are few bumps that need to be navigated first.
  • Firstly, I still see problems in the second half of this year.
  • This is because RFM’s research indicates that market expectations in H2 2016 are significantly ahead of what RFM thinks is possible given Facebook’s current level of development.
  • In essence, I think that the market is assuming that revenues will begin to flow from the new strategies before these plans are mature enough to begin generating revenues.
  • The result is likely to be a miss in Q3 16E or Q4 16E that will send the shares into a tail spin.
  • It is at that point that I would be looking to enter for the long term.
  • Secondly, many of Facebook’s new strategies to keep users within its ecosystem require artificial intelligence and machine learning.
  • I think that this is Facebook’s Achilles heel as this is not in the company’s DNA unlike Google.
  • Early interactions with Facebook M and the bots that have been launched (see here) show machines that are far too stupid to be of any real use.
  • If I was a company looking to build a bot to interact with my customers, I would not be using Facebook’s.
  • I would instead be looking at Google or Microsoft as a foundation for my machine intelligence.
  • This is a real problem as unless fixed, it will drive traffic away from Facebook properties and into the arms of its rivals.
  • Traffic is the life blood of Facebook upon which all future revenue growth depends.
• I am reasonably confident that Facebook has recognised its weaknesses as it has been quick to grasp the importance of the ecosystem concept and so I hope the AI problem will also be fixed.
• However, the biggest problem is the share split.
• Just like Alphabet did before it, Facebook is creating a new class of share that has no votes attached to it at all.
• Two class C shares will be created for every A and B share and will be distributed as a one-time dividend to existing shareholders.
• This will ensure that the founders’ control of the company will remain unchanged as control and economic interest will become even more divorced than they are today.
• For small, early stage companies a super voting structure makes sense as speed and decisiveness are needed but I firmly believe that this has no place in large public corporations.
• I find that the arguments for perpetuating this unfair structure have no merit and I fear that corporate governance has taken a turn for the worse.
• When this type of structure persists, no one minds until things start to go wrong.
• When problems arise, founders tend to be more emotionally attached to losing strategies than professional managers.
• Because no one can force them out or to change, they tend to stick with these losers far longer than they should.
• The result is that problems tend to be far worse and last much longer than they otherwise would if the shareholders had the power to enact change.
• The example of Ericsson’s emergency rights issue in 2002 is a great example of how bad things can get with these types of shareholding structures.
• While Facebook continues to beat expectations no one will care, but from a long term perspective any rational investor should put a discount on his fair value to account for this shortcoming.
• I place a 30% corporate discount on my estimate for Alphabet, and I see no reason why I should not do the same for Facebook.