By
Victor
Cook
:
The Art
Most visual artists concentrate on and attach themselves to the
main objects of their work. So it's easy to understand why they
often forget about a part of their work that is just as important:
the negative space
. This is the space around the object of their attention, but is
not part of the actual object itself. It is the opposite of the
identifiable object which is necessary to clearly define the
boundaries of the positive space.
Most CEOs also concentrate on and attach themselves to the main
object of their work. So it is easy to understand why they so often
forget about the space outside and around their company. Their
competitors, both small and large, define many negative market
spaces.
When Facebook's (
FB
) 2011 S1 Registration became available on February 1, 2012, it
was time to review a sample of the company's optimal revenue plays
in three different negative spaces. These are the
A
,
B
, and
C
spaces described in Table 1.
Table 1: Revenues and OPEX in Three Negative Spaces
2011 $b

Sales Revenue

OPEX

Negative Space:

FB

$3.7

$1.1

A

B

C

LNKD

$0.5

$0.4




YHOO

$5.0

$2.7




GOOG

$37.9

$13.0




MSFT

$72.1

$28.0




Group A:

$9.2

OPEX Space A:

$3.1



Group B:

$47.1

OPEX Space B:


$16.1


Group C:

$119.2

OPEX Space C:



$44.1

Negative space
A
in Table 1 is occupied by LinkedIn (
LNKD
) and Yahoo (
YHOO
). Each of these peers has its strengths and weaknesses, but they
more or less balance out. The
A
space implies that Facebook will pursue a cautionary strategy.
Competitors' operating expenses [OPEX] in negative space
A
were $3.1 billion in 2011. The corresponding strategic group
A
revenue including FB was $9.2 billion.
The addition of Google (
GOOG
) in negative space
B
calls for a more ambitious strategy. Google's addition ups the ante
in this negative space OPEX to $16.1 billion. Strategic group
revenue increases to $47.1 billion.
Microsoft (
MSFT
) added to negative space
C
increases competitive OPEX nearly threefold to $44.1 billion, and
increases strategic group revenues of $119.2 billion. This demands
that Facebook create a more aggressive strategy. The revenue of
strategic group
C
is 13x that of group
A
.
Of course, the OPEX of Microsoft includes spending on a
multitude of line items that do not appear in Facebook's income
statement. If this were a shortterm analysis, these noncomparable
expenses would be carved out of MSFT's OPEX. But we're not looking
at the short term in this analysis. Even so, you can bet a large
chunk of MSFT's operating expenses are now being sunk into social
dimensions for future Office releases.
The Science
Calculating FB's optimal revenues is complicated. In order to
understand exactly how it works, the following 14 equations
describe the process stepbystep so that management may code
worksheets to assess the impact on optimal revenues in any other
relevant negative spaces.
Begin by calculating Facebook's historical market share in
strategic group
A
from the data in Table 1 reported in
Yahoo
Finance
. FB's revenue divided by the sum of revenues for all three
competitors is its percent market share (
m dot
) as defined in Eq. 1:
It's important to report individual company values in the
denominator of this equation in order to distinguish the focal
company from its competitors (LNKD and YHOO) in group
A
.
Equation 1 also hints at the flexibility of using any dollar
denominated financial data from the income statement or the balance
sheet that fit the intent of the analysis. For example, though not
reported in Table 1, on June 4, 2012 the intraday market caps of
FB, LNKD and YHOO were $56.8, $9.2 and $18.2 billion respectively.
Calculating FB's share of market cap from these data returns:
FB's market share of revenues in 2011 is calculated in the same
way using the data in Table 1:
Note there is a large positive difference (+27.2 points) between
Facebook's share of market cap (67.5% in Eq. 1) and share of
revenue (40.3% in Eq. 2). This reflects the degree investor
confidence in the company's future as of June 4, 2012.
Using the symbols from my book
Competing for Customers and Capital
(End note 2, p 133) and dropping the $ signs for clarity, Eq.1 may
generalized in Eq. 4 to calculate market share (
m dot
) of revenues for any number of companies assuming a linear
relationship between share of revenues and share of OPEX. As you
would expect, this assumption generally holds true.
In Eq. 4 the value of
y
is Facebook's OPEX. The value of
f is
the sum of LNKD and YHOO operating expenses. Solving Eq. 4 for
y
returns Facebook's OPEX as a function of market share:
In Eq. 5,
y
is the theoretical value of OPEX that Facebook must support to
maintain, increase or decrease a given share of revenues. This
equation creates a forward looking market share metric. OPEX in any
strategic group is the sum of (1) marketing and sales, (2) research
and development and (3) general administrative expenses.
For example, FB's theoretical operating expenses required to
sustain a 40.3% share of revenues in group
A
are $2.1 billion, given that the combined OPEX of LNKD and YHOO was
$3.1 billion in 2011.
Theoretical spending levels calculated from Eq. 5 must be
adjusted to account for the company's operating efficiency. This is
the unobservable
x
factor in competitive analysis of financial statement data.
X
is the ratio of actual (
s
) to theoretical (
y
) operating expenses:
Recall from Table 1 that FB actually spent $1.1 billion on OPEX
to attain a 40.3% share of revenues vs. the $2.1 billion
theoretically required to maintain that share level. In other words
FB's operating efficiency ratio was 0.52:
This means that Zuckerberg and company spent only 52ยข for
operating resources that, on average, cost its competitors $1.00.
This is an extraordinary level of operating efficiency.
Adjusted for operating efficiency the theoretical OPEX function
is:
Next, express EBITDA as a function of market share:
In Eq. 10 is EBITDA;
g dot
is percent gross margin;
R
is strategic group revenue; and
m dot
is percent share of revenues. The
m dot
is necessary to distinguish a percentage share from an integer and
optimal share measures.
A company's optimal share of revenues is that point at which the
marginal cost of the next share point equals its marginal value.
This (unobservable) point may be calculated by subtracting the cost
of market share in Eq. 9 from the earnings of market share in
Eq.10; taking the first derivative with respect to
m dot
, simplifying, setting the result equal to zero and solving. The
process returns the following optimal market share (
m hat
) equation.
Given Eq. 11 and an
iPhone 4S
calculator one can solve for optimal market share on the back of an
envelope:
LNKD and YHOO operating expenses and Facebook's operating
efficiency appear under the radical in the numerator of Eq. 12.
These two metrics determine the cost of a market share point.
Facebook's percent gross margin and strategic group revenues in the
denominator determine the earnings of a market share point. These
four metrics are fundamental to calculating optimal share of
revenue for any company in any strategic group.
Finally, multiplying optimal share of revenue by strategic group
revenues yields the company's optimal sales revenue:
Facebook's optimal revenues in strategic group
A
in 2011 were $4.8 billion:
The company's actual revenues were $3.7b. If LNKD and YHOO are
considered to be FB's peers, Zuckerberg and company came close to
achieving optimal revenues in 2011.
The Results
The data items and calculations described above are the same for
each of the three negative space plays defined in the Table 1. The
results for each strategic group are reported in Table 2.
Table 2: Actuals and Optimals

Strategic Groups


A

B

C

Facebook

+ LinkedIn
+ Yahoo

+ LinkedIn
+ Yahoo
+ Google

+ LinkedIn
+ Yahoo
+ Google
+ MSFT

Strategic Group Revenues ($B)

$9.2

$47.1

$119.2

FB Actual Market Share

40.3%

7.9%

3.1%

FB Optimal Market Share

52.3%

40.5%

39.0%

FB Optimal Revenues ($B)

$4.8

$19.1

$46.5

As one would expect Facebook's actual market share falls
dramatically as strategic group revenues increase. Competing in
group
A
, Facebook's actual market share is 40.3%. It falls to 7.9% in
group
B
. And it bottoms out at 3.1% in group
C
. From the smallest to the largest strategic group, Facebook's
market share of revenues falls by 92%.
On the other hand, it is not surprising that Facebook's optimal
market share is relatively stable, regardless of the total revenues
in each strategic group. Facebook's optimal share of revenues
declines only 25% in the face of a 13 fold increase in group
revenues. This is due to its huge gross margins, extraordinary
operating efficiencies and dramatic increases in group revenue, not
to mention overspending by competitors. But the company's optimal
revenue is extremely sensitive to the size of the strategic group,
increasing nearly 10 times from $4.8 to $46.5 billion. These
revenue differences reflect the extraordinary changes in precisely
targeted OPEX required for longterm profitable operations in the
largest negative space.
Each quarterly financial report from this moment on will reveal
how Mark Zuckerberg is doing in his dynamic search for optimal
market share, revenue and earnings. This gives FB's management team
an opportunity to adjust its marketing and sales, research and
development and administrative expenses according to anticipated
competitors' spending; to fine tune the company's operating
efficiency; to squeeze out a few more basis points in its percent
gross margin; and to figure out the best way to produce reliable,
rolling, seasonal forecasts of strategic group revenues. In short,
this article provides a blueprint for Facebook's long term
adventures into alternative negative spaces.
Disclosure:
I have no positions in any stocks mentioned, and no plans to
initiate any positions within the next 72 hours. I am holding 100
shares of YHOO in my portfolio for the long term.
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