When Art Informs Science: Three Of Facebook's Optimal Revenue Plays

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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 S-1 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 three-fold 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 short-term analysis, these non-comparable 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 step-by-step 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 intra-day 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 long-term 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.

See also Revisiting TiVo After Q2 Earnings, Next Stop $11 on seekingalpha.com



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Investing , Technology

Referenced Stocks: FB , GOOG , LNKD , MSFT , YHOO

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