Tuesday, November 15, 2022

META Lesson 3: Tell me a story!

In my first two posts on Facebook, I noted that its most recent earnings report, and the market reaction to it, offers an opportunity for us to talk about bigger issues. I started by examining corporate governance, or its absence, and argued that some of the frustration that investors in Facebook feel about their views being ignored can be traced to a choice that they made early to give up the power to change management, by acquiescing to dual class shares. Facebook, I argued, is a corporate autocracy, with Mark Zuckerberg at its helm. In the second post, I pointed to inconsistencies in how accountants classify operating, capital and financing expenses, and the consequences for reported accounting numbers. Some of the bad news in Facebook's earnings report, especially relating to lower profitability, reflected accounting mis-categorization of R&D and expenses at Reality Labs (Facebook's Metaverse entree) as operating, rather than capital expenses. In fact, I concluded the post by arguing that investors in Facebook were pricing in their belief that the billions of dollars the company had invested in the Metaverse would be wasted, and argued that Facebook faced some of the blame, for not telling a compelling story to back the investment. In this post, I want to focus on that point, starting with a discussion of why stories matter to investors and traders and the story that propelled the company to a trillion-dollar market capitalization not that long ago. I will close with a  look at why business stories can break, change and shift, focusing in particular on the forces pushing Facebook to expand or perhaps even change its story, and whether the odds favor them in that endeavor.

Narrative and Value

As someone who has spent the last four decades talking, teaching and doing valuation that we have lost our way in valuation. Even as data has become more accessible and our tools have become more powerful, it is my belief that the quality of valuations has degraded over time. One reason is that valuation, at least as practiced, has become financial modeling, where Excel ninjas pull numbers from financial statements, put them into spreadsheets and extrapolate based upon past trends. Along the way, we have lost a key component of valuation, which is that every valuation tells a business story, and understanding what the story is and its weakest links is key to good valuation,

The Connection

In the first session of my valuation class, I pose a  question, "What comes more naturally to you, telling a story or working with numbers?", and I very quickly add that there is no right answer that I am looking for. That is because the answer will vary across people, with some exhibiting a more natural tendency towards story-telling and others towards working with numbers. In my valuation classes, the selection bias that leads people to come back to business school, and then to pick the valuation class as an elective, also results in the majority picking the "numbers" side, though I am glad to say that I have enough history majors and literature buffs to create a sizable "story" contingent. In the immediate aftermath, I then put forth what I believe is one of the biggest hidden secrets in valuation, which is that a good valuation is not just numbers on a spreadsheet, which is the number-crunching vision, or a big business story, which is the story-tellers' variant,  but a bridge between stories and numbers:

To explain what I mean by "a bridge", in a good valuation, every number you have in your valuation, from growth to margins to risk measures, should be backed up by a story about that number, and every story you tell about a company, including its great management, brand name or technological edge, has be reflected in a number in your valuation. If making this connection comes naturally to you, you are lucky and definitely the exception, because it is hard work for the rest of us. As someone who is more  naturally drawn to numbers, I came to the recognition of the need for stories late to the game, and I had not only to teach myself how to tell stories but also create a process where I stayed disciplined about incorporating them into valuations. In case you are interested, I did write a book on the process that I use to convert stories to numbers, but if you are budget-constrained, many of the ideas in the book are captured in posts that I have done over time on valuation.

Stories + Numbers: The Symbiosis

    The challenge in valuation, and it has only become worse in time, is that the divide between story tellers and number crunchers has only become wider over time, and has reached a point where each side not only does not understand the other, but also views it with contempt. Venture capitalist, raised on a  diet of big stories and total addressable markets has little in common with bankers, trained to think in terms of EV to EBITDA multiples and accounting ROIC, and when put in a room together, it should come as no surprise that they find each other's language indecipherable. At the risk of being shunned by both groups, I will argue int his section that each side will benefit, from learning to understand and use the tools of the other side.

1. Why stories matter in a numbers world

    If you are a numbers valuation, you start with some advantages. Not only will you find financial statements easier to disentangle, but you will also be able to develop a framework for converting these numbers to forecasts fairly easily. In other words, you will have no trouble creating something that looks like a legitimate valuation, with numbers details and an end value, even if that value is nonsensical. With a just-the-numbers valuation, there are four dangers that you face:

  • Play with numbers: When a valuation is all about the numbers, it is easy to start playing with the numbers, unconstrained by any business sense, and change the value. It is not uncommon to see analysts, when they estimate a value that they think is "too low", to increase the revenue growth rate for a company, holding all else constant, and increase the value to what they would "like it to be".
  • False precision: Number crunchers love precision, and the pathways they adopt to get to more precise valuations are often counter-productive, in terms of delivering more accurate valuations. From estimating the cost of capital to the fourth decimal point to forecasting all three accounting statements (income statements, balance sheet and statement of cashflows), in excruciating detail, for the next 20 years, analysts lose the forest for the trees, and produce valuations that look precise, but are not even close to being estimates of true value.
  • Drown in data: If the complaint that analysts in the 1970s and even the 1980s might have had is that there was not enough data, the complaint today, when they value companies, is that there is too much data. That data is not only quantitative, with company disclosures running to hundreds of pages and databases that cover thousands of companies, but also qualitative, as you can access every news story about a company over its history, and in real time. Without guard rails, it is easy to see why this data overload can overwhelm investors and analysts, and lead them, ironically, to ignore most of it.
  • Denial of biases: It is almost impossible to value a business without bias, with some bias coming from what you know about the business and some coming from whether you are getting paid to do the valuation, and how much. In a valuation driven entirely with numbers, analysts can fool themselves into believing that since they work with numbers, they cannot be biased, when, in fact, bias permeates every step in the process, implicitly or explicitly. Put simply, there are very facts in valuation and lots of estimates, and if you are making those estimates, you are bringing your biases 
If you are a number-cruncher, at heart, and have run into these or other problems when valuing companies, bringing numbers into your valuation can not just alleviate these problems, but also help you in convincing not just other people, but yourself, about your valuation.
  • Stories are memorable, numbers less so: Even the most-skilled number cruncher, aided and abetted with charts and diagrams, will have a difficult time creating a valuation that is even close to being as good a compelling business story, in hooking investors and being memorable. I believe that long after my students have forgotten what growth rates and margins I assumed in the valuation of Amazon that I showed them in 2012, they will remember my characterization of Amazon as my "field of dreams company", built on the premise that if they build it (revenues), they (profits) will come. 
  • Stories allow for consistency-tests: When your valuation numbers come from a story, it becomes almost impossible to change one input to your valuation without thinking through how that change affects your story. An increase in revenue growth, in a company in a niche market with high margins, may require a recalibration of the story to make it a more mass-market story, albeit with lower margins. 
  • Stories allow you to screen and manage data: Having a valuation story that binds your numbers together and yields a value also allows you a framework for separating the data that matters (information) from the data that does not (distractions), and for organizing that data. 
  • Stories lead to business follow-through: If you are a business-owner, valuing your own business, understanding the story that you are telling in that valuation is extraordinarily useful in how you run the business. Thus, if you want to follow Amazon's path to the Field of Dreams, your business strategy should be built around expanding your market and increasing revenues, while also mapping out a pathway to eventually monetizing those markets and gaining access to enough capital to be able to do so.
If you are a number cruncher like me, you will find that adding a story to your valuation will only augment your number skills and improve your valuations.

2. Why numbers matter in a story world

    I am not a story-telling natural, but I have tried to look at valuation, through the eyes of story tellers, over the last few years. Again, you start with some advantages, as a skilled story teller, especially if you also have the added benefit of charisma. You can use your story telling skills to draw investors, employees and the rest of the world into your story, and if you frame it well, you may very well be able to evade the type of scrutiny that comes with numbers. There are dangers, though, including the following:

  • Fairy tales: Without the constraint of business first principles or explicit numbers about key inputs, you can tell stories of unstoppable growth and incredible profits for your company that are alluring, but impossible. If you are a con man, that is your end game, but even if you are not a con man, it is easy to start believing your own tall stories about businesses. As you watch the unraveling of FTX, you have to wonder whether Sam Bankman-Fried (SBF) set out to create a crypto-based Ponzi scheme, or whether this is the end result of a business story that was unchecked by any of the big name investors who participated into its growth.
  • Anecdotal evidence: Story tellers tend to gravitate towards anecdotal data that supports their valuation stories. Rather than drown in the data overflow world we live in, story tellers pick and choose the data that best fits their stories, and use them to good effect, often fooling themselves about viability and profitability along the way.
  • Unconstrained biases: If number crunchers are in denial about their biases, story tellers often revel in their biases, presenting them as evidence of the conviction that they have in their stories. Using the FTX example again, SBF was open about his belief that the future belonged to crypto, and that his entire business was built on that belief, and to his audience, composed of other true crypto-believers, this was a plus, not a minus.
In every market boom, you see the rise of story tellers, and while many crash and burn like SBF, as reality bites, there are a few that succeed, building some of our greatest business successes. One reason is that they find a way to bring numbers into their stories, with the following benefits:
  • Numbers give credibility to stories: As we noted in the last section, stories are hooks that draw others to a business idea, but it may not be enough to get them to invest their money in it. For that to happen, you may have to use numbers to augment and back up your business story to give it credibility and create enough confidence that you have the business sense to make it succeed. 
  • Numbers allow for plausibility checks: If you are on the other side of a valuation pitch, especially one built almost entirely around a story, the absence of numbers can make it difficult to take the story through the 3P test, where you evaluate whether it is possible, plausible and probable. It is your obligation as an investor to push for specificity, often in terms of the market that the business is targeting and the market share and profitability numbers that will determine its profitability. Again, business owners and analysts who can respond to this demand for specifics and numbers are more likely to get the capital that they seek. 
  • Number create accountability: For business owners and managers, the use of numbers allows for accountability, where your actual numbers on total market size, market share and profitability can be compared to your forecasts. While that lead to uncomfortable findings, i.e., that you delivered below your expectations, it is an integral part of building a successful business over time, since what you learn from the feedback can allow you to alter, modify and sometimes replace business models that are not working well.
Just as great number crunchers can benefit from bring stories into their valuations, great story tellers will benefit by bringing in numbers to add discipline to their story telling.

The Facebook Narrative

    In the last few months, as Facebook has collapsed, investors seem to have forgotten about its astonishing climb in the decade prior, with market capitalization increasing from $100 billion at its IPO in 2012 to its trillion-dollar capitalization in July 2021. In my view, a key factor behind the stratospheric rise was the valuation story told by and about the company, and the story's appeal to investors.

The Facebook Story

    The core of the Facebook story is its mammoth user base, especially if you include Instagram and WhatsApp as part of the Facebook ecosystem, but if that is all you focused on, you would be missing large parts of its appeal. In fact, the Facebook story has the following constituent parts:

  1. Billions of intense users: If there is one lesson that we should have learned from our experiences with user-based and subscriber-based companies over the last decade, it is that not all users or subscribers are created equal. With Facebook, it is not just the roughly three billion people who are in its ecosystem that should draw your attention, but the amount of time they spend in it. Until TikTok recently supplanted it at the top, Facebook had the most intense user base of any social media platform, with users staying on the platform roughly an hour a day in 2019.
  2. Sharing personal data in their postings: As a platform that encourages users to share everything with their "friends", it is undeniable that Facebook has accumulated immense amounts of data about its users. If  you are a privacy purist, and you find this unconscionable, it is worth noting that these users were not dragged on to a platform and forced to share their deeply personal thoughts and feelings, against their wishes. 
  3. Which could be utilized to focus advertising at them: In 2018, at the peak of the Cambridge Analytica scandals, when people were piling on Facebook for its invasion of privacy, I noted invading user privacy, albeit with their tacit approval, lies at the core of Facebook's success in online advertising. In short, Facebook uses what it has learnt about the people inhabiting its platform to focus advertising to them.
  4. In a world where online ads were consuming the advertising business: Facebook also benefited from a macro shift in the advertising business, where advertisers were shifting from traditional advertising modes (newspapers, television, billboards etc.) to online advertising;  online advertising increased from less than 10% of total advertising in 2005 to close to 60% of total adverting in 2020.
In sum, the story that took Facebook to the heights that it reached in July 2021 was that of an online advertising juggernaut, whose success came from using the data that it had acquired on the billions of users who spent a chunk of their days on on its platform, to deliver focused advertising. 

And its appeal

    Every business, especially in its youth, markets itself with a story and it is worth asking why investors took to Facebook's story so quickly and attached so much value to it.

  1. Simple and easy to understand: In telling business stories, I argue that it pays to keep the story simple and to give it focus, i.e., lay out the pathways that the story will lead the company to make money. Facebook clearly followed this practice, with a story that was simple and easy for in investors to understand and to price in. Just to provide a contrast, consider how much more difficult it is for Palantir or Snowflake to tell a business story that investors can grasp, let alone value.
  2. Personal experiences with business: Adding to the first point, investors feel more comfortable valuing businesses, where they have sampled the products or services offered by these businesses  and understand what sets them apart (or does not) from the competition. I would wager that almost every investor, professional or retail, who invested in Facebook has a Facebook page, and even if they do not post much on the page, have seen ads directed specifically at them on that page.
  3. Backed up by data: In the last decade, we have seen other companies with simple stories that we have personal connections to, like Uber, Airbnb and Twitter, go public, but none of them received the rapturous response that Facebook did, at least until July 2021. The reason is simple. Unlike those companies, Facebook, from day one as a public company, has been able to back its story up with numbers, both in terms of revenues and profitability, as can be seen in the graph below, where I look at its revenues and operating profits from 2012 to 2021:

With revenues growing from less than $4 billion in 2011 to $118 billion in 2021, and operating margins of more than 40%,through almost the entire period, it is easy to see why both value and growth investors gravitated to this stock.

With value consequences
    I have valued Facebook many times over the last decade, and have bought and sold based upon my valuations. For those of you who have been following these valuations, I am sure that you are well aware that my most recent valuation of Facebook, at the end of February 2022, was $346 per share, well above the stock price then of $220/share:

Having bought shares in the company at $133/share after the Cambridge Analytica scandal in 2018, I stayed invested in the company. Obviously, at today's price of just over $100/share, it should be time for regrets, but I have none. There are clearly aspects of my valuation, where I overreached, including revenue growth of 8% a year that I would reset to a lower number, with the recognition that online advertising is seeing growth level off, faster than I thought it would, and is more cyclical than I assumed it would be. As for profitability, my estimated target operating margin of 40% looks hopelessly optimistic, given that the operating margins in the last twelve months is closer to 20%, but as I noted in my last post, that drop is less a reflection of a collapse in the online advertising business model and more the result of Facebook's big bet of Metaverse, and the expenses emanating from that bet.

Narrative Changes and Resets

    The value of a business is, in large part, driven by your story for the business, but that story will change over time, as the business, the market it is in and the macro environment change. In some cases, the story can get bigger, leading to higher value, and in some, it can get smaller, and we will begin by looking at why business stories change, and classify those changes, before looking at the Facebook story.

Narrative Breaks, Changes and Shifts

   If business stores change over time, what form will that change take? To answer the question, I broke down business story changes into three groups, with the proviso that there are some business changes that fall into more than one group:

  1. Story breaks: The most consequential value change comes from a story break, where a key component of a business story breaks, sometimes due to external factors and sometimes due to miscalculations and missteps on the part of the management of the company.  In the former group, we would include acts of God (terrorism, a hurricane or COVID) and regulatory or legal events (failure to get regulatory approval for a drug, for a pharmaceutical company) that put an end to a business model. In the latter, we would count companies where management pushed the limits of the law to breaking point and beyond, damaging its reputation to the point that it cannot continue in business. 
  2. Story shifts: At the other end of the spectrum are story shifts, where the core business model remains intact, but its contours (in terms of growth, profitability and risk) change, as the result of market changes (market growth surges, slows or stalls), competitive dynamics (a competitor introduces a new product or withdraws an existing one) or technology (working in favor of the story or against it). Note the resulting changes in value can be substantial, and in either direction, depending on how and how much the valuation inputs change as a result of the story shift. 
  3. Story changes: Finally, there are story changes, where a company augments an existing business story by investing in or acquiring a new business, shrinks its existing business by withdrawing or divesting an existing business or product or attempts a story reset or rebirth, by replacing an existing business story with a new one.

I summarize these possible story alterations in the picture below:

As you can see from the types of changes that can occur, some business story changes are triggered by external forces, and can be traced to changes in macroeconomic conditions, country risk or regulatory/legal structures, some business story changes are the result of management actions, at the company or at its competitors and some business story changes are the consequence of a company scaling up and/or aging. It is worth noting that disruption, at its core, creates changes to a sector or industry that can break some status-quo businesses, while creating new ones with significant value.

Facebook: A Narrative Reset?

    In the last section, we looked at the incredible success that Facebook had between 2012 and 2021 with its user-driven, online advertising business model, both in terms of market capitalization (rising from $100 billion to $ 1 trillion) and in terms of operating results. You may wonder why a company that has had this much success with its story would need to change, but the last year and a half is an indication of how quickly business conditions can change.

Forces driving a reset

    Facebook's original business story was built on two premises, with the first being the use of data that it obtained on its customers to deliver more focused advertisements and the second being the rapid growth in the online advertising business, largely at the expense of traditional advertising. Both premises are being challenged by developments on the ground, and as they weaken, so is the pull of the Facebook story.

  • On the privacy front, the Cambridge Analytica episode, though small in its direct impact, cast light on an unpleasant truth about the Facebook business model, where the invasion of user privacy is a feature of its business story, not a bug. Put differently, if Facebook decides not to use the information that you provide it, in the course of your postings, in its business model, a large portion of its allure to advertisers disappears. 
  • The halcyon days of growth in the online advertising market are behind us, as it acquires a dominant share of overall advertising, and starts growing at rates that reflect growth in total advertising. As one of the two biggest players in the market, with Google being the other one, Facebook does not have much room on the upside for growth.
While many investors were shocked by the stagnant revenues that Facebook reported in its most earnings report, and some have attributed that to a slowing economy, the truth is that the pressures on Facebook's business story have been building for a while, and it is only the speed with which the story has unraveled that is shocking. 

Choices for the company

    Faced with slower revenue growth and concerned about the effect that privacy regulations in the EU and the US will alter its business model, Facebook has been struggling with a way forward. As I see it, there were three choices that Facebook could have made (though we know, in hindsight, which one they picked):

  1. Acceptance: Accept the reality that they are now a mature player in a slow-growth business (online advertising), albeit one in which they are immensely profitable, and scale back growth plans and spending. While this may strike some as giving up, it does provide a pathway for Facebook to become a cash cow, investing just enough in R&D to keep its existing business going for the foreseeable future, while returning huge amounts of cash to its investors each year (as dividends or buybacks). 
  2. Denial: View the slowdown in growth in the online adverting market as temporary, and stay with its existing business model, built around aggressively seeking to gain market share from both traditional players in the advertising market and smaller online competitors. With this path, the company may be able to post higher revenue growth than if it follows the acceptance path, but perhaps with lower operating margins and more spending on R&D, if market growth is leveling off.
  3. Rebirth: The choice with the most upside as well as the greatest downside is for Facebook to try to reinvent itself in a new business. That may require substantial reinvestment to enter the business, and hopefully draw on Facebook’s biggest strength, i.e., its intense and mammoth user base. 
Facebook did pick the third path, and it made the choice well before the revenue slowdown in the most recent year, perhaps as early as 2014, with its acquisition of Oculus for $2 billion. In the last three years, the push into the Metaverse has intensified, with billions invested in Reality Labs and a name change for the company. 

Facebook has also telegraphed its commitment to be a leading player in this space, planning to invest close to $100 billion, over the next decade. The big question, as I noted in my last post, that hangs over the company is whether this investment can create enough in additional earnings and cash flows to cover these huge upfront costs.

What's the story?

    Facebook’s plans to invest tens of billions in the Metaverse makes it an expensive venture, by any standards, and there are some who suggest that it is unprecedented, especially in technology, which many view as a capital-light business. That perception, though, collides with reality, especially when you look at how much big tech companies have been willing to invest to enter new businesses, albeit with mixed results. 

  • Microsoft invested $15 billion for its entry in 2015 into Azure, its cloud business, and it has invested tens of billions in data centers since, expanding its reach. That investment has paid off both quickly and lucratively, and has played a role in Microsoft's rise in market capitalization.
  • Google, renamed itself Alphabet in 2015, in a well-publicized effort to rebrand itself as more than just a search engine, and has invested tens of billions of dollars in its other businesses since, but with a payoff primarily in its cloud business, which generated $19.2 billion in revenues in 2021. Just to provide a measure of how its other bets are still lagging, Google generated only $753 million in revenues from its other businesses in 2021, almost unchanged from its revenues in 2019 and 2020.
  • Amazon has also invested tens of billions in its other businesses, with its biggest payoff coming in the cloud business (notice a pattern here). It has much less to show for its investments in Alexa and entertainment, and it is estimated to have lost $5 billion on its Alexa division in 2021 and spent $13 billion on new content for Amazon video.
Facebook, Microsoft and Google have all used the cash flows from their core businesses (Online advertising for Facebook and Google, Windows and Office for Microsoft) to fund their entry into new businesses, but at Amazon, it is the AWS (its cloud business) that has provided the profits and cash flows to cover its growth plans in other businesses.
   Facebook's investment plans for the Metaverse represent a big bet, but it is not an unprecedented one, which raises the question of why investors have been less willing to cut it slack than they have for its large tech competitors. One reason is timing, since markets are much more receptive to big growth investments, when times are good, as they were for much of the last decade, than in bad times, as much of 2022 has been. The other is the story line that backs the investment. Fairly or otherwise, the big cloud investments that Microsoft, Google and Amazon made came with story lines of growth and profitability that investors bought into, and for the most part, the results have justified that view. The more opaque investments, including Google's bets and Amazon's Alexa and prime video spending have been viewed more skeptically. The problem that most investors have with Facebook's Metaverse investment is that it is not just that the payoff is uncertain, but it is unclear what business the payoff will come from. After all, the Metaverse is a space (virtual), not a business, and to make money in that space, you need a business model, which Facebook has not provided much guidance on. In fact, the most detailed document that I was able to find anything on Facebook's Metaverse plans were from 2015, where Zuckerberg described his vision for the business, and from 2018, in a 50-page presentation that Facebook, where the company talks about revenues coming from advertising and hardware, but only in very general terms. It is true that Facebook has laid out its Connect 2021 vision online, but the document is heavy on hype and technology, and light on business details.
    As I see it, the combination of market conditions and opacity about business plans is creating the worst of all combinations for Facebook, in financial markets. The market has clarity about how much Facebook plans to spend on the Metaverse and is not just skeptical, but extremely confused, about how exactly Facebook will make money in the Metaverse. To give you a sense of how negative investors are about Facebook's future prospects, I created the most conservative estimate of value, which I call my Doomsday valuation, for the company based upon the following assumptions:
  1. I used the company's actual operating income from its online advertising business from the last twelve months, weighed down as they are from a slowing economy and a stronger economy, and assumed no growth and a remaining life of 20 years for the business, with a zero liquidation value at the end of year 20.
  2. I assumed that the company will continue to spend R&D at the same scorching rate that it set in the last twelve months, where it spent just over $32 billion on R&D, for the next 20 years.
  3. I also assumed that not only will Facebook to lose $10 billion a year on the Metaverse, but also that this will continue for the next decade and beyond, with no payoff in terms of increased revenues or earnings from this spending.
  4. I assume that Facebook is a risky company, falling at the 75th percentile of all US companies in terms of risk, and give it a cost of capital of 9%.
The table below shows the value that I estimate with this combination of assumptions, and compares it to the value that I would obtain, if I removed the Metaverse numbers from the valuation:
Download spreadsheet
Note that in Doomsday scenario, where Facebook continues to spend money on R&D and invest heavily in the Metaverse, with no payoff in higher growth or longer business life from those investments, the value of equity that I obtain is $258.6 billion. Doing the valuation with the Metaverse revenues and expenses removed from the mix yields $330 billion, suggesting that treating the entire Metaverse investment as wasted expenditure reduces Facebook's value by approximately $71 billion.  

The market capitalization of Facebook on October 29, 2022 was $247 billion, below the Doomsday scenario value,  indicating that investors were, in fact, treating the $100 billion to be invested in the Metaverse as a wasted expense, a remarkably cynical and pessimistic take on a  company that has had a history of delivering profits. The market capitalization has risen to $311 billion as of November 15, 2022, and while that suggests a more positive perspective, that value still reflects a presumption that the Metaverse investment will destroy about $18.9 billion of Facebook's value. In truth, using a more realistic growth rate (rather than zero) or lowering the cost of capital (from 9% to 8%, the median cost of capital for a US company) or extending the life of the company (from 20 years to a longer period) can only add value to Facebook, and you can experiment with these inputs in the attached spreadsheet.

Turning the Trust Corner
    It is undeniable that Facebook has lost the trust of investors, and that it is being priced on assumptions that reflect that mistrust. In my experience, trying to jawbone investors to trust you does not work, but there is a plan of action that Facebook can follow, that will start the process of rebuilding trust :

  1. Tell with a business story for the Metaverse: Investors do not have a clear sense of what the Metaverse is, and more importantly, the business opportunities that exist in that space. Facebook needs to fill in that gap with a business story for its investments, laying out what is sees as a pathway to making money in that virtual world, as well as the strengths it will bring to delivering value on this path. I am sure that Facebook is much more qualified than I am to frame this story, but just in case they could use some guidance, here are a few possible Metaverse business models:

    Of these choices, advertising clearly is the most logical extension of their existing business, but it also offers the least upside, since the company is already a dominant player in the online ad business. The acquisition of Oculus and the VR headsets that Facebook sells give it a foothold in the hardware business, but hardware is a business with lower margins and limited market size. The most lucrative story, in my view, is a ecosystem story, where Facebook gains a dominant share of the virtual world, and takes a slice of any business (transactions, gaming, subscriptions) done in that world, mirroring what Apple has done in its iPhone ecosystem. It is worth remembering that the audience that you are trying to sell this business story to is not the audience that you will be seeking out in the Metaverse, which would imply that your story should be less about technology and more about business. (I may be old and cranky. I have zero interest in the virtual world, but as a Facebook investor, I would be interested to learn its business model for this world.) 
  2. Build in specifics into your investment story: Facebook has been clear about its plans to invest billions in its new businesses, but rather than just emphasizing the total amount that it plans to make, it would be better served connecting its investment plans with the business story being told. If nothing else, it would be useful to know how much of the $12 billion spent in Reality Labs was spent on people, on technology, on software and in making better VR glasses and why all of this spending is bringing the company closer to a money-making business model.
  3. With markers on operating payoffs: I know that there are huge uncertainties overhanging these investments, but it would still make sense to give rough estimates of how Facebook expects revenues and operating margins to evolve on its Metaverse investment, over time. That will give investors and managers targets to track, as the company delivers results, and use the results (positive or negative) to make changes in the way future investments are made.
  4. And escape hatches, if things don't work out: While many companies refuse to talk about what their plans are, if a business does not pan out, viewing it as a sign of weakness or lack of conviction, I believe that Facebook will be best served if they are open about what can go wrong with their Metaverse bet, and not only about what they are doing to protect themselves, if it happens, but also exit plans, if they decide to walk away. After all, if the market is already assuming the worst, as it was just a couple of weeks ago, how can any scenario you present, no matter how negative, worsen your market standing?
As I mentioned in my first post on Facebook a couple of weeks ago, I made an exception to my rule of not doubling down and doubled my holding of Facebook on November 4, 2022, because its valuation looks compelling. I did so with the acceptance that I will have little influence over the management of the company, in general, and Mark Zuckerberg, in particular, and it is entirely possible that I will come to regret it. If I do so, I am sure that many of you will remind me, and I okay with that as well!

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  1. Metaverse Value Effect
Facebook 2022 Earnings Report Posts

Thursday, November 10, 2022

META Lesson 2: Accounting Inconsistencies and Consequences

In my last post, I used Facebook's recent troubles to talk about the importance of corporate governance, and how we, as investors, have abandoned the power to change management at many younger tech companies in return for being able to invest in young tech companies, with growth potential and well-regarded founders. In this post, I will revisit Facebook's most recent earnings report, and argue that while it contained disappointing news on growth and profitability, the bad news was exaggerated by systematic inconsistencies in how accountants categorize expenses, skewing earnings and invested capital down in firms that don't fit the accounting prototype. That skewing can affect valuation and pricing judgments about these firms, and correcting accounting inconsistencies is a key step towards leveling the playing field.

Accounting 101

   I am not an accountant, and have no desire to be one, but I have used their output (accounting statements) as raw material in valuation and corporate finance. As I look at accounting from the outside, I see the primary role of accounting as recording and reporting, in a consistent and standardized form, the answers to three basic questions:

  1. What does a business own? List out the assets that a business has invested in, and how much it spent on those investments and perhaps what these assets are worth today.
  2. What does the business owe? Specify the contractual commitments that a business has to meet, to stay in business. Simply put, this should include all borrowings, but is not restricted to those
  3. How much money did the business make? Measure the profitability of the business, both with accounting judgments on expenses, and based upon cash in and cash out, over the period of measurement (quarter, year).

It is in pursuit of answering these questions that accountants generate financial statements, and the three most basic are:

  • The balance sheet, which summarizes what a firm owns and owes at a point in time, as well as an estimate of what equity is worth (through accounting eyes).
  • The income statement, which reports on how much a business earned in the period of analysis, while providing detail on revenues and expenses.
  • The statement of cash flows, which reports on cash inflows and outflows to the firm during the period of analysis and allows for a measure of cash earnings (as opposed to accounting earnings) and cash flows.
In recording transactions, most businesses are required to follow an accrual method, where transactions are recorded as they  occur, rather than cash accounting, where you record items as you pay for them or get paid. In accrual accounting, accountants categorize expenses into operating, capital and financing expenses, with the distinction, at least in theory, being as follows:
  • Operating expenses are expenses associated with generating the revenues reported by a business during a period. Thus, it includes not only the direct costs of producing the product or service the firm sells, but also other expenses associated with operations, including S, G & A expenses and marketing costs.
  • Financing expenses are expenses associated with the use of non-equity financing, and in most firms, it takes the form of interest expenses on debt, short term and long term. 
  • Capital expenses are expenses that provide benefits over many years. For a manufacturing company, these can take the form of plant and equipment. For non-manufacturing companies, they can take on less conventional and tangible forms (and as well argue in the next section, accounting has never been good at dealing with these).
This classification plays out across the financial statements and plays a key role in accounting assessments of profitability, capital invested and even cash flows. In the figure below, I trace out where operating, capital and financing expenses show up in the three financial statements:
Operating expenses become part of cost of good sold or other operating expenses (like SG&A and adverting costs) in an income statement, and are key inputs in determining operating income. Capital expenses create assets on the balance sheet, in the year in which they are made, and when amortized or depreciated, in subsequent years, the resulting amortization or depreciation becomes part of operating expenses in those years. Financing expenses are expenses associated with the use of non-equity financing, with interest expenses on borrowing (short and long term) being the most common items, with the non-equity financing showing up as debt on the balance sheet, with interest expenses reducing your taxable and net income. The statement of cash flows is explicitly broken down into operating, investing and financing categories, with the distinction being that it looks at cash flows, not accounting expensing.

Accounting Inconsistencies and Pricing Consequences

    In my introductory accounting class, I was  told that accountants were scrupulous about expense classification, and that misclassifying financing expenses or capital expenses as operating expenses occurred rarely. In the years since, I have concluded that this is not true and that expense mis-categorization is not only common, but that it varies widely across sectors, making it difficult to compare accounting numbers or ratios across firms.

1. Financing Expenses treated as Operating Expenses

    When a financing expense is treated as an operating expense, that mistake plays out across the financial statements. In the income statement, this classification error moves an expense that should be below the operating income line, to above it, reducing operating income. The misclassification also means that the balance sheet recording of debt will not include the financing that gave rise to the mis-categorized expense:

As you can see, treating a financing expense as an operating expense has no effect on net income, but its effects will ripple through elsewhere affecting operating income (usually lowering it) and understating the borrowing on the balance sheet. To the extent that these numbers are used in computing financial ratios, it will affect your measures of operating income and return on invested capital. Until accountants came to their senses in 2019, they routinely treated a large segment of leases as debt, with questionable reasons, and skewed operating margins, returns on capital and debt ratios in lease-heavy sectors like retailing and restaurants. However, leases are only one of many other contractual commitments that meet the "debt" criteria, and require similar corrections. Thus, the content commitments at Netflix, representing contractual commitments on content that Netflix has obtained rights to, from other studios, as well as some purchase commitments at companies may require the same corrective treatment as leases.

2. Capital Expenses treated as Operating Expenses

    Treating a capital expense as an operating expense also plays out across the financial statements, and we will use R&D, which is the most widely mis-categorized cap ex, to illustrate. When R&D is expensed, it pushes down both operating and net income for companies with growing R&D expenses over time; in the rarer case of declining companies where R&D has been dropping over time, it will have the opposite effect. In addition, the mistreatment of R&D as an operating expense will mean that the expense will not create an asset on the balance sheet, as capital expenses should, with consequences for your measures of book equity and capital invested:

The capitalization of R&D requires making an assumption about how long it will take for R&D, on average, to generate commercial products, with longer R&D lives for pharmaceutical companies and much shorter ones for technology and software companies. In general, correcting the accounting mistake will increase operating and net profits, at most firms, as well as book equity and invested capital, and for most firms that spend money on R&D, capitalizing R&D will lower accounting returns (return on equity and return on invested capital).

The arguments that we used for treating R&D as a capital expense, i.e., that the expense is intended to create benefits over many years and not in the current one, can also be used on other items that accountants routinely treat as operating expenses, such as
  1. Exploration costs at natural resource companies, since even if successful, the reserves found will not add to revenues or income until years into the future.
  2. Advertising expenses to build brand name at consumer product companies, and especially so at companies (like Coca Cola) that are dependent on brand name for both growth and pricing power. Note that not all business advertising is for building brand name, and capitalizing brand-name advertising will require separating advertising expenses into portions intended to sustain and increase current sales (operating expense) and for building brand name (capital expense).
  3. Use/Subscriber acquisition costs at user or subscriber based firms, at companies that have built their value propositions around user or subscriber numbers. Note that the capitalization effect will depend on how long an acquired subscriber or user will stay with the business, with longer customer lives creating a bigger impact, from correction.
  4. Employee recruiting and training expenses at consulting and human-capital driven firms, since their growth depends, in large part, on their employee quality and retention. Here again, the effect of capitalizing employee-related expenses will depend on employee tenure, with longer tenure creating a bigger effect, when the correction is made.
In making these corrections, you will face push back. Accountants will use the argument that the benefits are uncertain, true for some of these expenses, like R&D, but also true for many investments in fixed assets (factories, capacity etc) that are currently treated as capital expenses. Uncertainty about future benefits should never be the litmus test for whether to treat an expense as a capital or operating expense; instead, the focus should be on when you can expect to generate those uncertain benefits. Some may push back, arguing that making this correction will push up earnings at these companies, to which your response should be that this is exactly what you should be doing, if it reflects reality. The truth is that accounting has a legacy problem, where almost all of the rules that underlie accounting reflect the fact that they were written for the manufacturing companies that dominated the twentieth century. As technology companies, in particular, have taken an increasing share of the economy and the market, accounting has tried to catch up, with new rules on expensing and valuing intangible assets, but it remains decades behind reality. 

3. Pricing and Investing Consequences
    Even if you agree with me on the logic of correcting for accounting inconsistencies, you may wonder whether the effort of making these corrections is worth the effort. I believe it is, since failure to do so can have both valuation and pricing consequences. In the table below, I capture the effects of moving an item from operating to financing (as we do in the lease correction) and from operating to capital (as is the case when we capitalize R&D):
I believe that correcting for accounting inconsistencies is worth the trouble, given the value and pricing consequences. That is the reason I employ both corrections, albeit with a bludgeon, to reestimate  company numbers, when I do my data updates for industry averages (for debt ratios, accounting returns, profit margins and reinvestment) at the start of every year.

Facebook: Cleaning up the Accounting

    As you take a look at the most recent quarterly earnings report from Facebook, it is worth drawing on the discussion about accounting inconsistencies. Without contesting the basic conclusion that Facebook had a bad operating quarter, after its earnings report for the third quarter of 2022, let's review the accounting numbers to see how bad it truly was, and why.

The R&D Effect

    As a technology company with billions of users on its platform, and increasing calls for respecting data privacy, Facebook needs to spend on R&D, and it has done so heavily all of its corporate life. In the chart below, I report on Facebook's R&D spending each year from 2011 to the last twelve months (ending September 2022):

In the last twelve months, Facebook spent $32.6 billion on R&D, making it one of the largest corporate spenders on research and development in the world; seven of the top ten companies, in R&D spending, are technology companies with two pharmaceutical companies and one automobile company (Volkswagen) rounding out the list. From the graph, you can also see that Facebook's spending on R&D has only accelerated in the last five years, even as it scales up, and that R&D growth will determine the impact of capitalizing it. Using a 3-year life for R&D, I estimate the capital invested in R&D to be $53.1 billion (which adds to book equity in 2022) in September 2022, and the R&D amortization for the most recent twelve months to be $18.9 billion. (In R&D capitalization, I use a range of 2-10 years, depending on the sector, with 3 years for most technology and software companies). 

To correct earnings (net and operating income) each year, I add back that year's R&D expense and net out the amortization of R&D in that year, and I report this restated income from 2011 to 2022 in the graph below:

As you can see, the adjusted pre-tax operating income numbers are significantly higher every year, because of the adjustment, with the pre-tax operating income increasing from $35.5 billion to $49.3 billion in the last twelve months (ending September 2022). Since net income increases by the same magnitude, the company generated $42.5 billion in net income in the last twelve months, if you correct for R&D, rather than $28.8 billion, as reported.

Since R&D capitalization also pushes up the book value of equity, and by extension, the invested capital in the firm, I looked at the effect of capitalizing R&D on invested capital and return on invested capital, over time:

For the most part, capitalizing R&D lowers the return on invested capital, with the pre-tax return on invested capital dropping from 38.91% to 34.10%, in the most recent twelve months, after the correction. While these are returns that most companies in the world would gladly exchange for their own, the trend downwards over time is a reflection of the challenges of scaling up as well as competition within the business. The online advertising business is not just seeing slower growth, but increased competition and regulatory pressures (over privacy) are lowering the returns that can be made in the business.

The Metaverse Investment

    In the last few years, Facebook has been supplementing its R&D investments with substantive investments in the Metaverse, and it has been open about its plans to invest huge amounts in the future. The extent of Facebook's Metaverse bet, and its effects on the bottom line, are visible in this excerpt from the most recent quarterly report filed by the company:

Facebook 10Q, 2022 Third Quarter

In the last twelve months, Reality Labs, which comprises a big portion of  the company's investment in the Metaverse and houses its VR glasses (acquired originally from Oculus), generated revenues of $2,310 million (add the revenues in the first nine months of 2022 to the last quarter numbers from 2021), while adding $12,741 million to operating expenses. We are certain that while some of these reality-lab related expenses are operating, a large portion represent capital expenses that are being expensed. The effect of Reality Labs on Facebook's income numbers can be seen below:

Without the expense drag created by Reality Labs, Facebook's operating margin would have been almost 12% higher, at 53.54%, instead of the 41.7% that we obtained, after correcting for R&D. While it is true that Facebook has spent this money, no matter how you categorize it, it is also true that if accounting stayed consistent in its capital expenditure treatment, much of this money should have been treated as a capital expense.

    My intent, when I started this post, was not to promote or to discount Facebook as an investment, but to provide some light on where Facebook stands right now (in terms of growth, profitability and risk),  given the most recent quarter's earnings report:
  1. Profitability: There is no denying that Facebook's revenues have flattened out, though a stronger dollar and slowing economic growth are partially responsible. However, the drop in operating and net margins that you saw in the most recent earnings report should not be taken as a sign that the profitability of the company's online has imploded. In fact, correcting for R&D and the Reality Lab investment, you can see that the online advertising business remains a money machine, generating sky-high margins. In fact, almost all of the drop in profitability is coming from Facebook's R&D and Metaverse investments, and if a large portion of that expenditure were treated as capital expense, that drop would have been far smaller. 
  2. Pricing: As Facebook's market cap has declined to approximately $250 billion, some have noted that the company now trades at about 8 times earnings, if you use the net income of $28.8 billion assessed by accountants. However, if you are comparing Facebook's PE ratio to the PE ratios of non-tech companies, for consistent comparisons, you should be using the adjusted net income of $42.5 billion, which results in an adjusted PE ratio of about 6. I don't use PE or EV to EBITDA multiples as my primary stock picking tool, but if you do, Facebook looks far cheaper, relative to other companies, after you have adjusted for its misclassified capital expenditures (R&D and Metaverse).
  3. Valuation: From a valuation perspective, you care about cash flows, and since R&D and the Metaverse investments are cash outflows, Facebook's investments in these will lower cash flows. The value effect, though, will depend upon whether you think these investments will pay off in future revenue growth and higher cash flows in the future, and investors, at least at the moment, are not only not giving Facebook the benefit of the doubt, but seem to be actively building in the presumption that this is essentially wasted money, with no payoffs at all. As I will argue more extensively in my next post, I assign a great deal of blame for this investor mistrust to Facebook, because the company seems to have made almost no effort to explain its business model for generating revenues and profits from the Metaverse. In short, the only thing that Facebook has been clear about is that they will invest tens of billions of dollars in the Metaverse, while being opaque about how it plans to make money in that space. Remember that even if we all buy Facebook VR glasses and spend half our lives in the virtual world, for Facebook to make money, it has to either collect money from us (subscriptions or transactions) or show us advertising.
In sum, though, capitalizing R&D and the Metaverse investments is a good idea, whether you are an optimist or pessimist about the company. If you are bullish on Facebook, you will have convince others and, more importantly, yourself, that you expect Facebook (and Zuckerberg) to deliver a payoff on the Metaverse investment that justifies its scale. If you are in the pessimist group, it is important that your reasoning for why Facebook is a poor investment, at a PE ratio of 6, is not based upon the false premise that its prime operating business (online advertising) has becoming less profitable (it has not) but upon a judgment that you have made that Zuckerberg's ego has overridden his business sense, and that without the safety rails of corporate governance, he will continue to throw good money into a bad idea for the foreseeable future.

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Lessons from Facebook
  1. META Lesson 1: Corporate Governance
  2. META Lesson 2: Accounting Inconsistencies and Consequences
  3. META Lesson 3: The Importance of Narrative
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Friday, November 4, 2022

META Lesson 1: Corporate Governance

As we get deeper into earnings season for the third quarter of 2022, the biggest negative surprises are coming from technology companies, with the tech giants leading the way. Investors, used to a decade of better-than-expected earnings and rising stock prices at these companies, have been blindsided by unexpected bad news in earnings reports, and have knocked down the market capitalization of these companies by hundreds of billions of dollars in the last few weeks. Facebook (or Meta, if you prefer its new name), in particular, has been in the eye of the storm, down more than 75% from the trillion-dollar market capitalization that it enjoyed just over a year ago. In its last earnings report, the company managed to disappoint almost every segment of the market, shocking growth investors with a drop in quarterly revenues, and value investors with a sharp decline in earnings and cash flows. In the days after the report, the reaction has predictably fallen into the extremes, with one group arguing that this is the beginning of the end for the company's business and the other suggesting that this is the time to buy the stock, as it prepares for a new growth spurt. 

Having valued and invested in Facebook multiple times in the last decade, I will throw my two cents in, but rather than make the earnings report the center of attention, I will use the company's recent travails to talk about three issues that I think are big issues not only at Facebook, but for the entire market. In this first post, I will use the investor debate about Facebook to talk about  corporate governance, what it is, why it matters and how I think governance disclosure research, rules and scoring services have lost the script in the last two decades. In the next post, I will use Facebook's most recent earnings surprise to talk about inconsistencies in how accountants categorize corporate spending, and why these inconsistencies can skew investors perceptions of corporate profitability and financial health. In the third and final post, I will argue that Facebook's troubles with the market have as much to do with a failure of narrative, as they are about disappointing numbers, and present a template for what the company needs to do, to reclaim the high ground.

Facebook: Filling in the Background

   It is worth noting that in good times, when earnings are rising and stock prices are upward bound, investors do not seem to have much interest in corporate governance, and it is only when the numbers start to move against them, that they rediscover the importance of the topic. To understand why talk about corporate governance at Facebook has been muted for much of its corporate life, and why it is a prime topic of conversation now, let's retrace Facebook's journey, over the last decade, from a young VC-backed private company to a high-profile public company.

The Market Journey

    Facebook is a young company, at least in chronological time, having been public for just over a decade. I have written about the firm many times, over that period, starting with a valuation that I did of the company in 2012, just ahead of it going public. On May 12, 2012, Facebook's debuted in financial markets, with a capitalization of $104 billion, making it one of the most valuable IPOs of all time. After a rough start, with its stock price halving by August 2012, the company embarked on an extraordinary run in markets, adding almost $900 billion to its market capitalization to briefly breach a trillion dollars in July 2021. In a post in 2020, I highlighted how much of the increase in US equity values in the 2010-2019 decade was because of the FANGAM stocks (Facebook, Amazon, Netflix, Google, Apple and Microsoft):

Since July 2021, Facebook's market standing has fallen precipitously, with its market capitalization down to less than $250 billion (down more than 75% from its high) on October 27, after its most recent earnings report. As Facebook's market capitalization has collapsed, it is worth stepping back and gaining perspective about its market performance in the long term. 

  • Buy and hold returns: If you had bought shares in Facebook on its first trading day, you would have paid $38.12, and if you had held the stock through October 27, 2022, when it was trading at $93/share, that would have translated into a cumulative return of 144%. That would have left you lagging the 181% price appreciation that you would have earned on the S&P 500 during the period, and even more so, if you consider the fact that you would have earned no dividends on Facebook, while generating about a 2% dividend yield, every year on the index.
  • Current standing: At a roughly $250 billion market capitalization, Facebook is a large market-cap company, but it has lost its standing among the largest market cap companies in the world that if occupied for an extended period during the last decade. 
  • Trader's game: Along the way, Facebook has had its ups and downs, and a savvy trader who was able to time entry and exit into the stock at the right times, would have made a killing on the stock. I know that can be said of any stock, but the swings in fortune are much greater at companies like Facebook, making them them the preferred habitat for traders of all stripes.
In sum, the investor experience with Facebook over the last decade should be a cautionary note on passing judgment on companies after short periods, where the stock soars or sinks, sometimes for no good reasons. 

The Operating Journey

    The drop in Facebook's stock price that has occurred in 2022 is part of a larger story of a decline in tech companies during the year. For many value investors, the tech stock drop has been vindication that no sector, no matter how favored, can fight gravity in the long term, but they would be making a mistake if they bundle Facebook in with younger tech companies, many of which have unformed business models and an inability to be profitable. Through its entire life, one of Facebook's most impressive features has been its capacity not only to generate profits but very large profits, as you can see in the chart below:

Note that Facebook, then it went public, had revenues of only $3.7 billion, but it generated an operating margin of 47.3%, with its online advertising model. In the decade since, its has been able to scale up revenues dramatically, with revenues reach $118 billion in 2021, while preserving sky-high margins, close to 40% in 2021. In short, Facebook has been a profit and cash machine for its entire public market life, and there is more to this company than traders pushing up stock prices on momentum. 

    It is this historical context of high growth, albeit slowing as the company scales up, and consistently high operating margins, that should explain investor reactions to last week's earnings report. There were at least two negative surprises in the report that led to investor reassessment:

  1. Flat revenues: While revenue growth has been slowing in recent quarters, and investors would perhaps have lived with single digit growth, especially with advertising spending slowing, they were blindsided when the company reported its second consecutive year-on-year quarterly revenue decline . The company's contention was that the decline was driven by a slowing down in online advertising revenues at the firm, mirroring similar slowdowns at other online advertising platforms.

    That said, there is clearly more to it than an industry-wide slowdown, since the drop in revenues at Facebook has been larger than the drops seen across the sector; Google, for instance, reported a third quarter year-on-year revenue growth rate of 6% in October 2022.
  2. Drop in operating margins: The bigger shock in the most recent earnings report, in my view, was the collapse in operating margins.

    While the decline in operating income in the first two quarters of 2022 mirror drops in revenues in those quarters, the decline in the third quarter cannot be explained by lower revenues in that quarter. The company attributed the decline in operating income to its Reality Labs unit, which houses its VR headsets, with reported revenues of $285 million and an operating loss of $3.67 billion in the third quarter of 2022. 
It is undeniable that the third quarter numbers for Facebook were disappointing, but again taking a longer term perspective, most companies would gladly switch places with Facebook, with revenues of more than $100 billion, and operating margins of 20%-30%. The question that we face now, as prospective investors, is whether the market has overreacted to a quarter's bad numbers or whether this is the beginning of the end for the company's core business model. 

The Troubles

    While 2022 has been a particularly difficult year for Facebook, the troubles at the company date back to 2018, when it was revealed that Cambridge Analytica, a UK-based data service with political clients, had acquired and utilized Facebook data on tens of millions of users. In the aftermath, Facebook faced both political and investing backlash, with its stock price dropping by more than 10% and there were some doomsayers who argued that its business model was irretrievably broken, because of the privacy challenges. At the time, I pointed to the hypocrisy of critics complaining about Facebook's privacy lapses on their Facebook pages, and argued that the company would weather the scandal, albeit with scars. In the months after, that view was vindicated as Facebook spent billions on tightening security, while continuing to grow revenues and report sky-high margins, and the market responded by pushing up its stock price once again.

    While Facebook was able to deal with the privacy challenge, relatively unscathed in economic terms, there are three other problems that the company is facing that will not be as easily overcome:

  1. Online Ad Market Leveling off: Facebook is an online advertising company, and for much of its early years, it benefited from growth in the online advertising market, largely at the expense of traditional advertising (newspapers, television etc.). As online advertising approaches two-thirds of all advertising, that growth is now leveling off, and as one of the two largest players (and beneficiaries) of the market, Facebook is facing a growth crunch.
  2. Online advertising is cyclical: As online advertising has grown over the last decade, one of the questions has been whether it, like all advertising historically, is cyclical. Prior to this year, there were some who argued that online advertising would be more resilient than traditional advertising, in the face of economic shocks, but this year's developments have shown otherwise.  As economic growth has slowed and concerns about a recession have risen, revenue growth has dropped at all of the companies in this space has declined. The conclusion is that online advertising is cyclical, and if we are in the midst of an economic slowdown, the companies in this space will feel the pain.
  3. Reputation effects: While Facebook made it through the privacy challenges with revenue growth and profitability intact, it is undeniable that the company's reputation took a beating. In my view, this toxicity, as much as the desire to enter a new market in the Metaverse, explains why Facebook changed its name to Meta in November 2021. 

In fact, it is this trifecta of developments (a maturing online ad market, exposure to economic cyclicality and reputation damage), in conjunction with Facebook's disappointing operating numbers that has led investors to reassess its worth, and mark down its price. 

Corporate Governance

    As stock prices have dropped this year, not only is there an increased focus on earnings and cash flows, as I noted in my last post, but there seems to also be an reawakening among investors about the importance of corporate governance, as can be seen in this article about Facebook. Having seen these awakenings many times over the last 30 years, I am cynical that anything productive will come out of these discussions, since we seem to have lost sight of what corporate governance is and why it matters to investors.

The Stakeholders 

    To set the stage for understanding corporate governance, it is best to start with a recognition of the different stakeholders in a publicly traded company:

While all of these claim holders have stakes in the company, their interests will diverge, raising a key question of whose interests should be served by the managers of the company, when making business decisions, small or large. It is true that conventional corporate finance (and the Delaware courts) give primacy to shareholders, and it is not because shareholders are a special or protected group, but It is because they are the only claim holders that do not have a contractual claim on the firm; as shareholders you get what's left over after contractual claims (wages, interest expenses) have been met. Lenders can negotiate interest and principal payments and insert covenants to protect themselves, employees have employment contracts and sometimes unions to negotiate wages and benefits, and customers can choose to buy or not buy a company's products and services. 

    There is of course a notion that managers should be accountable to all stakeholders, not just stockholders, an idea that was born and nurtured in law schools, before finding a footing in business. In a 2019 post, I presented my arguments for why stakeholder wealth maximization is fanciful in its belief that it is management's job to juggle the divergent interests of different stakeholders and dangerous insofar as it makes managers accountable to everyone, and by extension, to no one. (Note that the G in ESG is about stakeholder governance, not shareholder governance, which may explain why CEOs have been so quick to jump on its bandwagon.)

Conflicts of Interests and Consequences
    If you are looking at a privately owned business, with a sole owner who also runs the business, the interests of owners and managers converge, but this is the exception, not the rule. Even in a family-owned business, where one family member runs the business, you can have other family members disagree about how it is run, leading to frictions and legal battles. (If you are a fan of Succession on HBO, you know exactly what I am talking about). As businesses seek external capital to grow, either from private hands (venture capitalists) or public equity, the divergence between the interests of those running businesses and the owners of these businesses will increase. That is the core challenge in corporate governance, and any discussion of the topic has to begin with answers to three questions:
  1. In what types of firms is this conflict of interest greatest? If the conflict of interest that is at the heart of corporate governance is that between the owners of a business and those who manage that business, it will begin when private businesses seek out capital from external sources, as founder and venture capital interests can diverge. These conflicts will expand, as companies go first go public, and the interests of insiders and founders, who run the firm, can be at odds with the interests of outside shareholders. As companies age, founders will move on and get replaced by professional managers, and these managerial interests can clearly be at odds with those of shareholders, with boards of directors, in theory, watching out for the latter. In short, conflicts of interest exist at almost all businesses, though the nature of the conflict will change as companies go from private to public, and as they age.
  2. When the interests of shareholders and corporate decision-makers diverge, what are the consequences for the company? When the interests of decision makers or managers at a business diverge from those of its owners, it is inevitable that there will be decisions made that advance the interests of the former at the expense of the latter. With private business that access venture capital, founders may make decisions (on product design, business models, marketing) that venture capitalists may not find to their liking. With public companies that are run by founders/insiders, the decisions made by inside shareholders to advance their interests may not align with the interests of outside shareholders. In older public companies, the investing, financing and dividend decisions that managers make may by in direct opposition to what shareholders would like them to do.
  3. What are the checks on these conflicts of interest? In each of the scenarios described above, it is true that there are mechanisms that exist to keep these conflicts in check. In private firms with venture capital investors, VC investors are often actively involved in management, and, if they have the power, have few compunctions about pushing out founder/managers who don’t serve their interests. In public companies, with insiders and founders in charge, the only recourse that outside shareholders often have, if they feel their interests are being ignored, is to sell and move on, hoping that the resulting drop in stock prices causes a change in course. In theory, the boards of directors at these companies are supposed to protect shareholder interests, but that protection is sporadic and often ineffective.
In short, while corporate governance is often framed as being entirely about the conflicts of interests between managers and shareholders at companies with dispersed shareholdings, its reach is much broader, and it is relevant at almost every business.

The Essence of Corporate Governance

    After five decades of research in corporate governance, my sense is that we have lost the forest for the trees, with the composition of boards of directors and rules on proxy voting receiving disproportionate attention, from both legislators and regulators, often at the expense of bigger and more consequential issues. In the aftermath of the Enron and Tyco scandals in the United States, where insider-dominated boards were negligent in their oversight responsibilities, the Sarbanes-Oxley Act was passed in 2002, with improved corporate governance as one of its objectives. At about the same time, you saw the advent of services that used the disclosures that companies were required to make on governance to estimate corporate governance scores. We were told at the time that the combination of independent boards, increased disclosure and governance scores would create a revolution in corporate governance, where managers would act to advance shareholder interests. It is clear that twenty years later that all that Sarbanes Oxley has accomplished is replacing ineffective insider-dominated boards with ineffective independent boards, while creating hundreds of pages of disclosure that no one reads and giving rise to scores that are close to useless in judging governance. With the push towards diversity in board composition now taking precedence, this process is hurtling even more into irrelevance, with the only positive being that the ineffective boards of the future will meet all our diversity criteria.

    I believe that for a true shift in corporate governance to happen, we have to reframe the meaning of good corporate governance, shifting away from a board-centered, check-box driven view to one that is centered on giving shareholders the power to change company management, if they choose to. In fact, good corporate governance is like a good democracy, where shareholders (voters) get the power to change management (governments), when they believe that their interests are not being served. As in a democracy, there is no guarantee that shareholders will make the right or even informed choices, sometimes choosing not to make changes, even when change is required, and sometimes deciding to replace good managers with bad ones. Good corporate governance is sometimes chaotic and often unsettling, and it is no surprise that there are many who are drawn to the benevolent dictatorship model, where "qualified, well-intentioned managers" are given lifetime tenure, with shareholders stripped of the power to challenge them. That latter model was the default for publicly traded companies in much of the world, for the twentieth century, and even in the US, you had managerial apologists like Marty Lipton and corporate strategists arguing that corporate management would be more effective, without shareholder oversight. 

The "Right" Management: A Corporate Life Cycle Perspective

    If corporate governance is about giving more power to business owners to change management at the companies that they are invested in, if they choose to, to understand it, we have to begin by looking at why management change may be needed in the first place. I will use the corporate life cycle, a structure that I have used in many other contexts, to set the stage for this discussion, by noting that the qualities that you will look for in "good" management will change as companies move through the life cycle, from start-up to growth to mature and then on to final decline. In the figure below, I have highlighted the role that top management play at a business, and how that role will change as companies age. 

Early in the life cycle, as a start-up, the quality that you value most in your top management (and especially in your CEO) is vision, the capacity to tell the story of the business, and get investors and employees on board. As you move from idea to product, you still need vision, but it has been paired with pragmatism, and you would like the business to be run by someone who is willing to make compromises on design and strategy, to create a market for the product. The trash can of failed businesses is filled with purist founders who insisted on having their way, and refused to bend their dreams to meet reality. In the next phase, you need a CEO who is willing to do the work needed to build a business, an often unexciting job that requires attention to supply chains, marketing campaigns and product manufacturing. As businesses look to scale up, they are best led by opportunists who can seek out new markets that allow small businesses to become bigger, and once mature, you want an executive at the top who can play defense against competitors and disruptors. In decline, you need a realist who takes what the business has to offer, and does not try to overreach, in many ways the polar opposite of the visionary you sought out as a start-up.

Management Mismatches across the Life Cycle

    Understanding how the qualities that you look for in good management change, as the company changes, provides a framework for assessing why you can end up with management mismatches, where the managers running the firm are unsuited to running it. In some cases, it can happen because the business changes (from start up to young growth or from high growth to mature), but the person running it does not, will not or cannot change. In other cases, it can represent a hiring mistake, as is the case when the board of directors at a high growth firm seek out the CEO of a mature company, competent but risk-averse, to run their business.  In still others, it can just be hopeful thinking, where the board of directors at a declining firm seek out a visionary CEO, hoping that this hire can reverse aging and become young again. In the figure below, I have listed CEO/Company mismatches across the life cycle:

I also highlight the catalysts for management change at each stage.  In very young firms, it is disgruntled venture capitalists who pressure founders who, they believe, are not paying enough attention to business-building, to change their ways or even leave their positions. In publicly traded firms, the catalysts can be activist investors, who pressure businesses to change the way they are run or even who runs them, hostile acquirers, hoping for revamps, or private equity funds, with plans for liquidating or breaking up the firm.

Management Mismatch Consequences
    In most firms, even in the countries that are viewed as strong on corporate governance, there are barriers to change that are daunting, which explains why forced management changes are infrequent. Thus, venture capitalists may be stymied, when trying to replace founders, by the founders' controlling stakes. With high-growth firms that are publicly traded, insiders and founders holding large stakes can make it difficult for outside shareholders to push for charge, and as firms mature and age, it is the passivity of institutional investors that is the biggest impediment to change. 

    When a management mismatch persists, the consequences can range from the benign to very damaging:

In the most benign case, the mismatched manager recognizes his or her limitations and hires help to remedy them. In my view, the biggest difference between Steve Jobs in his first iteration at Apple, when his stubbornness damaged the company, and his legendary second stint at the company, was the presence of Tim Cook, as his chief operating officer. In an intermediate scenario, the board of directors eventually faces up to the reality of the mismatch, often because of poor stock price performance, and replaces the management, but not before serious damage has been done. In the most malignant scenario, the mismatched manager stays in place, destroying value and running the business into the ground, and perhaps into bankruptcy.

Corporate Governance at Technology Companies
    With that long lead-in on corporate governance, let's look at technology companies, partly because they are the largest sector in terms of market capitalization, and partly because this post is on Facebook, a large technology company. I will argue, using the life cycle structure, that tech companies age much faster than non-tech businesses, and are thus more exposed to management mismatches. Troublingly, it is precisely in these companies, where the need for corporate governance is greatest, that we (as investors) seem to have acquiesced to structures that give us the least power to push for change.

The Compressed Life Cycle

    A corporate life cycle resembles the human life cycle, in terms of its sequence, but there are two significant differences. The first is that the mortality rate is far higher in the corporate life cycle, as more than two thirds of businesses do not make it through the early stages, than it is for human beings, at least in the twenty first century. The second is that unlike the human life, the corporate life cycle does not follow chronological time. Kongo Gumi, a family-owned Japanese company in the business of constructing temples and shrines, lasted for almost 1500 years, before being acquired in 2006. In contrast, there are businesses that are shooting stars that survive for only 15 or 20 years, before liquidating or selling themselves. In the figure below, I look at the variables that determine  how quickly a business grows, how long it stays at the top and the speed of its decline:

Companies in businesses with low capital intensity and ease of access to the market and capital will grow much more quickly than businesses without these characteristics, but those same features will make it difficult for them to stay at the top for very long and accelerate their decline. That is the basis for a post that I wrote about why technology companies have compressed life cycles, relative to manufacturing or infrastructure companies:

Just to illustrate, the great companies of the twentieth century, such as Exxon Mobil, GE and Ford, might be looking at the declining phases of their life cycles now, but they have had extraordinarily long lives (Exxon was founded in 1859, GE in 1892 and Ford in 1903). In contrast, a company like Yahoo! was able to get from its founding in 1994 to a hundred-billion dollar market capitalization five years later, but its glory days lasted until 2004, when Google entered the game, and decline, once it started, was unstoppable, leading to its demise in 2017. (Marissa Mayer tried, but she never had a chance...)

    We believe that this compressed life cycle has consequences for management mismatches. With the long life-cycle companies that characterizes the twentieth century, companies and managers both aged over time, allowing for transitions to occur more naturally. To see, why consider how corporate governance played out at Ford, a twentieth century corporate success story. Henry Ford, undoubtedly a visionary, but a crank on some dimensions, was Ford's CEO from 1906 to 1945. His vision of making automobiles affordable to the masses, with the Model T (but only in black), was a catalyst in Ford's success, but by the end of his tenure in 1945, his management style was already out of sync with the company. With Ford, time and mortality solved the problem, and his grandson, Henry Ford II, was a better custodian for the firms in the decades that followed. Put simply, when a company lasts for a century, the progression of time naturally takes care of mismatches and succession. In contrast, consider how quickly Blackberry, as a company, soared, how short its stay at the top was, and how steep its descent was, as other companies entered the smartphone business. Mike Lazaridis, one of the co-founders of the company, and Jim Balsillie, the CEO he hired in 1992 to guide the company, presided over both its soaring success, gaining accolades for their management skills for doing so, as well as its collapse, drawing jeers from the same crowd. By the time, the change in top management happened in 2012, it was viewed as too little, too late. Put simply, if the companies that dominate the market today have compressed life cycles, relative to the companies of the last century, we should ready ourselves for far more cases of management mismatches.

The Investor Surrender

    If you accept my thesis that shorter corporate life cycles increase the likelihood of management mismatches at companies, it follows that we, as investors, need tools and processes that increase our power to change management at these firms. It is in this context that we have look back, with dismay at how willingly we have given away the power to create change at companies, and especially so at technology companies. While corporate governance measurement services and academics were obsessing over board composition and management compensation, companies have been changing the rules of the governance game, tilting power decisively away from shareholders, with little or no pushback. In the last two decades, US companies,  have increasingly turned to dual-class shares, with one class having significantly more voting rights than the other, and with founders/insiders holding these voting shares. You can see this phenomenon play out in the chart below, where I graph out the percentage of companies, going public with dual-class shares, each year from 1980 to 2021:

By 2021, almost a third of all companies going public had two classes of shares, with different voting rights, and that trend was even stronger at tech companies, where close to half of all companies, going public, had shares with different voting rights in 2021. 

    Facebook, which went public in 2012, followed this path when it issued class A shares to the public, with one voting right per share, while Zuckerberg and a few insiders kept class B shares, with ten voting rights per share. In the figure below, you see the breakdown of share holding in both class A and class B shares at Facebook:

Cutting to the chase, Zuckerberg controls 57% of the voting rights in the company, while owning only 13.52% of all outstanding shares, largely because he holds the bulk of the voting shares. Rather Han a corporate democracy, Facebook’s elections resemble those in authoritarian regimes, where you can vote for whoever you want, but the winner is pre-determined. (Just as an aside, I found a Facebook proposal to the SEC, thankfully stillborn, to create Class C shares with no voting rights, in 2017. That would have added insult to injury!)

    In short, shareholders have been disempowered at some of our largest and most valuable companies, and they have, for the most part, gone along. There is plenty of blame to go around, but the following culprits stand out:

  1. Market-share seeking Stock Exchanges: For much of the last century, starting with a de facto ban in 1926 and a rule in 1940, the New York Stock Exchange barred companies listed on the exchange from  from issuing shares with different voting rights, and with its dominance over US equity markets, that became the rule followed by most US companies. The American Stock Exchange adopted slightly looser rules, hoping to get market share from the NYSE, but it was the NASDAQ that threw caution to the winds entirely and removed all restrictions on voting and non-voting shares. That proved to be a great business decision, since the largest tech companies of this century have not only listed on the NASDAQ, but chosen to stay there, but it came at the expense of shareholder powers.
  2. Founder Worshippers: For the last few decades, we have glorified the founders of technology companies, and while there is much to admire in their accomplishments, there is a danger in putting them on pedestals and attributing to them heroic or superhuman qualities. In the case of companies like Google and Facebook, and especially so at the time of their public offerings, there were many investors, including some of the largest institutional players, that were willing to make the trade off of giving up power to change management in return for being invested in companies run by "young, tech geniuses". In fact, there are some researchers who were willing to argue that removing the threat of shareholder power made founder-run companies more valuable, because founders are smarter and think more long-term than investors. 
  3. Lazy Investors: Much as we would like to blame others for our misfortunes, the truth is that get the corporate governance we deserve. Most of us, as investors, chose to give away our voting rights willingly because we wanted shares of the "next big thing", and at the time we did so, we rationalized it by arguing it that we would not need that voting power any time soon. I have little sympathy for the hand wringing and complaints from investors, institutional or retail, in Facebook that management is not listening to them. Investing in Facebook and complaining that Mark Zuckerberg will not listen to you is like getting married to one of the Kardashians and complaining that your privacy is being invaded.
  4. Lax Regulators: For some of you reading this post, the villain is going to be the SEC and regulators, with the argument being that they could have protected you by banning dual class shares. I see your point, but remember that the inertia, laziness or me-tooism that led you to buy dual-class shares, will outlast the regulatory ban. Regulators cannot protect us from our own worst instincts!
There may not be much you can do about companies that have already adopted dual-class shares, but marking their prices down will make them pay attention. Who knows? Losing a chunk of their wealth may lead the founders who run some of these companies to reassess their positions on differential voting rights.

The Consequences

    If the essence of corporate governance is the giving shareholders the power to change management at companies, where there is a mismatch, and if those mismatches are more likely to occur at tech companies, where shareholders have unilaterally disarmed, there are predictable consequences:

  1. Chaotic Management Transitions: It is true that we have made it more difficult to change management at tech companies, even when that change is overdue. That said, there will be tech companies where change will occur, but my prediction is that this change will often be forced by either insider in-fighting (where co-founders and insiders turn on each other) or precipitated by a pricing collapse. While Elon Musk’s acquisition of Twitter is one of a kind, the chaos that you are observing at the company is a precursor to changes that you will see at other tech companies in the years to come.
  2. Locked-in Mismatches: There are other tech companies where the game has been so thoroughly tilted in favor of insiders and incumbent management that change is impossible. In these companies, as an outside investor, you have to build that reality into your valuations, leading to discounts to your value that reflect how much you trust management. In short, if management has adopted policies that are value-destructive, in the long term, there will be a much smaller chance of reversal at companies with locked-in management than at companies where change remains possible. In the case of Facebook, the company has clearly made a huge bet on the Metaverse, investing $15 billion in the most recent year and planning almost $100 billion in additional investments in the coming years. It is too early to pass judgment on whether these investments will pay off, but assume that the data that comes in over the next two years indicates that Facebook should scale back its investments and slow down. I would like to believe that Zuckerberg is too smart a businessman not to do the right thing, but the qualities that made him a successful founder (over confidence, stubbornness in the face of failure, arrogance) may very well keep him on his pre-determined path, and without checks and balances, Facebook will lose a lot more money over a longer period, before he gives in. 
  3. Voting Share/Non-voting Shares: In a paper on valuing control from a  few years ago, I argued that the differential in prices between voting and non-voting shares will reflect the value of expected control in a company, and will be higher at companies where management change is plausible than in firms where it is unlikely. When tech companies go public, it is entirely possible that there will be a honeymoon period, perhaps even an extended one, where investors are dazzled by scaling successes and are willing to overlook shortcoming, when shares with different voting rights trade at the similar prices. As disillusionment sets in, I would expect voting share premiums to rise, and to rise more at those firms where investors trust managers the least.
As investors, should you avoid investing in tech companies with dual-voting right shares? If I said yes, I would be violating one of my own precepts, which is that I will buy any company, no matter what its faults, at the right price. You should avoid investing in these companies when they are priced on the presumption that their founder-managers can do no wrong, but as fear overcomes greed in markets, investors in these companies will start pricing in the worst-case scenarios, where founders continue with dysfunctional behavior in perpetuity, and at those prices, you may be getting bargains.  That is what I see happening, in 2022, at Facebook, in particular, and large tech companies, in general. It is the reason that having lost money on Facebook, since buying it in April, I will continue to hold it and I did add to my holdings, when the stock hit $100/share. I know that my Facebook investment will ride and fall with Mark Zuckerberg's ego, and while I have no delusions about being able to influence him, I think that at today's prices, the odds are in my favor. Time will tell!

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