Facebook's ONLY failure: Expectations management

Bubble stock shock

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Open ... and Shut As I type this, Facebook stock is trending toward a $26.84 per share price, valuing the company at $57bn, or roughly half the value Facebook held on its first day of trading two weeks ago. While the market plays a round of "You're to Blame!", Facebook is suffering from inflated expectations. Facebook's net profit margin and operating margin have both dropped since 2011, as expenses have mounted but revenues in its fast-growing mobile market have failed to keep pace. Its clear that Facebook isn't made of magical pixie dust.

It's also clear, however, that Facebook is an exceptional company that is doing quite well. The problem is one of managing investor expectations, and not really of managing the business.

Nor is Facebook alone in this. Silicon Valley is filled with promising businesses – eg, Groupon, Zynga, Jive, etc – that are getting hammered on the stock market because they've allowed the expectations of their business exceed the reality of their businesses. Those "realities" are not always rosy, but they are far more positive than gloomy.

Now if only the Silicon Valley hype-meisters could get in lock-step with the investors they keep duping...

But that's not likely to happen anytime soon. Silicon Valley's founders and venture capitalists still have far too much to gain by hyping valuations far beyond the fundamentals of their businesses. So long as investors are dumb enough to buy into hyper-inflated price-to-earnings (P/E) ratios, Silicon Valley will keep selling to them. Over the last 100 years, the average P/E is 15. Facebook's at the time of its IPO? 100.

What this means is that investors were willing to throw money at a company that couldn't hope to generate enough profit to pay back its valuation sooner than over 100 years. It means that these same investors were betting that Facebook could double its profits every year for several years, which would require claiming 10 per cent of all advertising dollars spent globally.

Possible? Perhaps. Likely? Not a chance.

Is this Facebook's fault? That's tough to say. The company managed to price its IPO to maximise its personal benefit, but before we find fault it's worth considering that it had little choice but to go for a $100bn valuation. As Barry Ritholtz, CEO of investment firm Fusion IQ, argues, Morgan Stanley, the underwriter for Facebook's IPO, was "hemmed in by the inefficient, opaque, clumsy secondary markets that had overpriced the shares".

This is a bit unfair on Facebook, which fired one senior employee for buying Facebook on a secondary market in early 2011 and has long seemed reluctant to countenance the markets, which forced the company toward an IPO, due to US securities regulations. Facebook also actively tried to block transfer of its shares on secondary markets through high fees and through the issuance of restricted stock units (RSUs) instead of options.

Facebook's main sin, like that of Zynga and other hot tech companies, may be that it didn't start to police transactions early enough.

With such crazed speculation piling onto Facebook's shares, its IPO was always going to be a crash course in navigating silly expectations based on hopeful dreams, not fundamentals. But Wall Street is ultimately governed by "old-fashioned" things like "profit" and "revenue", things even Silicon Valley must learn to care about.

However, as mentioned above, many of the same companies currently getting bludgeoned for their hype-inflated stock prices are the same companies that have built exceptional businesses. They just don't yet deserve galactic stock valuations.

Consider Splunk, which just took a beating because it could "only" deliver 80 per cent revenue growth. Its revenue growth is chugging along at a healthy 37.8 per cent. The problem is not really in its business, then, but rather in the expectations of its business.

Jive, too, has taken a big plunge off its initial $1.6bn valuation, now hovering under $1bn. Its financials are not as good as Splunk's, with red ink all over its books. But it has been growing revenue at a solid clip and narrowing its losses by a considerable margin over the last year. It's a good business that promises to get better. It just doesn't yet deserve an over-exuberant valuation.

The list goes on. One of the few companies to stand against the tide of IPO fallout is LinkedIn, which has consistently generated good financials and a good stock price. If its revenue growth dips – and there are good reasons to think this could happen – then its stock will get hit. But I suspect it won't plummet in the same way that Zynga, Groupon, and others have been slaughtered. Why? Because LinkedIn has been much more conservative in representing its business to the world. The company has always seemed a little staid, a little boring, compared to its high-flying peers. Ultimately, boring, predictable growth is much better than "Get on this rocket ship now!!!!" kind of growth.

Because ultimately only one is sustainable.

Perhaps this is one reason that while enterprise technology startups don't get a lot of love from Silicon Valley investors, they're getting a lot of love on the public stock markets. Of the 25 fastest-growing public tech companies, a full 21 are enterprise technology companies. They don't generate much hype, the Qliks and the Riverbeds and the Sourcefires, but they generate solid, predictable growth. It turns out this is a Very Good Thing on Wall Street.

It should be the same on Sand Hill Road, Silicon Valley's storied road of venture capital riches. With the fallout from Facebook's IPO, perhaps VCs will come to care about real revenue growth again, and not merely adoption and other pseudo-proxies for true growth. At some point every business needs to make money to justify its existence, because that's what businesses do.

At least, those not in Silicon Valley. ®

Matt Asay is senior vice president of business development at Nodeable, offering systems management for managing and analysing cloud-based data. He was formerly SVP of biz dev at HTML5 start-up Strobe and chief operating officer of Ubuntu commercial operation Canonical. With more than a decade spent in open source, Asay served as Alfresco's general manager for the Americas and vice president of business development, and he helped put Novell on its open source track. Asay is an emeritus board member of the Open Source Initiative (OSI). His column, Open...and Shut, appears three times a week on The Register.

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