# Tesla Update. Two Key Lessons.

I took some profits in my Tesla (\$TSLA) position yesterday for the first time in 7 years. Technically, this was my second time taking profits, but the last I rolled my profit into Solar City (\$SCTY), which was acquired by Tesla a year later.

Tesla’s share price was up over 50% on the week and up over 100% since the beginning of the year. This after a decent 30%+ gain in 2019. To me, the last week of action was an obvious “short squeeze” situation, making it a good time to take profits.

Another thing on my mind was the fact that Tesla stock is now about 10% of our net worth (minus the value of our business) and about 20% of my stock holdings across all of my retirement and brokerage accounts. I’m not too too worried about this. As Warren Buffet once said “If you have LeBron James on your team, don’t take him out of the game just to make room for someone else. … It’s crazy to put money into your 20th choice rather than your first choice.” Tesla is the Lebron James of my investment accounts.

The final thing I was thinking about was numbers from my Simple Tesla Model. A few years ago, I put together a simple spreadsheet to calculate the potential revenue, earnings, and share price of Tesla stock based on the production estimates Elon Musk was putting out. This is the first lesson I wanted to reiterate in light of the action in Tesla stock this week.

## Lesson 1: Don’t forget Main Street. Build Real World Models of How The Businesses Behind Your Stocks Make Money.

It’s easy to get caught up in the numbers and calculations of Wall Street. What’s a good PE ratio for a certain sector? This company has grown sales at 50% per year and could continue growing 50% per year for the next 5 years. This kind of math is useful for comparisons and valuations, but you want to make sure you take a step back and think about what that company looks like in the real world (Main Street) after growing revenues 50% for 5 years. Is that REALLY possible?

At the time I built my simple model spreadsheet for Tesla, there were many people talking about how a valuation in the tens of billions of dollars didn’t make sense for a company like Tesla. Traders who were short the stock talked about how Tesla could never make enough money to justify their share price. But when I put my spreadsheet together, I found that if Tesla could sell 500k cars, they’d likely make \$28B in revenue, which would justify a stock price as high as \$517. If Tesla only got halfway there, they’d be worth much more than the \$200 or so they were trading at in 2016.

To calculate in the risk of bankruptcy or larger failure, you would want to discount the price targets of the model to account for this, but we were already assuming Tesla would only hit 50% of their target, never grow past that, and never make money off their other business lines.

I’ve updated this model a couple times, most recently today. The current tab indicates a future share price of \$494 if Tesla can hit about 392k cars sold this year. This is BELOW the current price of \$734. And so I am much more comfortable selling Tesla stock when it’s trading above the values my models are spitting out.

Again, while I’ve updated the model to account for energy sales and service revenue, it assumes no growth in car manufacturing or those other business lines. If you plug in different numbers for where you expect Tesla to be 5 years out, you’ll get different targets.

I was also reminded of another important investing lesson:

## Lesson 2: Stock Prices Go Up Even When Companies are Not Yet Profitable

Many investors have shied away from investing in Tesla because they feared the company would never turn a profit and thus eventually run into cashflow problems. Not even eventually, Tesla’s investments into the Giga Factory and in general have required them to raise money through special stock sales a few times in the past. Each time this happens, the value of your Tesla stock is diluted.

If you wait for a high flying companies to turn a profit before investing, you might be waiting a long time and miss out on huge returns. Another big winner in my portfolios has been Amazon, who famously hit almost exactly \$0 profit each year for most of its existence. Only recently have they been showing a profit, and I would guess Bezos and Amazon would invest more to avoid that profit if they had things to invest in. (Or I don’t know, maybe they think they need the cash now.)

In any case, if you waited for Amazon to turn a profit, you missed a large gain from a well run company that is changing the world. The same can be said for Tesla. So how do you invest with confidence in a company that makes no profit? Here’s what I do.

First, I focus on revenues. As long as revenue is growing or likely to grow from current investments, I feel the companies stock is likely to grow in value as well. I lean toward valuation calculations based on revenue.

Second, I think about whether the company will be able to switch their focus from revenue to profits when they want to later. Will Amazon or Netflix be able to raise their prices? Will Tesla be able to lower their production costs? I tend to give these companies the benefit of the doubt unless there are very obvious concerns about this. You can choose to focus on the negatives, like when Tesla was forced to build cars in tents in the parking lot. Or you can focus on the positives that will drive higher production speed and higher sales margins. Things like removing purchase options that slow down production and figuring out the right mix of automated and human-powered labor will improve Tesla’s bottom line.

With more and more people switching to electric cars, Tesla continuing to own the electric car market, Tesla ramping up production in its existing factories and planning on building even more factories, the Model Y coming out soon, and so much potential in their other products… Tesla is set to potentially become a very large company making a lot of money. Tesla stock has generated a lot of returns for its investors and has a grand enough vision to continue doing that. That said, while the stock is temporarily inflated from a short squeeze, I booked some profits. Tesla is still a large percentage of my investment accounts, and I will continue to try to add to my position if and when the stock’s price falls below my fair value calculations.

# When does Twitter Stock become cheap?

I’m reading the book Sapiens: A Brief History of Humankind by Yuval Noah Harari. In a section on the Agricultural revolution, Harari reminds us that while farming allowed human populations to grow, the quality of life for the average farmer was worse than the average hunter-gatherer. Farmers worked longer hours, with worse health, and generally lived more repetitive (and possibly more boring) lives than their hunter-gatherer counterparts.

Still, living in cities with farms to work on meant more babies, which meant more people with more reason to cooperate, leading over the years to the complicated network of nations and societies we live in today. Similarly, are modern day humans are working harder than our ancestors worked. Are we living longer, but less fulfilling lives?

It’s unclear to me whether tools like Twitter, which are taking up more and more of our precious time, are making our lives better or worse. It does seem to me however, that Twitter and the Internet in general are bringing people together cognitively in the same way that farms brought people together physically. While sporting events, movie launches, wars and riots happen in different places all over the globe, everyone can share in these experiences in the same virtual space in real time scrolling through Twitter feeds 140 characters at a time.

What does this have to do with Twitter as a company and stock? I’m not sure, but hopefully we can come together here to figure out if Twitter is a good investment at \$22.45 per share.

Twitter (TWTR) stock is trading at around \$22.45 a share right now, putting it at a market cap of \$15.7 Billion. They have about \$4B in cash, revenues of \$2-\$B, and trailing 12 month earnings per share of -\$0.86 (negative 86 cents). Twitter IPO’d around \$45 per share, hit an all time high around \$75 per share earlier this year, and has since tumbled to the current price.

### Is Twitter stock cheap yet?

The answer to this depends on what metrics you are using for valuation. Technology companies like Twitter, which have ubiquitous use but indirect methods of making money, are especially hard to value. I’ll try my best.

For mature companies there are two benchmarks that I like to use when valuing a company. (1) A price to earnings ration (PE) of 15. (2) A market cap that is 2x revenue.

Why these numbers? I think that’s a good topic for another post or ten, but in short a PE of 15 is roughly the long term average PE for the entire stock market. Similarly 2x revenue is fairly average for companies across industries and maps pretty well to the 15 PE if you consider an operating margin around 10-20%.

These numbers are most definitely rules of thumb and shouldn’t be held sacred, however they are a good starting point for analyzing a stock. If a stock doesn’t trade at a 15 PE or 2x revenue, that is normal and expected, but you can learn a lot by asking WHY the stock is trading at a different PE or revenue number. Is there something structural about the company that makes it more or less profitable than others? Or, as we’ll find is the case with Twitter, do we need to wait around for revenue growth to justify the market cap.

Where does Twitter stand from a revenue and PE perspective? As of writing…

Stock Price: \$22.45
Market Cap: \$15.7B
PE: N/A (negative  86 cents per share earnings)
Revenue: 7x Revenue (estimated \$2.2B in 2015)

Not looking good, but let’s ask why the PE is negative and why the revenue multiple is so high.

### Why is the Twitter PE negative?

Twitter is spending more money than it makes. Obviously this can’t be sustained, but it makes sense for young companies that are transitioning from a user growth phase into a revenue growth phase.

Twitter earnings are also hard to figure out due to the large amount of stock options they use to compensate their employees which makes for a large difference between their GAAP (generally accepted accounting principles) and non-GAAP (shit we just made up) earnings numbers. This post is from 2014, but explains the difference in Twitter’s case pretty well.

As an aside, non-GAAP numbers are fine in principle and often help investors to understand special cases with regards to how a company is making money. More and more companies though are paying their employees in stock options, effectively moving that expense off the books by using non-GAAP numbers or diluting outstanding shares. It makes our job as investors harder.

The bottom line for Twitter’s PE is that negative earnings are obviously bad and if you invest in Twitter, you have to have some expectation that earnings will turn around at some point in the future. Hopefully sometimes soon before cash reserves run out. The good news is that Twitter’s earnings are trending up and future estimates are positive.

Specifically, to justify a \$15B market cap at a 15 PE, Twitter would need to generate earnings of \$1B per year. As we’ll see below, getting to the revenue and operating margin to bring in \$1B in earnings should be very doable for Twitter a few years out.

### Why is Twitter’s revenue multiple so high?

Twitter is currently trading at 7x revenue, which is above our 2x revenue benchmark. Why?

Again, Twitter is growing and investors know this. The 2x benchmark is for a mature company, i.e. one that is not growing or growing slowly. Twitter revenues are growing somewhere north of 50% quarter over quarter and year over year. At these rates, \$2B in revenue in 2015 becomes \$3B in revenue in 2016, \$4.5B in 2017, etc.

The obvious next questions are if current growth rates can last (hint: they never do), how they will trend in the future, and if the company will be able to make a profit on those future revenues.

### How big can Twitter revenue grow?

I’ll use a really simple method to calculate further revenues, which I’ll call “Twitter will make as much money as Facebook does”. More specifically, I suspect that Twitter will be able to make as much per user as Facebook is.

Anecdotally, Twitter’s new “put a sponsored tweet where you expect to see replies or click to reply” tactic is super annoying and probably making bank for them. I expect their revenue to beat in their next earnings report.

Facebook has about 4x the number of monthly active users (1.2B vs 300mm) but is making 8x the revenue (\$17.4B vs \$2.B). I believe that Twitter can close the gap and should be able to make at least \$4.4B from their 300mm users. This would put their revenue multiple at a respectable 3x. If we expect their user numbers to grow as well, they can very reasonably reach a 2x revenue multiple in 2-4 years.

A 20-25% profit margin (reasonable for an Internet services company) on \$4.4B in revenues leads to ~\$1B in earnings or that 15 PE we’re looking for as well.

We’re just doing math here, so it’s important for everyone to do their own homework to see if they think that these numbers we end up with make sense. The particulars of each company, what I would call “Main Street Analysis”, will tell you in the numbers make sense. In practice that might look like a lot of reading of earnings reports, other analysis, or general knowledge of how the business works. In our case, we’re being lazy and just saying that Twitter will have a similar trajectory that Facebook has had since IPO.

Based on this analysis and the expectation that Twitter can get to \$4.5B in revenue and grow respectively from there, Twitter is about fairly valued and just starting to get cheap. So I personally am considering starting a position with the expectation to add more as the price drops. I’ll probably purchase shares in my children’s brokerage accounts. (Christmas money for the win.)

If you expect Twitter to grow into more than just a platform to show ads occasionally to 300m people, you can basically get all of that extra stuff for free. The current price is inline with the straight forward, low risk, advertising business Twitter has now. So any extra revenue from Periscope, premium services, digital ID fees, or spoils collected from the governments it overthrows is gravy.

In my opinion, Twitter is very much an integral part of our society. When news happens, it happens on Twitter first. Facebook is starting to work like Twitter in this way, but I don’t see it overtaking Twitter without losing all of the other stuff we like about Facebook. The hole quick, 140 character, nonchalant nature of Twitter is actually exactly what makes it work so well. And considering they are ingrained in every news organization, business, and with every celebrity, I don’t see another service overtaking them without warning.

Assuming the general market doesn’t suffer a pull back, Twitter should be free of any new “bad news” that could move the stock lower. Weak investors should be shaken out soon, and if Twitter continues to grow as I expect it to, I suspect a slow rise with each new earnings report. Look for the stock to trade a bit lower, but turn around soon, and then rise up steadily from there.

# Apple. When are the fundamentals of the stock ever going to take charge of its price?

This post is inspired by a post by the user cyice on Stocktwits, who said: “when are the fundamentals of the stock ever going to take charge of its price“.

At \$110 a share, Apple (\$AAPL) is down around \$20 or 16% from it’s highs just over \$132. The stock trades at a PE ratio of 13. Minus the \$200B in cash Apple has, that’s a PE of about 9. Meanwhile, companies like Google and Microsoft trade at PEs of 20 and 32 respectively.

I won’t go into why the market thinks Apple deserves a PE 1/2 of other tech companies (I wrote it up and decided to scratch it — the market is crazy and crazy hard to understand). If we just assume that the market has different rules for Apple, we can try to figure out what those rules are.

A chart…

In July 2013, Apple traded at \$60 with a PE around 10. It touched \$130 this year and a PE around 15 and now trades at \$110 with a PE around 13. Also notice how the price bounced off the 200 day moving average in July 2013.

So one answer to the “when are the fundamentals of the stock ever going to take charge of its price” would be around a 10 PE, which would correspond to a price of about \$90 and also come close to that 200DMA. I’m long Apple in a retirement account and would back the truck up if it dips down around this area.

# The Long Case for Zynga \$ZNGA

Aside: I’m going to try to blog here when I do research for stocks I’m investing in and in particular when I am sharing ideas with my mother. Explaining an investment to my mother and to the blog here are remarkably similar processes… so two birds with one stone and all.

Next up: Zynga (ZNGA).

Zynga makes games for mobile phones and tablets and also for sites like Facebook. They famously made their fortunes on the back of games like Farmville and Mafia Wars before going public. Since then, they have done a number of acquisitions and spent a bunch of money, but generally failed to create hits as big as Farmville was at the time. Their stock has tanked from \$10/share at IPO to ~\$2.85/share right now.

Sounds glum, so why am I bullish now? I’ll try to bullet point the case here, dive into some of the numbers, and then post the risks.

### The Case

1. Downside is limited by cash and assets.

At \$2.85, Zynga’s market cap is about \$2.62 Billion. In 2014, they had about \$1.8 B in shareholder equity, including about \$1B in cash and equivalents and a \$300m office. This puts a floor of about \$2/share on the stock, with technical support at \$2.50.

2. Revenue is turning around.

Revenue numbers were up year over year the past 3 quarters. Zynga is already set to post their first annual YoY gain in revenue since the IPO and a surprise this quarter topping \$175m (which is above most estimates) would mean 4 quarters in a row of YoY revenue growth.

It appears that Zynga is turning the corner on revenues, and while up from all time lows, the stock price still seems to reflect a company that is shrinking and not growing.

3. Mobile games industry is still growing.

By one account, the mobile games market grew from \$21.7B to \$25 from 2013 to 2014. That 15% per year growth is going to be a nice tailwind for the mobile games market. So even though Zynga is not the only game in town, the pie is getting bigger.

Many traders are watching the iOS and Android store “top grossing” charts and trading parent companies as games move up and down the list. The position of games on this list is a great indicator of revenues for the parent companies, but it seems people are being harsh as games move down the list. A top 10 spot on the list today is worth as much as the top 1 spot a few years ago. And so Zynga with 2 top 20 games in Hit it Rich and Wizard of Oz Slots is making decent revenue despite sliding down the list a bit.

4. Games pipeline is strong.

Zynga released Empires and Allies this quarter, which has done well on the charts. It’s recently jumped up the free downloads chart (as high as #1) while simultaneously sliding down the grossing charts. This is really odd, and some have accused Zynga of manipulating the free downloads charts. There have been bugs forcing people to reinstalls (probably not adding bugs on purpose) and Zynga has been advertising Empires and Allies on Twitter and other places, both of which would inflate download numbers.

Historically, Zynga has done much advertising promotion for their games. Instead they relied on their social integration to get gamers to bug their Facebook friends for virtual wood to build their farms. In my opinion, the fact that Zynga is starting to advertise Empires and Allies is more a sign that they believe they have a good pipeline to convert ads into real customers than a sign of desperation to inflate unimportant numbers.

Besides Empires and Allies, Zynga will be releasing a couple games from Natural Motion which they acquired last year: CSR2 Mobile Racing and Dawn of Titans. Both games are visually heads and shoulders above other mobile games and could be very popular as customers look for something to take advantage of the beefier tablets coming out.

There is more demand for ads on mobile devices and game developers are getting better at integrating ads into their games in ways that are not intrusive and actually encourage users to watch video ads. In particular, users can watch video ads in Zynga slot games to earn money to spend on the slots. Similar features are being added to exiting Zynga games and will surely be included in all future games.

Ad revenues are not incorporated into iOS and Android “Top Grossing” and so can be missed by traders and investors focusing on those numbers.

Higher revenue from smarter ads means that Zynga can earn higher revenue even with lower daily active users.

6. Real Money Gaming could be huge.

Real money gaming hasn’t taken off on mobile yet, but as regulations loosen up or companies get bolder things could start moving fast. Gambling via fantasy sports is a booming industry, which is an indicator of demand for fantasy sports but also for gambling.

Zynga is in a good position here with top casino games, the top free poker game, and lots of real money gaming patents.

Future Stock Price Estimates

The general thesis here is that revenues are turning around, existing cash cows and cash chickens will support current levels of revenue while new games and eventually real money games will support growth in revenue.

If Zynga can grow back to \$1.2B/year in revenue and and make \$360m/year on 30% gross margins, their stock price could be:

• \$4.02 based on 2x revenue + cash value (\$3.7B Market Cap).
• \$6.03 based on 15 PE (\$5.55B Market Cap)

Again, this would be based on the assumption that Zynga can double revenues and achieve a decent profit margin. Considering they’ve hit these revenue numbers before, it’s not unreasonable to think a more mature Zynga might “get lucky” again.

It took Zynga 3 years to shrink from \$1.2B/year revenue to \$680m/year. If it takes 3 years to grow back to that level, the estimates prices above would represent total gains of 40% and 111% respectively, or annualized returns of 12% and 28% respectively.

Still, there are risks…

### Risks

The main risk to this thesis is that existing Zynga games drop off in users and revenue while new games coming out fail to gain users.

Also there isn’t a great explanation why Empires and Allies can have so many downloads without a similarly high placement on the top grossing lists. It could be that Zynga is wasting money advertising Empires and Allies without a proper return.

If the turn around in Zynga’s revenue is not accompanied by a turn around in earnings this year, then they will continue to lose cash pushing the \$2 price floor lower.

### Summary

I have a position in Zynga shares averaged around \$2.90 a share and added an amount equal to 50% of my old position recently in anticipation of Zynga beating Q2 revenue and earnings estimates in their August 8th earnings call.

If the earnings goes well, Zynga should climb to \$3.50 or higher. If not, there could be a pull back with technical support at \$2.50 and fundamental support at \$2.00.

# Looks like a buying opportunity in BBBY

My Mom asked me about Bed Bath and Beyond recently. She used to be a store manager there. She sold her stock a while ago (missed that big up swing) but thinks there may be a buying opportunity now. I also owned some way back and sold after a small gain, missing most of the big 2-3 year rally here.

Anyway, here is my analysis and response to her. (The spreadsheet I refer to is one based on Phil Town’s Payback Time book you should be able to find on his tools page here.)

BBBY looks like a good buy. They are in sound financial shape. I’ll save you the math, but here are some numbers. You can dig them out of the attached spreadsheet as well.

Earnings Per Share: 4.291
Earnings Growth Rate: 15% (Past 3 years has been 21%, analysts expect about 14-15% going forward. I usually take the lower of these.)
Average PE: 15
Min Acceptable Rate of Return: 15% (what we hope to make on our investments)
Margin of Safety: 50% (We want to buy \$1 worth of a company for \$0.50 just to be safe.)

Based on the above, the “sticker price” for BBBY is \$64.37. That means, this is the true value of the company if you expect all of the numbers above to go on for the next 5-10 years (e.g. keep growing at 15%) and have a rational market. (FWIW Trefis has BBBY valued at \$74.77. That’s the price they’ll show in Etrade in the research.)

The MOS price (we want to get a bargin) is \$32.18. This is the “it’s dumb NOT to buy this company at this price” price. If you change the MOS from 50% to 25%, which you can do if you feel you have extra knowledge about the company to lower the risk of something surprising happening against you, the MOS price become ~\$48.

So based on my #s the company is slightly undervalued (by about 20%) at \$55.

Here’s a 3 year chart to see what’s happened lately.

So there was a nice uptrend channel for the past 2-3 years that has been broken toward the downside. This is a stock in recovery mode. The next level of support is at \$50. Based on the chart, this stock will very very likely hit \$50. If that supports well, it should develop from there into a new uptrend. With new resistance at \$60, and the former trend line resistance back at \$75-80.

So things to think about: The trade here isn’t to buy and wait for it to go up and sell higher. That’s what you do when the stock is within the channel like it was for the past few years. Now you accumulate stock as cheaply as possible and wait for things to turn around to sell. I guess another way to put it is that this chart tells you more about when to buy vs. when to sell.

I would buy no more than a 25% position now. Buy 25% more if/when it hits \$50, and then if it drops below \$50, buy at \$40ish and \$35ish. At that level, unless the company is about to go out of business the stock price will be a bargain and turn around eventually. (Kind of like the ZNGA at \$2 buy and the NFLX at \$60 buys.)

If it stabilizes at \$50, then you can play that other 50% once it defines a new uptrend.

The one thing I didn’t talk about here is any news about the company. I haven’t heard anything and didn’t search the news while looking this stuff up. Did anything big happen to BBBY besides missing earnings this past quarter?

I may buy some of this too. I’ll let you know what I do.

# Trefis Puts Facebook at \$74 Billion

Trefis provides some great reports that show up in my Etrade account. Their analysis is very thorough. I especially like how they break down different business units and how much of a stock’s share price is tied to each unit.

Trefis values Facebook (based on the limited pre-IPO information they have) at \$74 Billion, based largely on their advertising business and growth via a growing user base (from 800 million to 2.6 billion) and increased ad revenues from video and music services Facebook is working on.

They go into how their estimates could be tweaked to get to a \$100B valuation. It’s interesting to see this analysis getting to a \$100B valuation without any new revenue streams outside of advertising. They basically give the very very optimistic view in terms to user and ad revenue growth.

# Facebook IPO Best and Worst Case Scenarios

Facebook released their numbers in preparation for an IPO, showing 2011 revenue of \$3.7 Billion and profits of \$1 Billion. Speculation is the IPO will be valued as high as \$100 Billion.

This would be a P/E of 100. That’s high, but then P/E’s are not as significant an indicator for young companies with a lot of growth potential. So can Facebook grow enough to justify a \$100 Billion price tag? I’m not so sure.

The easy justification goes like this:

• Facebook has been focused on user growth and they were still growing 100% per year. When they switch focus to revenues, they’ll make much more.
• If they “just” double revenue and profits in 2012 and again in 2013, that 100 PE will shrink to a 25 PE.

So that would be a \$100 B company making \$4B per year on \$15B revenue or so. (For comparison, Google has a \$190B market cap and made about \$10B profits on \$38B revenue in 2011.) One could see the stock of a company growing like that getting a 50 P/E and basically doubling your IPO investment in 2 years. It’s plausable.

All those numbers were out my ass. It’s easy to multiply numbers on a calculator. But how will Facebook REALLY make an additional \$11B in revenue and \$3B in profit?

### The Best Case Scenario

Facebook makes money on advertising on their site. They also make money from virtual currency sales, i.e. in-game payments in Zynga games. Roughly:

• \$1B from virtual currency.

Both those numbers will have to double twice over two years to get to our \$15B revenue target. (Same math as above.)

But what the hell, this is the best case scenario after all. Ad sales grow to Google proportions and hit \$12B in revenue.

Can virtual currency sales grow 200% over two years? Who’s the king in app sales? Apple. In the last quarter of 2011, when Apple made pretty much more money than any company has ever made, they made a cool \$2B on “Other music related products and services”, which includes “revenue from sales from the iTunes Store, App Store, and iBookstore in addition to sales of iPod services and Applebranded and third-party iPod accessories.” (Apple’s SEC Filing)

Let’s say Apple keeps that up for the next 3 quarters. They will make \$8B from app sales, music sales, books, and in-game sales. Facebook doesn’t currently sell apps, music, or books, but maybe they will start. Are they going to become half as big a player here as Apple is now? Let’s give them the benefit of the doubt. Facebook is one step away from the devices, so \$8B would be a bit much. Let’s say they grow to \$4B.

Facebook might add additional revenue sources. They could start making money in these ways (let me know if you have others):

2. Charge companies for their Facebook pages. (10M businesses x \$10/month = \$1.2B/year) (more ass numbers)
3. Partner with Bing to launch a search engine of their own (Yahoo! made \$500M doing this. Maybe Facebook can get to \$1B).
5. Get into Craig’s List’s business and sell property listings (Another \$500M?).
6. Get into Zynga’s business and develop games in-house (\$2B).

We end up with \$12B in ad sales, \$4B in virtual sales, plus another \$6.2B in new stuff for a total of \$22.2B in revenue. At a 30% margin that’s \$6.6B in profits. Our PE is now 15; market average. And with the growth they have, you could justify a big 50-60PE for a lot of investors. The company rises to a \$300B to \$400B valuation.

### Worst Case Scenario

What’s the worst case scenario? Put simply, it’s that Facebook’s growth will slow down, and this IPO is just a big liquidation event for existing share holders to cash out.

1. Zynga games and the like take off outside of Facebook. FB loses the games or is forced to lower their cut.
2. FB increases the number or the invasiveness of ads on the site. People flee to Google+.
4. FB Search, FB Jobs, and FB Properties all fail, costing billions in lost R&D.
5. MySpace comes back. Diaspora takes off. Twitter gains ground.

In the past few years, those 100% revenue gains have come along with similar-sized user gains. But user growth has slowed. So they’ll really need to squeeze more money out of advertisers.

All this might lead to minimal gains in current revenue streams (let’s say 25% year over year) and then let’s assume they just blow their \$5B raised on 1-5 above. That would equate to revenues of \$6.25B – 2.5B (5/2 years) or just 3.75B revenue in 2013. That’s where they are now.

With revenues and profits stagnant after 2 years, IPO investors are tired of waiting it out and flee the stock. Facebook apologizes for the missteps and vows to focus on their core advertising which is still growing 25% per year. Still the stock tanks 50% or more if sentiment turns.

### Summary

Well assuming the bullshit above stands, we got a 300 to 400% upside and a 50% or so downside. This actually might be a good investment. But I imagine I wasn’t tough enough in my worst case scenario. And I was surely too optimistic in my best case scenario.

Still, I wanted to think these things through. I wanted to focus on how Facebook will really make more money going forward, because that’s what they’ll have to do for the stock price to rise. And the money can’t come out of thin air. It has to come from some other company’s market share or from consumers and businesses purchasing something they haven’t before.

Personally, my initial reaction is that \$100B is too high a market cap for this company. After doing this post, I’m actually more optimistic for Facebook… especially if the IPO price sees a little dip at some point without hindering the excitement around the company. Still, I think this is definitely too uncertain for me to be an investor or to recommend the IPO.

I’d really love to hear more feedback about this. Am I delusional? I’m especially interested in anything I’m not considering with regards to how Facebook will make money going forward. Is it more than just pushing their ads harder? Perhaps as a public company, Facebook themselves will comment on this sometime.

# Why I’m a Buyer of Netflix Stock

Sometimes you look at a stock like Netflix when it was trading at \$300+ and think “Here is a great company in a market with super growth, but how can I justify the price?”

Well, it turns out you don’t have to justify the price because the market is beating the shit out of the stock. It’s trading after hours right now at around \$86, and who knows where the market will take it.

Hip Egg had the next level of support at around \$60, so I would look for the price to gravitate towards that level.

I own a small number of shares bought in the \$113-\$130 range. I thought that Netflix might blow away earnings due to the price increase (and they did), but the sandbagged forecast they gave is scaring more investors away. I plan on double or tripling my position as the price falls.

### With the stock under so much duress why am I a buyer?

Because Netflix is still the best video streaming company by a long shot and the growth prospects there are extraordinary. This company is going to make a ton of money. They may not get the price bonus they got as a WallStreet darling, but pretty soon the earnings will force people back into the stock.

I think the company is on a good path right now. I had my doubts, especially when they announced that Qwikster business. I thought they were panicking and losing site of the strengths of their platform. Hastings, who was probably too aware of customer complaints about seeing titles that were only available on DVD, seemed surprised that users would want to see both streaming and DVD titles in one queue.

It was a welcome site to see them reverse that decision. And Hastings’ explanation that the DVD business “holds value for our 10 million subscribers” is great and shows that they are really thinking about what is best for their customers again.

I think most people by now agree that the price change (really a price alignment) from earlier in the summer was the right move. It makes sense for people who want DVDs to pay for that package separate, and for people who want streaming to pay for that package separate. And I don’t blame the Netflix executive team for not anticipating the backlash that occurred. To me the story was always like this:

You know those streaming movies that you’ve been getting for free with your DVD package for the past year? Well, now you’re streaming more movies than you are getting on DVD. We’ve come up with a price for the streaming service. It’s only \$7.99. That’s less than you were paying for your DVD plan before, and hell that’s only \$7.99 now too. That’s less than any other competitor, and we still have the best service.

For me, the biggest risk to Netflix’s future profits was in their ability to obtain more material for their streaming service without being shook down. The studios owning video content have a lot of motivation to play hard ball with Netflix on their prices. Conspiracy theorist will see them working together cartel-style to see a company they are more friendly with oust Netflix as the market leader. Maybe Hulu because they own a piece of it… or Amazon or Walmart because those companies sell so many DVDs and BlueRay Discs for them already. But even without illegal price-fixing, it’s easy to see the studios going after Netflix because the money is there, and other sources of money may be drying up.

I’m still worried about the content problems, but I think Netflix has a handle on it. They are throwing money at it, which is good. This will increase their library and their costs, but their other costs are going down. Streaming is cheaper than mail. And user acquisition costs are down as well.

I think there is a new risk to the stock and the business though. And that is the risk that the board will give into public pressure to relieve Reed Hastings. I don’t want to start rumors or drum anything up. But there are a lot of jaded investor folks who are asking for Hastings’ head. I don’t know if the board is behind their man or not. I’d like to research that some more to see where the board stands.

A drastic seat change like that would obviously be yet another blow to the stock price, and I’m not sure the replacement would have the vision Hastings has for the future of streaming at Netflix.

### Risks to the Stock Price

The price will drop tomorrow. It probably will go down further. Management is warning that Q4 revenue and earnings may come in lower. Even more, they are saying that earnings in Q1 will be negative as they spend more money on expansion and licensing deals.

Support is in the \$60 range, but who knows if that will hold. Amateur investors will bail more as the stock price falls. Institutional investors will bail more as earnings go into the red.

### The Bright Side

Netflix will continue to grow subscribers world-wide and will continue to make money. Netflix typically has strong fourth quarters. (Anecdotally, I know a lot of people gift Netflix for the holidays. And a lot of people pick it up to take advantage of new TVs and gadgets.)

If the price really drops to \$86 or so. With earnings around \$4 a share, that’s a PE of about 22 for a company that is growing at 50% year of year.

Netflix currently has about 24M subscriptions. There is plenty of room to grow. There are at least 96 million cable/etc subscriptions in the US. Imagine 96M Netflix subscribers.

Throw in growth overseas.

Tomorrow, the single largest source of internet traffic in the United States will be run by a company with just a \$4B market cap. Netflix owns a huge portion of our mindshare that will only grow larger. As long as they stay smart and continue to perform to their own standards, their business will flourish. Investors will have to return.

# “Payback Time” Analysis for GOOG

I still own a few shares of GOOG. It’s felt overpriced recently, but I’m holding onto a minimal amount at all times and trying to add more over time. So I’m hoping the price drops a bunch so I can pick up more cheaply.

Do a search here for GOOG for my previous thoughts (years old), but I basically think that the world will continue to be drowned in data. Google’s goal to organize the world’s information and their expertise at scaling Internet apps puts them in a great position to be a contender in just about any future technology.

Anyway, I’ve recently read Phil Town’s new book Payback Time. The title there, like most investing books lately, takes advantage of the recent drop in the stock market to entice readers. However the content and tone of the book isn’t as whiny as you might think, and is generally applicable to investors in all markets.

We were big fans of the first Phil Town book, Rule #1, mostly because it described things in layman’s terms and gave readers a clear method for putting the books theories into practice.

Payback Time works the same way and repeats a lot of the ideas in Rule #1. There are still the 4 M’s (Meaning, Moat, Margin of Safety, and Management) for example, but instead of using technical analysis (in the form of Rule #1’s red/green arrows) Payback Time recommends a form of dollar cost averaging, Town calls “stock piling”.

Of course, Town has a section in the book titled “Why This Isn’t Dollar Cost Averaging” that I’ll try to summarize here. Town says (emphasis his), “DCA means investing a fixed dollar amount at fixed intervals no matter what the price of a given stock.” He then goes on to list the numerous flaws and criticisms of dollar cost averaging.

For further reading, Christian writes why you should consider “Averaging Down“, and here Steve “The Undertrader” describes his stockpiling-like investing style.)

So Town calls stockpiling “DCA with a brain”. You don’t buy any time or on predefined schedules. You buy when the stock price is within your Margin of Safety. And you don’t hold indefinitely. You sell if the stock price goes about your Margin of Safety.

I’ll buy that. And I like this a little better than using “the tools” or “the arrows” or technical analysis to judge a stock because it’s one less thing to calculate. If you are calculating a “sticker price” and MOS price anyway, might as well use them to trade. If you thought of stocks as commodities or discounted dollars, this kind of trading would make even more sense. I value \$1 at \$1. If the market is pricing it at \$0.80, I buy. If the market is calculating it at \$1.10, I sell. Sure I could have waited for the price to drop to \$0.70 before buying, or \$1.20 before selling. I would have made a better trade, but I’m always making a winning trade if I buy when the price is lower than what I value it at (plus my MOS) and sell when the price is higher than I value it at.

So the Payback Time strategy should be a little easier to follow than the technical analysis from Rule #1. Well, to a certain extent. Town introduces another calculation called “the payback time” (maybe that’s the true meaning of the title) to pretty much calculate the MOS from a different angle. And he brings technical analysis back in, talking about support and resistance levels. Here’s a good recent analysis from Hipegg on Google.

Alright, so that out of the way, let me share some of my calculations on Google stock (GOOG). I’m basically running through the Payback Time Spreadsheet found on the Payback Time website. It’s a handy tool.

Here I would want to do a large Google Moat analysis, but I’m lazy. So I’ll say hey, they have a huge margin and virtual monopoly in search. And while there stance is vulnerable (MSFT is gaining ground lately), this moat is fairly stable because (1) it takes a lot of knowledge and investment to serve billions of searches a day quickly and (2) advertisers and publishers benefit from consolidation and drive the market towards one winner.

Charlie Munger and Warren Buffet at Berkshire Hathaway like Google’s moat. Not sure if they are investing. Buffet shies away from tech.

Here I would want to do a large Management analysis, but I’m lazy. I’ll say hey, these guys strive to do no evil. Page and Brin seem like great folks who are in it for the long term. They are standing up to China vs. going for short term profits. They don’t fudge their numbers (other than tweaking the Adsense lever). They don’t mess around with finance gimmicks like splits, etc. They are smart and clearly have a better understanding of the future than the average C-Level exec.

Some numbers:
* 5 year EPS Growth has averaged 34%.
* 3 year OPS (operating cash flow per share) Growth has averaged 17%.
* 5 year Sales Growth has averaged 40%.
* 5 year BVPS (book value per share) Growth has averaged 58%.

Nice all around. You usually want to go as far back as you can on these numbers. We can’t go much further back than 5 years because Google only started trading in 2004. If you wanted to be more conservative, you could use more recent (last 2-3 years) numbers since Google basically went from nothing to a top 10 company in 2 years and since then has grown a little slower.

Some more numbers:
* ROIC (Return on Invested Capital) = 18%
* ROE (Return on Equity) = 18%

Nice again. BTW, you can get some of these numbers in chart and spreadsheet form at YCharts.

Now, let’s calculate a sticker price and MOS.

* EPS = 21.97 (according to Yahoo)
* Earnings Growth = 14% (That’s my number. Historically we’re looking at 34%, and analysts are estimating 19% for next year. Should do more “main street” analysis of this considering how large Google is.)
* Future P/E = 24 (that’s about average for Google. 2x earnings would be 28)
* MARR = 15% (This is my “minimal acceptable rate of return, i.e. I want to make at least this much per year)
* MOS% = 25% (Ideally you would want 50%, but that is hard to get with GOOG and I’m pretty confident in them.)

I get MOS numbers then like:
* EPS = 21.97
* EPS in 10 Years = \$81.45
* Stock Price in 10 Years = \$1,954.74
* Sticker Price Today = \$483.18
* MOS Price = 3/4 = \$362.39

So according to this, I am a seller above \$483.18 and I am a buyer under \$362.39.

For completeness, here is the Payback Time Analysis using these numbers. To recoup my investment in 8 years, I’d want to buy GOOG at \$331.43. That basically means that if you bought all of GOOG at \$331.43, you would earn that back in Revenues (assuming our growth numbers) in 8 years. That would be a good investment if you were buying a franchise, and should be a good investment when buying stock as well.

I hope this was informative. Feel free to pick apart my numbers. In particular, I am always interested in pondering what a company that grows at 14%+ for 10 years would look like in the future. I’ll do that in a future post.

# Digital Textbooks Sales Projection

Via blog.xplana.com:

Personally, I think this is a little conservative… though kids and professors on campuses would probably know more about how motivated professors are to switch to digital textbooks. What I do know is that no one likes spending \$100 for a textbook and my professors were always empathetic to this.

Obvious investment plays are Apple and Google stock. Both are probably fairly priced now. None of these companies mentioned in the article are public, but there may be more like them. Another plan would be to find a publisher who is ahead of the times and keep and eye on them. They might develop into a best of bread company that investors flock too as the other publishers go broke.

Current Digital Textbook Sales and Trends

While digital textbook sales currently represent a small portion of the overall textbook market – approximately 0.5% – year-over-year increases show strong and steady growth.

• CourseSmart, a joint venture of five large college textbook publishers, reported a 400% increase in sales in 2009 from the year before;
• MBS Direct, representing 900 client institutions and 34 academic publishers, showed increases in digital textbooks sales of more than 100% in 2009;
• Interviews with representatives from leading textbook publishers reveal year-over-year increases between 80%-100% for the past three years, with sales growth in 2009 topping 100%;
• According to “On Campus Research Student Watch 2010,” a 16,000-student survey released by the National Association of College Stores in fall of 2009, about 42 percent of students have either purchased or at least seen an e-textbook. That’s an increase of 24 percentage points from 2007