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Reviewing Facebook's capitalisation strategy

23 Apr 2014 10:13
Facebook's persistent appetite for acquisitions was clearly not sated by the $19 billion acquisition of WhatsApp in February, with the company spending a further $2 billion on virtual reality company Oculus late in March 2014.
"It seems to be taking a shotgun approach to capital allocation," says Paul Whitburn, a portfolio manager at RECM, an independent asset management company. "It's something Microsoft did for ages - it will do a hundred different things across multiple technologies in the hope that one of them comes off."

Defensive move

"My gut feel is that its recent acquisition of WhatsApp was more of a defensive move than a strategy to monetise the $19 billion purchase price. I think it is looking to shut down anything that could break into its market, as it did with Instagram, maybe it worries that WhatsApp could morph into a social media space. I don't think the WhatsApp transaction is a game changer but it does help it to maintain its advantage for a little while longer.

"We're always wary of hype. There are many good technology companies out there and we have owned several of them for our clients, including Microsoft, Dell, Hewlett Packard and Intel. These are excellent businesses that are dominant in their areas but they were hugely hyped in the late 1990s and early 2000s and seriously overvalued so we could not invest in them. It took nearly a decade for them to get to prices sufficiently below their intrinsic value to justify investing in them.

However, he points out that it is not that easy to pin down an objective fair value for a company like Facebook. "It is difficult to say just how big its potential market is. Internet advertising is still a new phenomenon so there is no telling what it will become. We've seen internet businesses disrupt established sectors - Craigslist wiped out billions of dollars of classified advertising revenue for newspapers in the US."

Competitive advantage is key

The question is how sustainable any advantage is likely to be in a relatively new industry. "We look for companies that have a competitive advantage over their peers - what Warren Buffett calls an economic moat. We believe Facebook has that through the network effects of its 500 million users. With social networking businesses, first mover advantage is massive and tends to stay in place for a while. However, it is difficult to pick the ultimate winners. There is always someone in a dorm room somewhere dreaming up the next big thing and, if he or she develops a good product, it can compete very quickly - we saw how quickly MySpace became irrelevant. It is much harder to disrupt established businesses that have built up customers, products and brands over decades.

"We just don't like to base investment decisions on forecasts. We do not feel we are any better at guessing the future than anyone else - nor any worse, for that matter - but it does not make sense to make investments on that basis. We prefer to focus on established businesses with a proven history of strong cash flows over a long period. Cash flow is a great demonstration that a business can monetise its products and generate good returns for shareholders. That is not something you are going to get from high growth companies in new industries."
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