5014_ASS 3 # DRAFT 1 # Financial Engineering to Enhance Shareholder Value # MBA # FLEXPAH CAPELLA

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RUNNING HEAD: FINANCIAL CONDITION ANALYSIS

RUNNING HEAD: FINANCIAL ENGINEERING TO ENHANCE SHAREHOLDER VALUE

Financial Engineering to Enhance Shareholder Value

Jamie Depre

Capella University

This assessment is being completed to fulfill requirements for Assessment 3 in MBA-FPX5014

Scenario

I have just been made the Chief Financial Officer of Facebook Inc. (“Facebook”). The CEO and Board of Directors has tasked me with preparing a report on ways to financially engineer the company to increase stock price. Via sources inclusive of the Wall Street Journal, Bloomberg, GuruFocus, Yahoo Finance and EDGAR, I will conduct extensive research on the current financial and company situation.

This report will include the financial statements (income statement, balance sheet, and statement of cash flows) and 10K reports, and conduct a financial ratio analysis including the following: current ratio, debt to equity ratio, return on equity (ROE) ratio, dividend yield, earnings per share (EPS or the last 4 quarters), price to earnings ratio (P/E), and market to book ratio as requested. It will also compare the ratios to the company’s nearest competitors. I will estimate the company’s current WACC.

Senior management wants to maximize shareholder value by increasing the price of stock. This report will analyze the options of a capital expenditure, merger/acquisition, stock repurchases, dividend policy change, reduction of debt, expansion into a new geographical market and the possible introduction of new product(s).

Financial Condition Analysis

Facebook Inc.’s History

Facebook Inc. was founded in February of 2004 by a group of students at Harvard University in Cambridge, MA. Those students, Mark Zuckerberg, Eduardo Saverin, Andrew McCollum, Dustin Moskovitz and Chris Hughes initially started the social network as a platform for college students from particular colleges to communicate with each other. But, in just 10 months, the subscribers to the network soared to 1 million users. By 2017, FB had 2 billion users and that doesn’t include users of its other properties. In its wave of growth, FB has acquired 66 companies spending $23,124,700,000.00 in acquisitions (based on disclosed numbers).

Facebook Inc. is currently headquartered in Menlo Park, CA with Mark Zuckerberg as the CEO. As of March 31, 2019, Facebook Inc has 37,773 employees and a global geographical reach with users in all seven (7) continents. Additional offices include Atlanta, Austin, Boston, Chicago, Dallas, Denver, Detroit, Fremont, Los Angeles, Menlo Park, Miami, Mountain View, New York, Pittsburgh, Redmond, San Francisco, Sausalito, Seattle, Washington, D.C., Woodland Hills, Amsterdam, Auckland, Bangkok, Bengaluru, Berlin, Bogota, Brasilia, Brussels, Buenos Aires, Copenhagen, Cork, Dubai, Dublin, Geneva, Gurgaon, Hamburg, Hong Kong, Hyderabad, Jakarta, Johannesburg, Kuala Lumpur, London, Madrid, Manila, Melbourne, Mexico City, Milan, Montreal, Mumbai, New Delhi, Oslo, Ottawa, Paris, Rome, Sao Paulo, Seoul, Shanghai, Singapore, Stockholm, Sydney, Taipei, Tel Aviv, Tokyo, Toronto, Vancouver, Warsaw, Zurich with Data Centers in Prineville, Forest City, Luleå, Altoona, Fort Worth, Clonee, Los Lunas, Odense, Papillion, New Albany, Henrico, Newton, Eagle Mountain, Huntsville, and Singapore.

“According to the website, Facebook Inc’s mission is “to give people the power to build community and bring the world closer together. People use Facebook to stay connected with friends and family, to discover what’s going on in the world, and to share and express what matters to them”.

There are over 41 current products in the Facebook family. Some of those products include Facebook (facebook.com), Instagram, Boomerang, Facebook Marketplace, Facebook Messenger and FB Messenger Kids, Facebook Live, Facebook Watch, Facebook for Creators, Facebook for Developers, Facebook Business Manager and the list goes on (full list can be found here: https://www.minterest.com/list-of-all-facebook-products-and-services/).

Financial Analysis

Income Statement

An Income Statement/Profit and Loss Statement focuses on a company’s revenue and expenses over a determined period of time. Income Statements must be reported to the Securities and Exchange Commission (SEC). The four items an income statement targets are revenue, expenses, gains and losses. This makes it an ideal statement to determine the financial health of a company. The income statement will conclude with the Net Income of the company. Net Income is (Total Revenue + Gains) – (Total Expenses + Losses). It will also identify sections of the company that may be underperforming as well as efficiencies.

In Figure 1 below, Facebook Inc.’s revenue increased by $13+ billion from 2016 to 2017 and then increased by $15.2 billion from 2017 to 2018. Net Income has also increased; 2016-2017 by $5.7 billion and by $6.2 billion for 2017-2018. Additionally, the Earning Per Share keeps rising; 2016: $3.49 billion, 2017: $5.39 billion, 2018: $7.57 billion. “Earnings can cause stock prices to rise, and when they do, investors make money. If a company has high earnings per share, it means it has more money available to either reinvest in the business or distribute to stockholders in the form of dividend payments. In either scenario, the investors win” (fool.com).

Figure 1: Facebook Inc. Income Statement 2016- 2018 per January 31, 2019 Annual Report

Balance Sheet

A balance sheet is a financial statement reporting assets, liabilities and shareholder’s equity during a specific period for a company. There is a simple formula used to calculate the balance sheet: assets = liabilities + shareholder’s equity. This essentially means, to pay for items the company owns, it’s assets, it will either borrow money (take on liability) or have investors invest it (issue shareholder’s equity) (Hayes).

One important item a balance sheet will show investors is the amount of debt a company owes. Facebook Inc. has no debt and hasn’t for at least the last three years. It utilizes only its equity capital. In a 2017 report, it was stated “Investors looking for stocks with high market liquidity and zero debt on the balance sheet should consider Facebook Inc (NASDAQ:FB). With a market valuation of $511.60B, FB is a safe haven in times of market uncertainty due to its strong balance sheet. In times of low liquidity in the market, these firms won’t be left high and dry. They are also relatively unaffected by increases in interest rates” (Edmonds). This means risk associated with Facebook Inc. based on debt is non-existent. This provides another factor indicating the financial strength of Facebook Inc.

Facebook Inc’s balance sheets shows very favorably for cash on hand in both 2018 and 2017, $10 billion and $8.1 billion respectively with year-over-year growth of $1.9 billion. Total assets for 2017 came in at $84.5 billion and grew to $97.3 billion in 2018; growth of $12.8 billion.

Figure 2: Facebook Inc’s 2017-2018 Balance Sheet per Jan. 31, 2019 Annual Report

Cash Flow Statement

A cash flow statement is a third financial statement utilized to determine the financial health of a company. As its name suggests, this statement indicates the amount of cash/cash equivalents flowing in and out of the company. This statement measures how well a company manages and generates cash to pay any debts it may have and cover its operating expenses.

Cash inflow from operating activities has increased year-over-year; 2016-2017 by $5.1 billion and by $8.1 billion for 2017-2018. However, cash from financing has decreased. This could be due to several acquisitions; 6 in 2016, 3 in 2017 and at least one known $100 million acquisition in 2018. Facebook Inc also appears to have purchased property and equipment. 2017). There is a $12.9 billion decrease for stock repurchases as well. However, Facebook Inc. is investing in businesses that make sense for their future based on the cash flow sheet.

Figure 3: Facebook Inc’s 2017-2018 Cash Flow Statement per Jan. 31, 2019 Annual Report

Financial Ratio Analysis

Using multiple financial ratios as well as comparison to industry competitors will gage Facebook’s financial position, health and outlook.

Ratio: PE Ratio

· Equation: PE = Market Value Per Share/Earnings Per Share

· Used to determine the relative value of a company’s shares to ensure investors are getting the most bang for their buck

· Type: market value

Calculation based on market close June 5, 2019 = $167.17:

168.17 (Share Price)/ 6.73 (Earnings per Share) = 24.99

This number indicates it will take the company 24.99 years to earn back the price paid for the stock. However, this number is based on the company’s earnings staying the same for that 24.99 years. It’s based on the volitle market as well. However, using it as an industry comparative tool, Facebook Inc. is running right in the middle of the pack amongst it’s competitors.

Figure 4: Facebook Inc’s PE Ratio Competitive Comparison- gurufocus.com

Ratio: Current Ratio

· Equation: Current ratio = Current assets / current liabilities

· Used to give an indicator of the company’s ability to pay back short term liabilities with short term assets.

· Type: short term liquidity ratio

Calculation based on Dec. 31, 2018 year end financials:

50480 (current total assets)/ 7017 (current total liabilities) = 7.19

A health current ratio for businesses fall between one (1) and three (3). If the ration was less than one (1), it would suggest that the company could not pay back its obligation should they come due. With a current ratio of 7.9, Facebook Inc. is very healthy and could meet its obligations when and should they come due.

The chart below shows a comparison of companies deemed industry competitive to Facebook Inc. based on end of Q1 2019. Looking at this data, Facebook Inc. is in a healthier position than any of its competitors.

Figure 5: Facebook Inc’s Current Ratio Competitive Comparison- gurufocus.com

Ratio: Debt-to-Equity Ratio

· Equation: Total Liabilities/Total Shareholders’ Equity

· Used to measure the financial leverage a company has

· Type: solvency

Calculation based on Mar 31, 2019 Q1 financials:

0 (current total liabilities)/ 86516 (current total stockholders’ equity) = 0.00

Because the debt-to-equity ratio is zero (0), Facebook is not using debt to finance its growth. This means that should Facebook decided to use financing, it would be at a low risk. However, Facebook has for the last several years not used debt to finance. They have been using cash on hand and shareholder equity to grow. The industry competitors, with the exception of LinkedIn recently acquired by Microsoft, all have relatively low debt-to-equity ratios. VeriSign, however, has a negative debt-to-credit ratio. In essence that means that the company’s value is negative with liabilities higher than assets.

Figure 6: Facebook Inc’s Debt-to-Equity Competitive Comparison- gurufocus.com

The Financial Ratio Analysis methods used have solidified my initial theory that Facebook Inc. would be a strong potential buyer for PacificCoast. With growth year-over-year, no current debt and a middle-of-the-pack PE ratio, Facebook Inc. shows consistent financial stability.

SWOT Analysis

A SWOT analysis (Strengths, Weaknesses, Opportunities, and Threats) analysis attempts to identify a company’s internal strengths and weaknesses, as well as its external opportunities and threats. The SWOT analysis below will identify some of those factors for Facebook.

Figure 7: Facebook Inc- SWOT Analysis

As indicating in the SWOT analysis, I do believe Facebook Inc. currently has more Strengths and Opportunities than Weaknesses or Threats. However, I do believe their biggest threat is that Social Media relies on people and people are unpredictive and opportunistic. For those reasons, Facebook Inc. will need to work on its Opportunities area and find strategic ways to continue to improve their platform and brand. It cannot face another press scandal in the next couple of years, although it did survive its latest scandal. Facebook Inc. needs to continue to growth and not become stagnate in a market that is highly competitive.

Current WACC

GuruFocus will serve as the source for calculating WACC. The formula for calculating the weighted average cost of capital (WACC) is:

E / (E + D) * Cost of Equity + D / (E+D) * Cost of Debt * (1-Tax Rate)

The current weight of equity ( E / [ E+D]) is 517,604.442 / (517,604.442 + 665.5) = .09987 and the current weight of debt ( D / [E + D]) is 665.5 / (517604.442 + 665.5) = .0013 .

The Cost of Equity = Risk-Free Rate of Return + Beta of Asset * (Expected Return of the Market - Risk-Free Rate of Return)

Using GuruFocus’s 10-Year Treasury Constant Maturity Rate as the risk-free rate (updated daily), The current risk-free rate is 2.10%. Facebook Inc.’s beta is 1.33. GuruFocus requires the market premium to be 6%. Therefore, the current Cost of Equity is:

2.10% + 1.33 * 6% = 10.08%

Facebook’s interest expense at year ending 2018 was $9 million. As previously calculated, the Book Value Debt is $665.5 million. Therefore, Cost of Debt is:

9 / 665.5 = 1.3524%

The latest two-year average tax rate is 17.72%.

The WACC calculation would then be:

.9988 * 10.08% + .0012 * 1.3524% * (1-17.72%) = 10.07%

This indicates that Facebook is generating higher returns on investment that it costs the company to raise the capital needed for that investment. (GuruFocus).

Figure 8: Facebook Inc’s WACC Competitive Comparison- gurufocus.com

Based on Competitive Comparison, Facebook Inc is performing at a higher WACC than Twitter and LinkedIn, two of its main social media competitors. This is largely in part due to the gap in market capital between Facebook Inc and its competitors. “In theory, WACC represents the expense of raising one additional dollar of money.” (Segal). With a WACC of 10.07% means the company must pay its investors an average of $0.1007 in return for every $1 in extra funding. Typically, having a high WACC would signify that there is a higher risk associated with the company’s operations, Facebook would be paying a penny on the dollar to its investors in extra funding. As indicated above, Facebook is not using debt to finance its current projects and hasn’t for several years and Facebook is currently yielding a higher ROI than it cost the company to raise the capital it needs for the investment.

Facebook Inc.’s Stock

When Facebook Inc first debuted as a publicly traded company, its stock was valued at $38.00/share valuing the company at $104 billion. Today, Facebook’s stock price is $188.20/share. The sales price for stock has soared due to acquisitions and growth. Based on the seven options presented to financially engineer increased growth, capital expenditures, expansion into a new geographic market and reduction of debt would be three nonviable options. Facebook Inc has no debt to reduce (since 2016). Facebook is already a worldwide entity operating on all continents with 2.1 billion users and offices located strategically around the world. There is no real opportunity for capital expenditures currently.

Introduction of New Product/Services

Introduction of new product and services is an option and is already occurring. Facebook is getting ready to debut an integrated feature for online dating, Dating Home. Facebook intend to rival Tinder as something built for long-term relationships, “not hook ups” (Zuckerberg). Another new feature getting ready for launch is Watch Party, allowing users to watch videos and chat with friends. Instagram and WhatApp are getting video group chat abilities to rival current apps like House Party. Most importantly, Oculus Go, Facebook’s virtual reality company, began shipping its Oculus Go VR headsets for $199.00. A computer free and cheaper version of the current Oculus headsets. Users will be able to watch tv on the virtual headset as well as stream show from Hulu, Netflix and ESPN together. The commercials are already running across the televisions and Oculus Go is expected to sell 1.3 million headsets in 2019. During its launch, Oculus Go two spots on Amazon’s Top 10 in the Video Game category.

Figure 9: Amazon Top 10 May 2018

Oculus Go paved the way for the newly launched (May 2019) Oculus Quest. In the first two weeks, $5 million of content was sold for the Oculus Quest. Facebook Inc does not share its sales data on VR products. As of right now, indicators are pointing to the purchase of Oculus by Facebook as not having a ROI in the $2 billion investment. Without knowledge of sales, it’s difficult to see an increase in shareholder value. Based on the data below from Yahoo Finance,

there doesn’t seem to be a surge in stock. In fact, right after the launch, there was a drop (although this is usual). Only time will tell if the new products increase shareholder value.

Date	Open	Close*
17-Jun-19	$ 185.01	$ 188.65
14-Jun-19	$ 180.51	$ 181.33
13-Jun-19	$ 175.53	$ 177.47
12-Jun-19	$ 178.38	$ 175.04
11-Jun-19	$ 178.48	$ 178.10
10-Jun-19	$ 174.75	$ 174.82
7-Jun-19	$ 170.17	$ 173.35
6-Jun-19	$ 168.30	$ 168.33
5-Jun-19	$ 167.48	$ 168.17
4-Jun-19	$ 163.71	$ 167.50
3-Jun-19	$ 175.00	$ 164.15
31-May-19	$ 180.28	$ 177.47
30-May-19	$ 183.08	$ 183.01
29-May-19	$ 183.50	$ 182.19
28-May-19	$ 181.54	$ 184.31
24-May-19	$ 182.33	$ 181.06
23-May-19	$ 182.42	$ 180.87
22-May-19	$ 184.73	$ 185.32
21-May-19	$ 184.57	$ 184.82

Figure 10: NASDAQ Opening and Closing Stock Prices for FB- Yahoo Finance

Repurchase of Stock Shares

In July of 2018, in a bid of transparency, Facebook released its expectation that its growth will slow down, and profit margins will narrow as social media is saturated and it will be starting to look to new business models. Additionally, Facebook was faced with some bad press, privacy scandals and a growing concern over the misuse of user information and data. On the heels of this announcement, Facebook’s stock slumped. On December of 2018, Facebook announced that it would be buying back $9 billon of its shares (Facebook had previously done this in 2017 for $15 billion of its shares). This is to boost confidence in the company (Frier). The repurchase will take advantage of the stock’s current lower pricing and the board is taking advantage of that opportunity. The buy back is easily affordable for Facebook (generating 17.5 billion in free cash flow over the last twelve months). After the December 2018 announcement, Facebook shares grew 3.2%. The buyback seems to have sparked the increase in shares that Facebook was desiring.

Merger/Acquisition

Facebook is not shy when it comes to acquiring companies that meet its business needs and organization plan. With close to 80 acquisitions and $23,124,700,00.00 spent, at any moment another company could be named under the Facebook Inc. umbrella. Facebook still has a solid future with Instagram as it has been growing rapidly and continues to attract more users, currently 500 million. With Facebook topping out at 2.1 billion, Instagram definitely has more growth potential.

I would choose this as a desired option to increase shareholder value and I would encourage the acquisition of GoPro. GoPro is rumored to be looking for a buyer currently with a price tag of $900 million dollars. Facebook could easily afford this as an all cash purchase and not having to take on any debt. Specializing in cameras, camcorders and drones, this would be an ideal buy. Facebook is already experimenting with using drones to carry WiFi up over areas (such as schools) that wouldn’t otherwise be able to connect to the internet. Instagram is a tech platform that is all based on pictures and pictures stories. Marrying the hardware of GoPro with the software of Facebook Inc. could be an ideal pairing and send stocks soaring.

Dividend Policy Change

Facebook is part of the FANG group of companies (Facebook, Amazon, Netflix and Google) and historically, the FANG group has avoided paying cash dividend on their stocks. But, Facebook is starting to peak when it comes to user growth. With 2.1 billon users, it could be running out of human subscribers. Facebook is already partaking in stock buybacks although that took some time as well only beginning in 2016. The next logical approach would be moving toward dividends. Competitors, direct and indirect, (Apple, Microsoft and Intel) are all currently paying dividends and even raising dividends annually. Facebook is currently in the position to comfortably pay out dividends. Facebook grew rapidly and is well established in the technology sector. Investors know that the benefit of dividends is that they are more reliable than stock buybacks as buybacks will halt if times get tough. But, companies tend to be less likely to cut dividends. If Facebook took the $9 billion dollars in buyback option and committed instead to a “$9 billion annual dividend, it would immediately become one of the top dividend payers in the corporate world. The resulting payout of $3.75 per share on an annual basis would give Facebook an above-average dividend yield of 2.5% -- and more importantly, it'd send a signal to investors that the social media giant thinks it's here to stay, regardless of the controversies it's faced recently.” (Caplinger)

I believe that this is also a viable option for Facebook to increase shareholder value and engineer a financial increase in stocks. Investors will be happy to collect the cash dividend and Facebook still thrives with cash flow even after paying out dividends. It sends a message that Facebook is confident in its financial standings. This should cause a surge in the market for stock.

References

Caplinger, Dan (21 Jan. 2019). Retrieved from:

https://www.fool.com/investing/2019/01/21/will-facebook-start-paying-a-dividend-in-2019.aspx

Edmonds, Andrew (7 Dec 2017). Retrieved from:

https://finance.yahoo.com/news/know-facebook-inc-fb-financial-230313209.html

Frier, Sarah (7 Dec 2018). Retrieved from:

https://www.bloomberg.com/news/articles/2018-12-07/facebook-plans-to-repurchase-9-billion-more-of-its-shares

Hayes, Adam. (19 May 2019). Retrieved from:

https://www.investopedia.com/terms/b/balancesheet.asp

Noyes, Dan (29 May 2019). Retrieved from:

https://zephoria.com/top-15-valuable-facebook-statistics/

Toth, Steve (4 Jan. 2018). Retrieved from: