Facebook Finally Buys Class A Shares

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Facebook repurchased some of its voting, Class A shares during the quarter ended March 31, 2017. Last fall, Facebook announced a $6 billion stock repurchase plan beginning in 2017.

So far this year, Facebook has purchased $228 million of the Class A stock. Facebook’s repurchased stock could later be used for another acquisition since founders, due to tax reasons, may prefer voting stock over cash.

FB’s Next Earnings

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Look for this when Facebook releases its earnings on May 3, 2017: Did Facebook buy-back any stock during the quarter? Last year, Facebook announced a $6 billion share repurchase program that begins this year.

In the future, Facebook could use the repurchased stock for acquisitions like those of the past: Oculus, WhatsApp, and Instagram.

What Amazon’s Win Means for Facebook

Amazon just won in Tax Court against the IRS. If Amazon would have lost, then it would have owed about $1.5 billion in taxes. The Amazon case is similar and could provide insight into one that Facebook is currently contesting with the IRS. In the Facebook case, if the IRS wins, it could collect between $3 to $5 billion in taxes from Facebook.

More importantly, the IRS is contesting a tax strategy common in the tech field. A company such as Amazon establishes a foreign subsidiary somewhere with low tax rates. Amazon then transfers intellectual property (IP) to the foreign subsidiary and in exchange, the foreign subsidiary makes royalty payments to Amazon.

Amazon pays taxes on the royalties received from the foreign subsidiary. The royalty payments in turn depend on the value of the IP transferred. A higher valuation mean higher royalty income for Amazon and more taxes to be paid. This is what the IRS wants, so it valued the IP Amazon transferred at $4 billion or sixteen times larger than Amazon’s estimate.

The Tax Court didn’t agree with the IRS’s valuation and sided with Amazon, and now Facebook faces the same issue. Facebook established its foreign subsidiary in Dublin, Ireland and also transferred IP which Facebook valued at $4 billion. Unfortunately, the IRS valued Facebook’s IP at $14 billion or three times higher than Facebook’s estimate.

With the higher valuation, the IRS is looking for more royalty income and hence more taxes from Facebook; that will only occur if a Tax Court agrees with IRS’s valuation method, something which did not happen in the Amazon case.

 

Facebook Can’t Copy This Snap Innovation

May be haunted by 1980s Steve Jobs, Alphabet and Facebook offered the public dual classes of stock to concentrate voting and thus control with the founders. Snap’s initial public offering was the first to issue only non-voting shares which upset large investors like pension funds and mutual funds. Arguments can be made on both sides, but missing from the discussion, like disappearing messages, is that technology disrupts incumbents and the status quo.

Snap founders, Evan Spiegel and Bob Murphy, want total control for “long-term stability” and to avoid, among other things, an unwanted take-over. Large investors take issue with the lack of votes since it doesn’t allows for holding management accountable. For example, investors may prefer an acquisition of Snap since it would increase their investment return. In addition, large institutional investors fear that other Unicorns will also adopt Snap’s non-voting share innovation.

Large investors also don’t like the potential lack of transparency at Snap. Snap filed under the JOBS Act as an “emerging growth company” which allows companies to limit public disclosure on such matters as executive compensation. In addition, Snap can choose not to have its internal controls reviewed by auditors, a requirement of the Sarbanes Oxley Act, intended to avoid future audit failures of the early 2000s. This is important because Snap already had problems with its internal controls.

While Snap’s decisions are still to be decided, the initial reaction from the public markets is positive. On its first day, Snap stock increased forty four percent over the offer price. In the prospectus, Snap warned investors that non-voting shares may not trade the same way as shares with voting rights; this means the non-voting shares may trade at a lower price and trading could be limited. Comcast didn’t seem to mind the non-voting issue either as it made a $500 million strategic investment in Snap.  

On March 9th, the SEC looks into the issues raised by Snap’s public offering, but one advantage for Snap is lower costs. Kurt Schacht, who will be part of the discussion, said, We’ll try to explore both sides. Is this is a slap in the face of corporate governance, or is this the market efficiency of the future?…”.

Oculus in VR Winter?

 

Facebook taking a loss on Oculus? No, not yet according to the Facebook’s recent annual report. Mark Zuckerberg paid $2 billion for Oculus in March 2014 because the VR startup company had the “the potential to expand our platform” as stated in the 2014 annual report. Getting there may take longer than Facebook expected which is different than the initial reasoning for purchasing Oculus.

When asked in ZeniMax Media Inc. v. Oculus VR Inc. about the future of a virtual reality platform, Mark Zuckerberg said, ….”we may have to invest even more money to get to the goals we had than we had thought up front.” This month Business Insider reported Bestbuy closed 200 of 500 Rift demo stations with Oculus attributing the closures to “seasonal changes”. But the closures could mean Oculus is taking longer to reach mainstream.

Once hot, virtual reality could be headed back into winter. If it does, Facebook could write-down its Oculus investment. Each year, Facebook tests to see if Oculus is still worth the $2 billion paid. If the worth (fair market value) declines, then a loss would occur. Facebook purchased Oculus to expand the platform, if that takes longer then expected, then may be Oculus is not worth as the $2 billion paid.

Right now, Facebook doesn’t think so.

 

Facebook’s 4Q16 Earnings

What’s absent from the Facebook’s 4Q16 earnings, were any stock buybacks including those announced in November 2016:

The repurchase program will go into effect in the first quarter of 2017 and does not have a fixed expiration. The timing and actual number of shares repurchased will depend on a variety of factors, including price, general business and market conditions, and alternative investment opportunities.

Don’t worry, some stock repurchases could be currently underway and something might show up in the 1Q17 earnings release. Facebook’s stock buyback is notable for at least one important reason; a lesser reason may be that stock buybacks increase earnings per share, and consequently the Facebook stock price.

 

Facebook’s 1st Stock Buyback is About Control

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Facebook recently announced a $6 billion stock buyback starting next quarter. Stock repurchases are common with mature, rather than growing companies such as Facebook. In fact early Facebook investor, Sean Parker, said when interviewed by Bloomberg, “Facebook has so much growth left in it”. The stock repurchase is a really way for Mark Zuckerberg to both maintain control and invest in the future.

Over the past four years, Facebook has expanded its platform with the acquisitions of Instagram, Whatsapp, and Oculus. Those companies were purchased with a combination of cash and stock. To purchase Instagram for $521 million, Facebook issued 12 million Class B shares for $221 million. Stock represented more than 80% of the consideration in the Whatsapp and Oculus purchases.  Facebook issued 178  million Class A shares for Whatsapp and 23 million Class B shares for Oculus.

Issuing millions of voting stock began diminishing Mark Zuckerberg’s control over Facebook. Class A stock gives its holder one vote and Class B stock has ten votes per share. So starting this year, Facebook distributed as a dividend to existing shareholders, the non-voting Class C. While it may be a good way to maintain control, the non-voting Class C stock is lousy for making acquisitions.

Founders of acquired companies are usually selling appreciated stock with large unrealized capital gains. The gains can be taxable and trigger a large tax bill when the company is sold for cash. But when the founder sells stock and receives stock in exchange, instead of cash, then the tax bill is delayed. Unfortunately the tax deferral only works with voting stock.

Deferring taxes is not for important tax-exempt limited partners such as university endowments, pension plans, and sovereign wealth funds. Paying of tax is important to individuals such as as founders, employees, and venture capitalists. Facebook recognized this fact it disclosed issuance of the class C stock:  

Sellers may have a preference for a transaction in which they can defer taxes owed, in which case we may have to structure the acquisition in a different manner or may be precluded from using shares of Class C capital stock to fund the acquisition.

To fund future acquisitions, Facebook needs either Class A or B shares. Issuing more shares is not an option since it will diminish Mark Zuckerberg’s control, but buying shares from existing shareholders is a solution. At the market price of $117, Facebook’s $6 billion could buy back approximately 50 million shares or 2% of the Class A shares currently outstanding. Rather than retire the repurchased shares, Facebook would just reissued them when the right acquisition comes along.

Mark to Oculus: It’s F***cking Over!

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In the recent cavalcade of earning reports, this one fall through: Oculus finally shipped the Rift. Here’s another: Oculus met its earn-out terms. Investors are happy, but no longer lucky. Now the clock starts ticking on when Luckey and company can finally leave Facebook.

This was a big story when it happened: Facebook buying Oculus for $2.150 billion in 2014. The purchase price also included $284 million in stock vesting over four years. So beginning in 2018, key employees are set free? Well maybe not yet.

Due uncertainty, the Oculus deal included an earn-out representing eight percent of the total price.  If certain performance milestones were met, then cash and stock totaling $169 million would be earned.  At the time, Facebook did not disclose what milestones had to be met.  Were the milestones technical or financial?

What Facebook has disclosed in its recent 10-Q is that Oculus has met the milestones as of June 30, 2016. Since Oculus started delivering the Rift in March 2016 and has cleared out the backlog, the performance milestones must have been technical.

Now Luckey and company can receive cash of $60 million and three million shares of Facebook stock. As of June 2016, Facebook values the stock to be received at $200 million. The shares are also subject to vesting, so some Oculus employees will need to stick around a little longer.

 

How Innovation Dies at Apple

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Steve Jobs passed away about five years ago and some question whether innovation passed away at Apple too. Due to its secrecy, it is hard gauging the developments inside Apple, unless you’re an employee or have a golden ticket. From the outside, should Apple’s innovation be measured by new products, new ideas, patents, or spending?

Apple and its competitors have increased spending on research and development since 2011. By looking at Chart I below, you can see that the direction is upward for Apple, Alphabet, Facebook, and Amazon. Apple has nearly quadrupled spending on research and development from $2.4 billion in 2011 to $8.5 billion in 2015.

R D Spending
Source: Annual Reports

So all is well? It difficult to determine the success or failure based solely on money spent. There is no direct connection between research and development spending and the bottom line. Ratios could be used such as research costs to total revenue.  But since there is no causality between the money spent and net income, financial ratios may not be the best measure.

Another way to judge Apple is by the number of patents granted. Chart II shows the number of utility patents granted to Apple and its competitors, per year, for 2011 to 2015. By showing the yearly change, rather than the overall total, one can see that Apple is reversing and Alphabet is speeding  ahead.

Patents Granted
Source: Intellectual Property Owners Association’s Annual Top 300 Organizations Granted U.S. Patents

In addition, you can see the emergence of Facebook during the same period. Since its IPO, Facebook has increased research and development spending from $1.4 billion to $4.8 billion. In the same period, Facebook was granted 127, 279, and 374 patents for 2013, 2014, and 2015 respectively.

Amazon is another surprise. Like Apple, Amazon is very private. Rather than not say anything, Amazon obscures its true actions. For example, Amazon does not report its annual research and development expenses. So the amount shown in Chart I above is somewhat misleading. And it could also be misleading to those outside of Amazon.

Amazon reports its research and development as technology and content. Technology includes primarily research and development expenses, but Content does not. Content includes all the costs associated with “category expansion, editorial content, buying, and merchandise selection.” Technology and Content went from $2.9 billion in 2011 to $12.5 billion in 2015.

Since Amazon buries its  research and development expenses, you really know nothing. You do know from patents granted, that something is happening at the on-line retailer. In 2011, Amazon was granted 180 patents and five years later, it was granted 1,136 patents. In terms of patents granted, Amazon has come from nowhere while Apple is slowing down.

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Beware of Facebook’s New C Class?

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Everyone said, “Facebook’s Class C stock is no big deal, don’t worry about”. To the average shareholder, it means more stock. Every Class A and Class B shareholder, receives Class C stock as a dividend. And then there are three: three classes of stock. Only founders and venture capitalists should really care.

Since going public, Facebook used stock in part to acquire three companies: Instagram, Whatsapp, and Oculus. For example, Facebook used Class B stock and cash to get Oculus back in 2014.  The advantage of Class A or B stock to the seller – founder or venture capitalist – is any taxes on the deal are paid later, not now. This is not the case with non-voting stock, such as the Class C stock.

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When voting stock is used, taxes can be delayed. This occurs when the buyer (Facebook) exchanges its voting stock for the assets or stock of the seller (Whatsapp, Instagram, or Oculus). When the non-voting stock is used, there is no tax deferral. So if you want to do the deal, you may need to find another way. And if you can’t, maybe the deal does not get done. Facebook said the following:

Sellers may have a preference for a transaction in which they can defer taxes owed, in which case we may have to structure the acquisition in a different manner or may be precluded from using shares of Class C capital stock to fund the acquisition.

Think about, if Mark Zuckerberg really wants another company, then he may need to issue more Class A or Class B stock. That gives more voting stock to others, as was done with Instagram, Oculus, and Whatsapp. This would defeat the purpose of the Class C stock: maintaining voting control for Mark Zuckerberg.

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