Facebook / Google –A whim and a prayer

The Oculus acquisition puts the spotlight on corporate governance.

• Facebook is an internet company that makes its money by monetising the traffic of users of its free service.
• There is no rational reason for it to suddenly branch out into virtual reality hardware.
• I cannot see any way that this acquisition will create value for Facebook shareholders.
• This is because:
  • First: There is no way that virtual reality hardware will enhance the Facebook service that generates the traffic that is used to earn revenue.
  • Second: The price paid for this asset is so high that even in a blue sky scenario Facebook shareholders will probably lose out.
• Consequently, this looks like a whimsical acquisition that does not have a prayer of earning a decent return.
• This deal looks very much like Google’s decision to turn a ship into a floating retail store or to spend $1bn on a London HQ that it does not need.
• This is a fundamental issue with both of these companies in that the economic interest and the control of the company are not aligned.
• The founders have a much higher share of the votes compared to their economic interest which gives them the licence to spend other people’s money with no accountability.
• Even when things go badly wrong, investors have no power to remove management, vote down resolutions or force it to return their own money back to them.
• This was the problem that took Ericsson to the brink of bankruptcy 12 years ago resulting in a deeply discounted emergency rights issue.
• While things are going well and the shares are rising, no one seems to care about this issue but when things go wrong it will be front and centre.
• I can be pretty sure that any crisis in Facebook, Google or Alibaba will be much deeper and longer in duration because of investors’ inability to force management to act.
• Hong Kong lost the listing of Alibaba to the NYSE because it would not allow an inequality of voting rights and economic interest.
• Many commentators are berating the Hong Kong exchange for being out of date but in fact the reverse is true.
• History has shown that it is the companies where the economic interest and the voting interest are aligned that always fare better in the longer run.
• This inequality is perfectly acceptable in smaller companies where there a few expert investors who all know the score but in large public companies it is a completely different story.
• I deal with this issue by valuing these companies on a fair and reasonable basis and then reducing that number by 30% to account for the governance shortcoming.
• If there is still upside after that adjustment, then I can consider an investor well compensated for the additional risk he is taking.