Description

Facebook, Inc. (NASDAQ:FB)

Investment Pitch – LONG

September 9, 2018

(dollars in millions except per share figures; FYE December 31)

Industry Dynamics and Background:

1. Social media is an increasingly important advertising platform that should continue to grow at an above-GDP rate for the foreseeable future: U.S. Adults spent 5.9 hours per day on digital media in 2017, up from 5.6 hours the year before and 4.3 hours in 2012. Of that, roughly one third of time spent online is on Social Media. Internet advertising grew 21% in 2017, with the majority of growth coming from mobile. As users continue to shift their time towards digital and social media, ad dollars will continue to follow.

2. Facebook is the clear market leader in a global social media advertising market with an attractive and stable oligopoly structure: Facebook, Inc. is the well-known owner of the Facebook, Instagram, Messenger, and WhatsApp social media platforms. Facebook is the dominant number one player in the ~$58Bn social media advertising market (~$40.7Bn of 2017 ad sales / ~70% share), distantly followed by Tencent (~$3.8Bn / 6%), YouTube (~$3.5Bn / 6%), and Twitter ($2.1Bn / 4%), which combine for ~16% market share. Snapchat, which receives a significant amount of media attention as a competitor, had only $0.8Bn of sales in 2017, giving it ~1% share. Although the industry is relatively young, these market shares have been fairly consistent over time, suggesting a stable oligopoly.

3. The oligopoly structure is protected by barriers to entry consisting of economies of scale in the form of high fixed cost leverage and customer captivity in the form of network effects: Social media cost structures are almost entirely fixed, with sales commissions and data center electricity representing the only truly variable cost components for marginal sales dollars. The high-fixed-cost nature of the business provides significant economies of scale to Facebook as the largest player, allowing it to invest $7.8Bn in research and development in 2017 compared with Twitter’s $0.5Bn despite Facebook’s industry-leading operating margins of 49% being significantly higher than Twitter’s 10% margins. Separately, social networks become more valuable to users as their user base and depth of user information (a.k.a. social graph) grows. Companies with larger social graphs have more captive user bases and therefore more captive advertising customers. The combination of high fixed costs and captive customers is a major deterrent to new entrants and contributes to stable market shares among existing players. Even well-capitalized and highly-motivated entrants such as Google+ and Yammer have been unable to enter the market in a meaningful way.

4. The Cambridge Analytica Scandal in March 2018 first led to a negative information cascade that sent Facebook stock from ~$185 per share to a low of ~$150 per share: A consulting firm called Cambridge Analytica reportedly collected information on as many as 87 million Facebook users beginning in 2014 and was accused of using that data to influence the 2016 presidential election in favor of Donald Trump. This event generated thousands of negative articles and Mark Zuckerberg (Facebook’s CEO) was called to testify in multiple Congressional hearings. It also sparked significantly higher risk of increased government regulation of social media firms and their data in coming years.

5. After recovering to ~$217, the stock plummeted to ~$172 after the company reduced forward revenue and earnings guidance on the Q2 2018 earnings call: Facebook provided guidance on their July 25th earnings call that 1) revenue growth would decelerate from 42% in Q2 at high single digit rates sequentially in both Q3 and Q4 due to anticipated foreign currency headwinds, growth of less-monetized products, and possible EU user declines from GDPR regulation, 2) 2018 expense growth would be 50-60%, 3) long-term operating margins would trend down from the current 49% level to a “mid-thirties” percent level, and 4) 2018 capex of $15Bn would be more than double the $6.7Bn spent in 2017. This guidance resulted in at least 2 analyst downgrades and 19 analyst price target reductions out of 44 analysts, sending the stock down ~20%.

Investment Merits:

1. Facebook’s social graph is the most advanced in the industry and creates a very strong network effect: Facebook’s competitive advantage lies in the combination of its number of users (2.5 billion or one-third of the world’s population) with the amount of data that each user shares with the platform (every user is no more than 3.5 degrees separated). Facebook’s graph is built to scale up to one trillion pieces of information (edges), and more than 10 million websites leverage Facebook’s software development kit to interact with its social graph, adding more edges to the graph in the process. This graph creates captive users and advertisers.

2. Facebook’s high relative market share in a highly fixed-cost business couples with its network effects to create an incredibly strong competitive advantage: In addition to its network effect advantage, Facebook’s high relative market share (>10x the size of the nearest U.S. competitor) allows it to spend more on R&D to match and exceed competitors’ features. For example, Snapchat launched its stories feature on October 3rd, 2013 and reportedly spurned a $3Bn takeover offer from Facebook the next month. Facebook began spending on R&D to create its own “Stories” feature, and Instagram launched stories on August 2nd, 2016. In less than six months, users of Instagram Stories surpassed Snapchat’s DAU’s. In this example, Facebook’s economies of scale allowed it to spend heavily on R&D to match a competitor’s feature and its captive user base quickly swarmed to the feature once available, preventing Snapchat from gaining market share. This strategy should be repeatable to defend against future encroachment.

3. Facebook’s ad model prices incredibly well through inflation, making it an attractive long-term hold: The ad-market model used by companies such as Google and Facebook allows advertisers to bid the highest price they’re willing to pay for each ad view or click. In addition to being perfectly efficient, this model has the benefit of never having to explicitly raise prices on advertisers because the advertisers do it themselves. While Facebook invests heavily in data centers and software to support new users, an ad that costs $5 requires no more infrastructure than one that costs $1.

4. The market has a history of underpricing Facebook’s revenue and EPS growth: Facebook has beaten revenue and EPS estimates, respectively, in 23 and 25 quarters out of 26 since going public. Additionally, 2H 2018 revenue guidance is potentially sandbagged by management’s speculation on future foreign currency movements and potential revenue effects from GDPR ad restrictions, which management also acknowledged have not been material to-date.

5. Management’s revenue deceleration guidance appears to be primarily based on decelerating ad quantity (supply) growth with no mention of offsetting price increases: The two components of Facebook’s revenue are number of impressions or clicks (quantity/supply) and the price per impression or click (price/demand for available supply). Management’s comments on revenue deceleration due to user impacts from GDPR and promotion of under-monetized content are related to expected reductions of ad impressions and clicks (supply) in 2H 2018, but assuming advertiser demand for ads remains fairly constant or grows then revenue should be helped by partially-offsetting price increases. Data from AdStage supports the historical inverse correlation between Facebook’s ad supply growth and price growth (see Exhibit A).

6. Messenger and WhatsApp monetization deliver upside for medium and long-term earnings that is currently underappreciated: The majority of sell side research does not include meaningful Messenger or WhatsApp revenue in valuations despite citing their monetization as a potential source of eventual upside. Many analysts and investors are skeptical that monetization will be possible or happen quickly. However, all signs point to Facebook monetizing these channels sooner than anticipated. A review of digital marketing trade publications and tech blogs makes it clear that Facebook is beginning to roll-out monetization for both platforms. For Messenger, the company has launched Click-to-Messenger ads on both Facebook and Instagram, which allow advertisers to use both automated and human responses on Messenger to supplement marketing from display ads with closely-related direct messaging interactions. Encouragingly, multiple digital marketing trade publications have indicated that advertising ROIs for Click-to-Messenger ads are currently elevated – as high as 7x those of regular ads despite more than 8 billion messages being exchanged between users and businesses every month. I would expect marketers to increasingly utilize these ads until ROIs compress to normal levels, leading to increasing CPM and adoption. At WhatsApp, monetization has been held up by culture clashes between Facebook’s management team and the anti-ad, anti-data WhatsApp founders. With both founders “worn down” and forced out between November 2017 and April 2018, Facebook engineers are now making quick progress rolling out ad products and launched three new products starting in August 2018: the WhatsApp Business API (serving 3 million businesses), WhatsApp Status ads (a clone of Instagram Stories with 450M DAU’s within WhatsApp), and Click-to-Message ads for WhatsApp (WhatsApp has 1.5Bn+ MAU’s). WhatsApp Status ads alone could be material to Facebook’s revenue growth given that the service’s 450M DAU’s have now eclipsed the 400M DAU’s of Instagram Stories.

7. Other short and long-term value creation levers are underappreciated by the Street: 1) 9 of 11 sell side research models I reviewed did not forecast a continued share buyback despite $7.8Bn of repurchases remaining under the current authorization and $5.1Bn of repurchases in the past 6 months. 2) Mark Zuckerberg’s Facebook Developer Conference (F8) Keynote in May made it clear that Facebook will be making a push into online dating, which will drive more user engagement and ad impressions and is not discussed extensively in sell side research. 3) Facebook Marketplace now has 800M MAU’s and 1 in 3 U.S. Facebook users use the service monthly; Facebook currently does not charge a fee for transactions but can eventually begin doing so. 4) Facebook’s virtual reality headsets, Oculus Rift ($400 MSRP) and Oculus Go ($200 MSRP), occupied 2 of the top 5 spots in PC Mag’s 2018 best virtual reality headset rankings; Facebook was the only U.S. company in the top 5 and has won many similar reviews/rankings with other publications such as Tom’s Guide and Wareable. Oculus also boasts more than 1,000 apps and can integrate well with Facebook’s social graph, a feature that will only improve over time.

Investment Risks and Mitigants:

1. Users could become disinterested in social media and use the platforms less over time: Pew Research released a study on September 5, 2018 that spooked investors with findings that 1) 42% of survey respondents said they have taken a break from checking Facebook for several weeks or more in the last 12 months and 2) 44% of 18-29 year-old respondents have deleted the Facebook app from their phone in the last 12 months. While media outlets and investors seem to be taking these results at face value, in my opinion surveys on this topic are subject to significant response bias and not good indications of actual user engagement. For example, as someone in the 18-29 year-old demographic, I would have responded yes to both of the above questions despite being a regular user of both Facebook and Instagram because I often try to force myself to take breaks from the service. In my case, this is more of an indication of how strong Facebook’s pull on my time is than an indication that I will use the service less in the future. I prefer to look at the DAU / MAU ratio over time as a gauge for user engagement because it is hard data and not subject to bias – the DAU/MAU ratio has remained fairly consistent around 65% since 2015 and both DAU’s and MAU’s have increased significantly since then. Fundamentally, I believe that humans are social creatures and will continue to want to spend significant portions of their internet time on social media. What’s more, I feel very confident that Facebook has the competitive advantage necessary to maintain share within the social media category.

2. Advertising is exposed to the economic cycle and a downturn will mute Facebook’s growth and possibly its EPS multiple: Advertising expenses are often cut by cash-strapped companies in downturns, exposing Facebook to the broader economic cycle. For comparison, Google’s revenue growth decelerated from ~30% to ~8% between 2008 and 2009, although EPS still grew at 53%. A broad economic downturn however, would not permanently impair Facebook’s value but rather delay its realization and may actually cause some of its weaker competitors (i.e. Snapchat) to go bankrupt, allowing Facebook to further increase share.

3. Facebook could be significantly overearning at 50% operating margins, and operating costs may accelerate faster than revenue growth in 2019E and possibly beyond, causing margin erosion: Management’s guidance on the Q2 earnings call implied that they believe the company to be overearning and that investors should plan for significant operating margin compression from ~50% to ~35% in the coming years. If true, this implies that the company was previously underinvesting in security and compliance and that ad prices will not increase to cover further investment in these areas. This is a very real risk, but typically a company is overearning to the tune of 15% on its operating margin when there are capable competitors waiting in the wing to erode return on capital. However, as discussed previously, Facebook’s competition is muted in most geographies excluding China, where Tencent and Weibo are strong competitors. Regardless, my valuation factors in operating margin reduction to 35% in 2020 and beyond.

4. Regulatory headwinds after the Cambridge Analytica Scandal could cause increases in capital and operating expenditures, creating a drag on earnings: This argument goes hand in hand with the overearning argument above (Risk #3), but increased regulation would actually create a new universal fixed cost that would further benefit Facebook as the largest incumbent firm. Increased regulatory compliance costs would act as a new barrier to entry that would make it more difficult for start-up firms and smaller incumbents to compete.

5. Fallout from the Cambridge Analytica Scandal could cause users to abandon Facebook’s platforms: Per the Q2 2018 earnings call, users on the core Facebook platform are growing in all regions except the U.S. and Canada, where they are flat due to market saturation, and Europe, where there was a slight decrease after implementation of GDPR regulation. Any fallout from the scandal would likely be immediate and lessen over time, suggesting that actual effect on platform usage has been minimal.

6. High stock-based comp detracts from free cash flow per share growth: Similar to many tech companies, Facebook uses a significant amount of share-based compensation to incentivize employees. This economic dilution has been a cause of concern for shareholders, but Facebook began to buy back stock in Q1 2017 and has aggressively ramped the program over the past two quarters, repurchasing $3.3Bn of stock in Q2. The diluted share count has decreased over the past two quarters.

Valuation:

1. Current prices represent an attractive entry point: As of Friday’s closing share price of $163.04, FB trades at 23.0x LTM EPS (net of cash) vs. a comparable S&P 500 multiple of 23.4x as of September 7, 2018. The free-cash flow yield is 4.8% excluding my conservatively estimated LTM growth capex (30% of total capex) and 4.0% when burdened by all capex. It is not every day that investors are presented an opportunity to buy shares in a dominant market leader in a quickly growing sector for the same EPS multiple as the overall market. Facebook deserves to trade at a significant premium to the market given its high relative market share (>10x larger than nearest U.S. competitor), return on capital (~20%), and growth (~30%+).

2. Facebook’s conservatively modeled DCF value represents a significant premium to today’s share price: My unlevered 5-year DCF model produces a share price of $209.78 using conservative assumptions as follows:

• YoY revenue growth decelerates by 5% sequentially in each of Q3 and Q4 of 2018 to 37% and 32% respectively (YoY Q2 2018 revenue growth was 42%). Management guided for “high-single-digit percentage decreases in growth in both Q3 and Q4.”

• Global MAU’s grow at a 2.9% CAGR from 2018E-2023E (vs. 15% average annual historical growth from 2013-2017) and Advertising ARPU grows at a 14.4% CAGR from 2018E-2023E (vs. 35% average annual historical growth from 2013-2017). This implies that Facebook’s share of the global ad market increases from 10% in 2018 to 20% in 2023. For context, Facebook has roughly 20% share of the U.S. ad market today and is growing that share rapidly. I have also modeled no growth in North American or European MAU’s.

• Total expenses increase at 53% in 2018. Management guided for a 50-60% increase.

• Operating margins decline from 50% in 2017 to 45% in 2018E, 41% in 2019E, and 35% thereafter per management’s guidance that operating margins should settle in the “mid-thirties percent.”

• Capex of $15Bn in 2018E per management guidance, increasing to $29Bn by 2023E.

• Taxes, working capital, and interest modeled in-line with historical financials and management guidance.

I believe these revenue growth numbers represent a fairly conservative floor for forward-revenue growth given how conservative they are relative to historicals. The sensitivity table on the following page provides context for the imbedded upside in the stock if revenue growth exceeds expectations:

Why this Opportunity Exists:

1. Negative press post-data breach combined with disappointing guidance have caused negative investor sentiment amongst both shareholders and sell side analysts.

2. As noted above, the market has a history of underpricing Facebook’s growth potential.

Conclusion and Recommendation:

Facebook is a best-in-class company that is currently underappreciated by sell side analysts and Mr. Market. It is available for a market multiple of earnings today. I would recommend initiating a 5-10% position and using any negative price movements as opportunities to add to the position.

Exhibit A:

Source: AdStage

Catalyst

Catalysts:

1. Continued revenue and earnings beats.

2. Continued share buyback. An activist or insider could encourage Facebook to increase its share buyback that was just started in 2017 (~8% of market cap currently sits on the balance sheet in cash).

3. Longer-term monetization of Instagram Stories, Messenger, and WhatsApp.