Description

Everyone on here knows on a TTM basis, ex Reality Labs, FB trades at a low multiple of reported earnings.  This write up summarizes my thoughts on the main market concerns, and why I think the recent sell-off is an overreaction and the future continues to be bright for FB despite a more competitive environment.  Note, I’ll use FB to mean Facebook and Instagram.

Q4 Commentary / Q1 Guidance

Management blamed low YoY Q1 growth guidance (+3-11%) on iOS changes, competition/mix, and macro concerns. The iOS changes will result in a one-time step down in targeting capability and once lapped, FB should return to the long-term trend of continuously improving ROAS, and therefore higher ad prices, as a result of investments in AI and shops.  The iOS changes were already an issue in Q4, therefore I believe the sequential slowdown in revenue growth is mostly the result of macroeconomic challenges (and to a much lesser extent, competition).   Why do I think it’s mostly macro and less so competition?

Q1 2021 had incredible tailwinds for FB that won’t be present in Q1 2022.  First, there were two stimulus checks sent out last Q1.  $600 per person per household was paid in early Q1, and $1,400 per person per household in late March.  That’s $8,000 in the quarter paid to the average family of four; roughly 50% of the average family’s quarterly pre-tax earnings.  At the same time, COVID cases were peaking; January 8^th, 2021 was the pre-Omicron peak.  The stimulus came at a time when people were generally cautious about spending money on experiences.  Demand for goods obviously surged (retail spend in the US was up 16.5% YoY last Q1), increasing advertiser demand.  Additionally, people were spending more time engaging with social media because of school/office closures, meaning impressions increased.  This was the perfect storm of benefits and why advertising was up 46% YoY in Q1 2021 for FB compared to 17% YoY in Q1 2020.  So that’s the comp FB is up against in Q1 2022. 

Besides comping that quarter without stimulus checks and without hyper-engagement, FB is now affected by Apple’s iOS changes (as already reflected in the Q4 #’s), Reels mix issues, and supply chain issues.  If you’re selling out of inventory, why spend money on ads to drive incremental demand that you can’t fill?  And as FB pushes Reels onto users, it creates some new engagement, but largely takes engagement away from Feed/Stories.  Since Feed/Stories monetize substantially better than Reels now, this is a headwind.  Count me in the minority, but I don’t think growing 7% YoY against that comp with those headwinds indicates any impairment in the competitive positioning of this business.  The two-year stacked comp in the last full quarter pre-covid (Q4 2019) was 63%, and the guidance (with IDFA impacts) for Q1 2022 implies a healthy 59%.   I expect revenue growth to accelerate meaningfully in the back half of the year.  

I think the iOS explanations for sequential declines vs Q4 (which already had iOS impacts) are just attempts to put the regulatory spotlight where it really should be, on Apple.  It makes no sense to me that Q1 would have materially worse IDFA impacts than Q4.  And I think the TikTok comments were overexaggerated attempts to again take the spotlight off FB and show FB is not a monopoly.  Of course competition (TikTok) is affecting impression growth on the margin, and as FB pushes Reels engagement it makes sense that this would slow impression growth as they are prioritizing the user experience over monetization to compete with TikTok.  But I believe the vast majority of the deceleration in revenue growth is a result of the tough comp in the 1^st half of the year.  

Competition (TikTok)

While TikTok and FB certainly compete for attention, I believe there is a limit to how much user attention TikTok will steal from FB. TikTok and FB have differing use cases. Instagram/Facebook are generally used for chronicling your real life and staying connected with friends and family and/or following the real lives of influencers you care about. TikTok on the other hand is used for watching entertaining videos posted by people you don’t know. TikTok has grown rapidly (to ~1B users), skewing heavily to younger users, and many believe that points to a bleak future for FB. But 3rd party data sources don't indicate any meaningful reduction in average time spent on FB's family of apps.

Younger cohorts don’t really need to follow the lives of their friends and family, they see them every day; they don’t need FB to help them stay connected.  But younger users have plenty of free-time and browsing endless entertaining videos serves a need that wasn’t met by FB.  On the other hand, older cohorts don’t have endless time to consume short-video entertainment.  But they do want to stay connected with their friends and family that they now have less time to engage with (or live apart from); that’s where FB’s family of apps becomes useful.  I think TikTok has likely won the war for younger user’s entertainment time; but I think as younger users age (as young people tend to do), their needs will change.  Their time will shift more from watching short videos posted by strangers to staying connected with friends and family and over time, I think the mix of an individual’s time slowly shifts from TikTok to FB.

I think FB will be a great investment even if TikTok maintains dominance of young audiences.  But I also think there is a reasonable chance that FB will be successful in growing Instagram engagement among younger users with its push to invest in Reels.  Instagram is now mixing suggested Reels into the News Feed and investing heavily to encourage content creation and improve suggestions on Reels.

Opex Growth, Earnings Decline

Management is guiding for opex to grow by 30%, and Q1 revenue to grow by 7%.  This has led some to speculate that FB has been overearning.  I think FB could earn basically whatever Zuckerberg wants it to earn (between $0-100 billion) if he was managing for the short-term.  But he is correctly, in my view, (as it relates to investment in core FB) investing for the long-term.  Investing in paying creators to get the Reels flywheel going, investing in compute capability to use AI in ways that improve ad targeting and improve Reels/Feed suggestions, investing in servers for greater bandwidth usage that comes with video, investing in content moderation, etc.  And then, of course, there’s probably A LOT of Metaverse expenses that I’ll describe below.  Bottom line is, I believe the increased opex is to set the business up for future success and I think the TTM earnings almost certainly represent a conservative estimate of what the business could earn if it was just interested in growing along with GDP.  And even if you assume opex grows 30% and revenue increases 10% YoY (which I think will prove conservative), and don’t exclude Metaverse losses, it’s still priced at ~18x earnings ex-cash.  From that base I expect expense growth and revenue growth to begin converging in 2023 and eventually this business should have significant operating leverage.

Metaverse

The market is rightly concerned about Metaverse spending but that was telegraphed so I don’t think that’s the reason for this sell-off.  I agree with the consensus, this seems like a waste of capital, but to quote a friend of mine, “If I invented Facebook, I’d be a millionaire right now… because I would have sold it the minute someone offered me $1 million.”  Zuckerberg has built an extraordinary business, many times making incredible decisions none of us would have made without the benefit of hindsight.  I recall most analysts ridiculing the Instagram acquisition, as the most obvious example.  My guess as to what Zuckerberg sees is that just as the world went from text (Facebook) to images (Instagram) to videos (Stories/TikTok), the world will eventually go to immersive social media once the technology is ubiquitous.  Would these catchy dance videos on TikTok be more engaging if you felt present in the room?  Or will I eventually be able to let my parents feel like they’re sitting in the room with my kids watching them play instead of just sending them a video?  I don't know, but it seems likely that at some point in the medium term, short-form user generated video entertainment could be viewed in VR, and that it would enhance the experience.  I think worst-case scenario, the Metaverse spending ends up being a poor use of capital that is at least a valuable gaming platform (and a hedge against my RICK position…).  I don’t think Zuckerberg is going to spend $10B/year forever with no results.  I think either we’ll see incremental progress with a real business case over the next 5 years, or the spending will slow down.  FB has $55B in cash/securities/investments.  I make a simplifying assumption that the NPV of FB’s Metaverse spend is negative $55B.  You can make your own judgement, but to me, that seems conservative.

Valuation

At $220/share, FB’s market cap is $600B. 

FB ex-Reality Labs earned $47.3B after-tax last year.  FB trades at 12.7x those earnings, an 8% core TTM earnings yield.  This is a far below average price for a far above average business in my opinion.  At this price, I don’t think you need to believe there is any growth ahead, I only think you need to believe (1) time spent on FB’s family of apps will not shrink materially and (2) Zuckerberg will eventually (call it 5-10 years) either be successful in building a valuable ecosystem with Reality Labs or will be smart enough to stop spending money on it.  

But I believe more than that.  I believe engagement will continue to increase over time as the internet engaged population grows and, more importantly, I believe ARPU still has significant room for growth.  We’re still in the 1^st inning of Shops on Instagram.  I think in the post-IDFA world, all retailers are going to need a Shops presence on Instagram.  That will take a few years to occur, but the end state is that advertisers will have a closed loop in Instagram where customers purchase within the app and advertisers have clear visibility on their ROAS, and better data to optimize their spend.  It also creates a better user experience.  ARPU will also continue to benefit from continuous AI driven improvements in targeting capabilities and global GDP growth. 

I also have little doubt that Zuck will eventually find an effective way to monetize WhatsApp and Messenger. They talk about click to messenger ads being a relatively large business already, but those are just Instagram ads by another name; zero value is being extracted right now from user engagement within FB’s messenger apps and significant expense is related to those apps.  They are testing payments solutions in WhatsApp in India, and that could be one method of monetization. Or we might see future technologies that allow FB to use WhatsApp data in anonymized ways to better target ads.  Last summer it was reported that FB was recruiting “researchers with backgrounds in privacy-related technologies including homomorphic encryption, secure computation and data anonymizations”, technologies that are aimed at maintaining privacy and “simultaneously expanding the efficiency of Facebook’s market-leading advertising systems.” I doubt they would do this any time soon with the headlines surrounding the company.  This would probably be the last resort if all other options like payments don’t monetize well. 

Catalyst

1) If the stock stays at this price, I think we’ll see a levered buyback later this year.  In the last 4 months, FB has been buying back stock at an annual pace of ~$80B.  They have $48B in cash and will likely produce ~$20-30B in operating cash flow this year after elevated capex and Metaverse losses.  Zuckerberg clearly thought $330/share was cheap, so I don’t see how with the questions around capital allocation (Metaverse) he can afford to (or would want to) slow down buybacks now at $220/share.  While he probably doesn’t care about the temporary mark on his personal wealth, I think he does need to care about employee morale and therefore is probably concerned about this sell-off.  I put high odds on this pace of buyback continuing if the stock remains near these levels and I wonder how the narrative on capital allocation might shift if FB retires 10-15% of the float in the next 12 months.

2) Revenue reacceleration through Q3 / Q4.