Note: This post has many similarities to my “100 Years” Google post. Some sections are even repeated verbatim. That’s because the more and more I looked into Google, the more I realized Facebook is the Ying to Google’s Yang. Why have one when you can have both.
The story: Imagine creating a product where the user of the product was also the product (to a 3rd party) but never thought of himself/herself as such. This user then constantly provided the most intimate details of their lives as content for free and then gives you the privilege to bundle their personality up and sell to the 3rd party (an advertiser). Essentially, cost of good solds at no cost. Creating this all from the starting point of your dorm room. Then waking up one day to realise that your company might have played a not-so-small role in electing a leader who is the living breathing antonym of all your liberal ideals, leading you to one day do some deep self-reflection and wonder where it all went wrong in a post on the network you created. You can’t make this stuff up.
Facebook post by Mark Zuckerberg on Sept 30th 2017
All that being said, Mark Zuckerberg is a great CEO. He is only 33 and seems to sincerely want the world to be a better place. See his Harvard commencement speech and US
2020 presidential campaign tour but as the saying goes, “The road to hell is paved with good intentions.” Only time will tell.
Now on to brass tacks.
Theme: As Marc Andressen put it, “Software is eating the world.” The firms most likely to benefit from this are technology platform companies. Ben Thompson put it best in his brilliant post “Aggregation Theory.” The theory breaks down how suppliers are being modularized by technology platform companies, the new distributors, who then take a disproportionate share of the spoils. For example, Airbnb modularizes the rooms in an apartment building which then disrupts the previous supplier (hotels).
Thesis: Facebook has a stellar management team and a strong moat through its network effect. Its messenger platforms (FB Messenger/Whatsapp) are yet to be monetized. Facebook ad buys might not be underindexed in Europe and the company will benefit from improving standard of living in emerging market economies. Human beings are social creatures thus social data might be more valuable than other forms of data to advertisers. In addition Facebook has a walled garden with information that is currently inaccessible to the biggest data beast of them all, Google. It is also possible the stock is underbought by many institutions due to the sometimes negative connotation attached to FANG stocks.
The business: Facebook sells ads programmatically worldwide mainly through its platforms Facebook and Instagram. It owns 2 other messaging platforms with over a billion users, Facebook Messenger and Whatsapp, that are yet to be monetized. Its virtual reality efforts are housed under Oculus. Finally, Facebook has a small payments/fees business is approximately 3% of revenues.
Market Size: Global advertising is an approximately $600B market with online being approx 38% of this at $228B. At $33B LTM Revenue, Facebook is just 6% of global advertising and 14.4% of online advertising. After reading this post on the total addressable market (TAM) of search it is possible to imagine long term market size being grossly underestimated. Take the following thought experiment: if a brand, say Louis Vuitton, has to close a prime retail location (in, for example, London or Manhattan) because more and more retail is migrating online, how much of its former rent will LVMH pay for a “prime location” on Google Search or one of Facebook’s many platforms (Whatsapp, Instagram, Messenger, Facebook)? See it this way and the TAM of search becomes more unbounded.
Competitive Advantage/Moat: Facebook and its umbrella properties have created the largest network effect mankind has ever seen. Some numbers. Facebook has 2B monthly active users (MAUs) and 1.3B daily active users (DAUs). Whatsapp has over 1B DAUs. Facebook Messenger has 1.2B MAUs. Instagram has 800M MAUs. It has now become much more difficult for a social network to achieve massive scale. Edge cases exists where a niche is created (see Tinder or Twitter) but Facebook size social networks will become increasingly difficult to create. To deepen the moat Facebook continually adds new features to drive engagement. In addition, in the old days when your competitor created a revolutionary product the lead time one needed to catch up might be months or years (product development, testing, manufacturing at scale etc). Now it takes Facebook just weeks or months to copy the features of would be incumbents.
Average Revenue Per User: In Q2 ‘17, across all its platforms Facebook earned $18.93 per user in US & Canada, $6.19 per User in Europe, $2.12 per user in Asia Pacific, $1.47 in Rest of World, and averaged $4.65 per user Worldwide. Looking at these numbers two observations come to mind that might indicate the room FB has to grow. Firstly, US & Canada revenue per user is 3.05x that of European but North America GDP Per Capita GDP is only 1.6x European per Capita GDP. This indicate Europe is possibly under indexed for Facebook Ad spend. The other comparison is between US & Canada ARPU and Asia Pacific & Rest of World, $18.63 vs $2.12 & $1.47 respectively. As the poorer regions of the world become wealthier, it is entirely possible that brands reach their customers most efficiently through Facebook. Facebook is a play on a richer world 5, 10, 20 years from now, without the heavy capital expenditures that greenfield projects usually entail. Additionally, from comparing my personal user experience on Facebook to that which I had on Instagram, one gets an intuitive feel that Instagram is under-monetized. The delicate balance management has to maintain is to load ads but not interfere with user experience.
Whatsapp/FB Messenger: In times past, the West has led in technology and China has been accused of producing knockoffs but this is not the case when it comes to messaging. One only needs to look at China’s WeChat to see the potential of Whatsapp/ FB Messenger. In addition to messaging, WeChat can be used to shop online, pay for physical goods, share large files, exchange money. Although Facebook has not been clear on how it is going to monetize its messaging services, on the most recent earnings call Zuckerberg’s comment was “I want to see us move a little more quickly” when ask about monetizing Whatsapp. At the F8 Developer conference held in April 2017 the company stated that their roadmap was to focus on video now, messenger in 3 to 5 years, followed by virtual reality and augmented reality over the longer term. The chart below from the Economist shows the potential of Whatsapp/FB Messenger. It might be absolute domination like WeChat might have due to services like Venmo that already exist but the potential is there.
Zuckerberg the Monopolist: Zuckerberg is only 33 and has been a great owner/operator thus far with a long runway ahead of him and with monopolist tendencies to boot. He has sought to crush competitors at every opportunity. Instagram Stories as a rebuttal to Snapchat. Facebook Live as a rebuttal to Periscope. He has completed acquisitions at every opportunity in order to protect the network effect at all costs (e.g. Instagram and Whatsapp), There was even a rumored failed bid for Snapchat. In addition, Facebook barely shares its economics with its ecosystem as opposed to Google that shares ad revenue with Youtubers and with websites via its Adsense network. Recent announcements to focus on more content initiatives might hurt margins but will probably be best for the ecosystem.
World Class Supporting Cast: This includes the fantastic COO Sheryl Sandberg, the very underrated Jan Koum of WhatsApp (who managed to sell a 55 employee business for $19B), Marc Andreessen of the venture capital firm Andressen Horowitz, Peter Thiel (Zero to One is a must read), Reed Hastings of Netflix, statesman Erskine Bowles and you have an all star top brass.
It is important to keep things simple when it comes to valuation. My approach is to look out 5 years, estimate what the company is going to earn and what it might be worth then and what its future might look from that point on. So, in the last 12 months Facebook earned $13.2B, with a market cap of $516B and $35B of cash on the balance sheet, one is paying roughly $481B and 36x earnings for the whole business. EPS has grown at a CAGR of 62% over the past 5 years and is expecting to grow at a CAGR of 28% over the next 5 years by some street estimates which I will use for simplicity’s sake. I think these estimates might end up looking conservative. Management has started making investments in content that might put pressure on gross margins but a lot of operating leverage will appear from increasing ad load outside the US & Canada and bringing more users online in the developing world. As supply decreases (by not bombarding consumers with ads), demand (programmatic ad buys) will increase which will probably result in higher ad prices. So in 5 years time Facebook might be earning around $45B. Throw on a conservation 20x to these earnings due to a more mature growth profile after 5 years and the business is worth $900B sometime in 2022. So it’s entirely possible that you could compound your money at 13% annually over the next 5 years with Facebook. I have excluded effects of dilution for simplicity, as market value gets larger, an increasingly smaller portion of aggregate value will be used to compensate employees. As of last count they were 2.7M options at a weighted price of $7.38 and 100M RSU at a weighted price of $100, with 2.9B shares outstanding at the last count this is less than 5% of the share count and won’t make or break the valuation case. As Broyhill Asset management points out here, in a market that has a dividend yield of 2%, real earnings growth of 1.5%, inflation of 1.5%, expected P/E increase change of 0% as P/Es already elevated, although not impossible, it is difficult to imagine the S&P 500 gaining more than 5% annually going forward. In that context a 13%, again not fact but estimate, by Facebook is decent.
Technological Disruption: The world of bits (tech companies) will always be more prone to change than the world of atoms and immutable laws of physics (railroads, utilities, etc.).
Consumer Revolt: Although hard to estimate, they have been times in the past where consumers revolted against advertising which is in some ways exploitative. If this happens do users move to another platform? Alternatively, Facebook could move to a subscriber model if/when that happens.
Antitrust: In a world of slow growth, higher inequality and more winner take all scenarios there is the chance of a backlash against tech companies having a larger share of the spoils. See Google’s $2.7B settlement with the EU as an example. A situation could occur where a company like Facebook could have it profits taxed at a much higher rate than currently persists.
Amazon: If Facebook is a tool to capture people’s attention and subsequently advertise to them but more and more retail product is going through Amazon which has its own advertising program (Amazon Affiliates), it is entirely possible that a Facebook ad might not have the same value in 10 years as Amazon becomes more pervasive.
Recession: Advertising is cyclical to some extent. In a scenario where there is a recession in the next 5 years, Facebook business and multiple might get really affected.
Conclusions/Standing on the shoulders of giants/the institutional imperative.
It does not hurt that investment managers much smarter than me, like Pat Dorsey at Dorsey Asset Management and Shad Rowe at Greenbrier Partners, have Facebook as their top holding, but on the other hand, the stock has been either completely ignored or taken up as a small holding in the institutional world (ex ETF). From anecdotal conversations with a few analysts at some big shops that I’ve spoken to, the train of thought goes something like this, “We are a value shop, no way I’m convincing my PM to buy FB at close to 40x earnings.” or “We have avoided FANGs this far in the bull market, the optics of owning one now is hard to sell to clients. It either shows we were wrong all along or we do not believe in our process.” This evidence is purely anecdotal but it is possible there are reasons for not owning the stock that have nothing to do with FB and its actual merits. It will be great to be able to buy Coca-Cola at a single digit multiple and to have it grow at double digits like Buffett did in the late ‘80s, but there is some good research about acquiring companies with long runways and high growth at high multiples and still ending up ahead due to the power of compounding, see this great paper by LindsellTrain.
With all credit due to:
Ben Thompson’s blog, Greenhaven Q2 ‘17 Letter, Alex Moazed’’s Modern Monopolies, Facebook’s Investor Relations, Stevenoop’s TAM post, Horizon Kinetic’s Q2 ‘17 letter, John Lanchester’s amazing review of 3 books, World Bank Per Capita GDP Data.