Disclaimer:
Paradise Divide Capital is long Facebook’s equity. It “the Fund’s” largest position, at roughly 16.1% of the Fund. This is not investment advice, or a solicitation to buy Facebook’s equity, rather it is purely informational and educational. Do your own due diligence.
Overview of Facebook:
Most people know Facebook as the social media platform that was cool in 2012, but nowadays you just think of it as the place where your crazy aunt gets her vaccine misinformation. But, Facebook Inc. is a much larger enterprise that owns Facebook, Instagram, WhatsApp, Oculus, and more. Facebook uses the term “family” to describe the larger ecosystem of apps and social media platforms that it owns. In total, Facebook’s family has 2.81 billion daily active people (DAP) and 3.58 billion monthly active people (MAP). Facebook is able to, per quarter, make an average revenue per person (ARPP) of $8.18, and that number is much higher in the United States where Facebook is able to make $52.34 of ARPP per quarter.
Overview of Outside Threats to Facebook:
Over the last two months, Facebook’s stock has fallen from around $380 per share to $315 per share as of today, October 26, 2021. Let’s see if we can rationalize this drop in share price.
On April 26, 2021, Apple released iOS 14.5, which allowed users to dictate whether or not advertisers were allowed to track users across different apps to optimize ad targeting. Facebook is so effective at advertising because they have so much data on their users, and are thus incredibly effective at targeting ads to the user. The IDFA, or what allowed Facebook to track users across apps, was just one of these data points, but it was very effective.
The IDFA has impacts on Facebook, but is not destructive. For example, with the release of Facebook’s 3rd Quarter 2021 earnings, many expected that the repeal of the IDFA would put a dent in their revenue, but their revenue grew by over 35% from the previous year's quarter. This number would have been higher if the IDFA was still in place, but the absence of the IDFA didn’t hurt Facebook too much.
While the advertising, and the rescinding of the IDFA, makes an impact on Facebook’s income statement, the largest headwind for the stock has been the threat of regulation. Every other day Mark Zuckerberg, Sheryl Sandberg, or Mike Schroepfer are forced to sit in congressional hearings and answer questions from congressmen and congresswomen who learned about the internet from their staffer twenty minutes before the hearing. This is because Facebook’s greatest advantage is also their biggest problem: their data they have on their users and the perceived lack of privacy by users that is associated with this.
To fully optimize advertising, Facebook uses mostly in-app data about the user's interaction with the platform to target content and advertisements. For example, if a Facebook user were to like a post about mountain biking, that user would likely see advertisements and content pushed to them that has to do with mountain biking. Facebook also uses how much time a user spends on a post, whether the user comments on the post, whether the user shares the post, who the user follows, what clubs or activities the user is a part of within the Facebook ecosystem, and more as part of their data they use to target ads and content. Facebook uses their proprietary AI to optimize this process and automate it. Probably the largest misconception is that Facebook is selling their data on users to other platforms, an idea that is perpetrated by politicians and widely believed by the public. Facebook does not sell data to third parties, as this would not only be an invasion of the user's privacy, but it would undermine Facebook’s advertising business and the data would be inaccessible to third parties because it is written so only the Facebook AI could read it.
Politicians, from both the right and the left, see this as an invasion of privacy, and want to regulate it. In my personal assessment of the risk that this poses to Facebook, I think that something isn’t likely to materialize here. I have 4 reasons for this: politicians won’t be able to make specific enough legislation to impact Facebook, Facebook will be willing to spend hundreds of millions on lobbying to prevent this, their is too much division in the legislative branch to get anything significant passes, and Mark Zuckerberg and the Facebook team will be able to outsmart to politicians to subvert the effects of any legislation passed.
The second political headwind for Facebook is politicians perceive it as a “monopoly.” The fact that this is even a conversation is hilarious, but it is a conversation nonetheless. This is because Facebook is by far the largest social media network in the world and it owns Instagram and WhatsApp. What politicians fail to consider is the definition of a monopoly. Since I feel that it is important to be accurate in talking about this, I will insert the legal definition of a monopoly here: “a control or advantage obtained by one entity over the commercial market in a specific area.”
Let’s evaluate why this is not the case for Facebook, it is rather simple: Facebook has intense competition. Domestically and internationally, Facebook faces competition from Snapchat, Twitter, TikTok, YouTube, WeChat, Pinterest, Reddit, Discord, and more. There is not much else to say on the topic of Facebook being a monopoly, other than it is a flashy political talking point for Amy Klobuchar and Elizabeth Warren, and it is not backed by any legal argument or common sense.
What politicians likely see is Facebook’s “scapegoating” from other platforms. Most notably, they copied the idea of “Stories” from Snapchat and “Reels” from TikTok. But, this isn’t the composition of a monopoly. Facebook didn’t steal any code from Snapchat to do their own stories or they violate Snapchat’s patent to do their own stories. Facebook didn’t violate any laws in doing this, and people still use Snapchat and TikTok, so what is the threat of Facebook and Instagram having Stories and Reels?
In fact, every social media app scapegoats ideas from other social media apps. Some examples that don’t include Facebook are Twitter creating “Spaces” to rival Clubhouse, Twitter creating “Fleets” to rival Snapchat, and Snapchat creating “Spotlight” to rival TikTok. Facebook is just more effective at this implementation, as you have probably heard of “Instagram Stories,” but you have likely never heard of “Twitter Fleets.”
Again, I think this “monopoly” argument is just political posturing and has no basis whatsoever in an antitrust court of law. In fact, a judge dismissed a suit brought by the Federal Trade Commission (FTC) that alleged Facebook of being an illegal monopoly. The judge saw the ridiculousness in this argument, and he dismissed it before even hearing oral arguments. This case will likely serve as precedent for Facebook and will be a significant tailwind in antitrust cases going forward.
Politicians fear the competence of Facebook. They fear that Facebook seems to always be one step ahead of regulation, on the cutting edge of technology and innovation, and that they are able to create a platform that gushes out profit.
Analysis of Facebook’s Expenditure:
With Facebook’s 3Q 21 earnings release, many questions were raised about how they could be so profitable on a gross margin basis, but not as profitable on a net income basis. This is because they are spending a ton of money on capex (capital expenditures), and most of this capex spend comes from their project dedicated to advancing the metaverse.
In the investing world, this is a source of controversy. Presumably they could use the money they would spend on the metaverse project to buy back more shares than they are already doing, which would deliver some of the profits back to the shareholders. During 3Q 21, they bought back $14.37 billion of Facebook stock, and Facebook announced that they are starting a $50 billion buyback program. But, many investors say that this could be higher considering the amount of profit that Facebook makes.
Facebook announced in their earnings call that they will be spending ~$30 billion in 2022 on capex. The majority of this capex spend is going to their metaverse project, which is Mark Zuckerbeg’s vision for how the world will be in the future. In short, the metaverse eliminates any barriers of interaction that people have between each other. A large cohort of investors see this as pointless and a waste of money that could be used to buy back shares. I don’t have an opinion regarding the furthering of the metaverse, but I will take this moment to defend Mark Zuckerberg’s decision here. In my opinion, the risk/reward here for Facebook is worth it. If the metaverse is as big as Zuckerberg thinks it is, Facebook is going to be at the epicenter of a multi-trillion dollar industry. If the metaverse ends up not materializing, so what? Is the difference between an $50 billion buyback and an $80 billion buyback substantial enough to warrant not investing in what could be the future of interaction?
I think that investors being so hyper focused on this difference is not beneficial, Facebook still produces 10 billion dollars of free cash flow and their metaverse project isn’t going to change that. Invest in the future now, buy back shares later.
The Facebook Bull Thesis:
Now that I have addressed, and hopefully answered, all the bear points for Facebook, I will now delve into my bull thesis for the company, and why I personally think it offers the most upside of nearly any equity in the market.
I will start off with Facebook’s valuation, which I believe is currently being dislocated to the downside. Facebook is currently trading at 16x next-twelve-months (NTM) Price/Cash Flow Per Share (P/CFPS). To put that in context with all other “big tech” companies, Amazon is trading at 22x NTM P/CFPS, Apple is trading at 23x NTM P/CFPS, Google is trading at 18x P/CFPS, and Microsoft is trading at 26x P/CFPS. And in comparison with companies that are traditional “value” stocks, Walmart is trading at 15x P/CFPS, Pfizer at 13x P/CFPS, and Procter & Gamble at 20x P/CFPS.
The difference between Facebook and those value stocks that I mentioned, is that Facebook is growing 30%+ per year and is a profit generating machine, and those value stocks don’t experience much year-over-year growth. The market will typically give a company, like Facebook, with high velocity of growth and high gross margin profitability a high valuation, which is why Facebook’s relatively low valuation is surprising.
This low valuation presents an opportunity to capitalize on Facebook’s “multiple” expanding. A multiple expansion would be if Facebook were to be priced more expensively than it is today. For example if Facebook’s P/CFPS expanded from 16x to 22x, that would be a multiple expansion of 37.5%
In my opinion, considering the growth and profitability of Facebook, it should be trading at 22x P/CFPS, a multiple commensurate with the rest of the big tech companies. This would imply a 37.5% upside for Facebook without pricing in any of Facebook’s future growth. Taking into consideration future growth, this upside could be 50-100%.
The next reason for my bullish sentiment on Facebook’s equity is the power of social networks. In a social network such as Instagram or Facebook, Facebook doesn’t have to pay users to post, share, like, comment, or engage. Rather, users feel compelled to do this, which is to the benefit of Facebook. Users are constantly drawn back into the social network because they want to see what their friends, favorite celebrities, or favorite companies are posting or sharing. Once these social networks are established, they are almost impenetrable. The vast majority of people want to stay engaged in the networks, and they are rewarded by doing so, as the content that Facebook or Instagram pushes the user is more optimized the more the user is on the social network.
These social networks also serve as a moat for Facebook. The fact that Facebook and Instagram have already established these networks makes it hard for competitors to establish networks of their own. It takes a massive amount of people to join a social network and engage in a social network to make that network effective. This serves as an advantage to Facebook.
My next reason for bullishness is rather simple, but Facebook is probably the most effective at it in the world: advertising. Much of Facebook’s advertising power was already explained above, so I will try to keep this concise. I won’t explain the user side of this, as it is rather intuitive, but I think it is fascinating the enterprise side of Facebook advertisements.
For example, I own a small business that wants to post an advertisement on Instagram for a new pair of skis. First, the simplicity of the ad platform, from the enterprise side, is unbeatable. It is easy to set up what I want to advertise, who I want to advertise to, and how many people I want to advertise to. From there, I can say to Facebook that if they give me a 3x return on investment for my advertisement, they can keep advertising until that return drops below 3x. No extra ads need to be bought, and Facebook can ensure that I get the traffic to my ad that would give me that return. From Facebook’s perspective, if they can optimize who that ad goes to, they can keep making more and more money.
Facebook’s advertising platform is more advanced than that, but Facebook won’t spill their secrets to the efficacy of their advertising. The advertising platform is extraordinarily effective for businesses, especially small businesses who wouldn’t have had the reach, or access, before these advertising tools that Facebook offers.
My fourth reason for Facebook bullishness is their lateraling into other industries such as e-commerce and payments because of the social networks they have. For example, they have Instagram Shop, wherein companies and vendors can sell their products to people directly on Instagram. This makes it easier for companies to acquire customers and get the customers to buy their products, and it makes it easier for the customers to find brands and buy from those brands. This, of course, is all being optimized through Facebook’s advertising and existing AI infrastructure, so that companies and users get the most out of it. Facebook can make money on this twofold: both by the advertisement opportunities and by a cut of the e-commerce sale that happens on the platform.
The next lateral opportunity that Facebook is taking advantage of is payments. As of right now this is being implemented in two ways: Facebook has a PayPal-like platform for e-commerce and they have a Venmo-like platform for users to send and receive money from other users on the platform. The latter is very effective and important because a user sending money has the network already set up through Instagram or Facebook and they don’t need to find out that person's Venmo username to send them money. It also decreases the chance that you are sending money to the wrong person because if you are friends with them on Instagram or Facebook, it is guaranteed that is the right person that user should be sending money to. Of course, Facebook takes a cut of the transaction fee and makes money.
There are even more opportunities than just payments and e-commerce for Facebook to explore, and it makes it easier to do so when there are pre-established social networks.
The final bull case I will lay out here, I have others, but I would rather not ramble for days, is Mark Zuckerberg’s vision in general. In my opinion, I believe that Mark Zuckerberg is the best CEO of our time, and that the company is capable of prosperity when he is in charge. Zuck took what was an app for rating Harvard girls to a network connecting nearly 4 billion people--that doesn’t happen by accident. When he made the Instagram acquisition, Instagram was an app that was designed just to edit and post photos, and he turned that into what it was today. He was able to navigate through Analytica, through congress, and other roadblocks, all while having Facebook grow stunningly fast and deliver massive profits. He makes pragmatic decisions, all while being a visionary for the future.
Conclusion:
Wow! That was long. I felt like I had been drafting this in my head now for months, and I just needed to get it all on paper. Thanks so much for reading, it means the world to me. It’s been about a month since my last Substack, but this behemoth of a write-up makes up for it, I believe. I love you all <3.
Great balanced analysis of the bull/bear story for FaceBook (now Meta). While there will continue to be political pressure and subsequent negative headlines spearheaded by the left, the American public will not support any real effort to curtail free speech or meaningfully handcuff IG and/or FaceBook. Biden and his supporters have a lot of other "fish to fry" than to focus their attention on breaking up Meta. (Note: Trump tried to squash TikTok which is controlled by the Chinese. How did that work out for him? Not well.) I think Charles has this one 100% correct. Good for him taking a contrarian view. My question to PM Charles: where is META going to be trading in 4Q 2022?
I'm not on FB or any of its other family platforms, but I love the stock! Great analysis. Let's Back Up The Truck!