“What company? That one. The company that shows up once in a very long while — the Google of yesterday, the Microsoft of long ago… That company that’s on the cusp of Changing the World, that’s still small enough where each employee has a huge impact on the organization… where you know you’ll kick yourself in three years if you don’t jump on the bandwagon now, even after someone had told you it was rolling toward the promised land.”
- Former Google employee Justin Rosenstein, in a June 8, 2007 email to his former colleagues about his new employer, Facebook (quote from In the Plex)
Facebook is a lot larger now, but it appears to me that they still have the intangible quality that Rosenstein referenced.
Facebook reported earnings this week, and I thought I’d update readers with some quick thoughts here. Nothing really new in terms of my opinions on the business or my estimate of the valuation, but I had a few thoughts I wanted to share anyhow, some of which has nothing to do with the earnings report (which I typically only place minor emphasis on).
There was obviously a lot going on over the past few weeks, and a lot of negative headlines, but there are a lot of things to like as well. I think the business has a lot of momentum in both the namesake advertising platform, as well as emerging business lines such as Messenger, WhatsApp Business, and Facebook Watch. There are wildcards such as mobile payments, hardware, and AR/VR technology. And of course, Instagram is growing like a weed as well. It’s remarkable how much value are in the various platforms that Facebook owns, especially when you think about the fact that they are getting the vast majority of revenue from just one thing: ads on their namesake site.
Matt wrote a great post on Facebook a couple months ago, and I followed it with some brief thoughts here as well.
Before I mention a few points on the earnings, I just wanted to reiterate some basic fundamentals of the business, which I think are among the very best in business. Every time I review an earnings report on Facebook, I’m amazed at how good the company is (and frustrated that it took me until just recently to become an shareholder of the company).
The economics of Facebook’s business are incredible. There are no capital requirements, 50% operating margins that continue to expand as each new ad is nearly pure profit, and lots of free cash flow.
And as I implied above, the company is underearning its potential. Instagram is a fast growing network but still produces only a small portion of Facebook’s revenue, and WhatsApp and Messenger have over 1 billion users and are very valuable assets, but haven’t yet been monetized.
The combination of strong network effects, high incremental margins, a very large addressable market, and strong user and advertiser value has led to explosive growth:
This growth continued in the first quarter that just ended, with revenues up 49% and profits up a whopping 62%. The Cambridge Analytica story unfolded very late in the quarter, so it’s too early to tell if this will have an impact on advertising growth, but my hunch is it will not. There is very little evidence that users are leaving the platform. As I said in the last post, if you’re in media or you’re in finance, you likely have a tendency to overemphasize the impact (at least on usage habits) of a story like Cambridge Analytica. It’s not that the story isn’t a big deal – it is. But I think we in the finance/media world tend to draw inaccurate conclusions because of a false premise (users will leave because of privacy concerns). The everyday person doesn’t care about their data being used by Facebook (just do a survey among your non-finance friends).
As I also mentioned previously, this doesn’t mean the business doesn’t face risks. It certainly will be collecting a lower amount of data going forward, in part due to its own internal changes and possibly in part due to regulations (GDPR takes effect in Europe next month, a sweeping regulatory regime that will force companies to get consent from users in order to utilize their data). But over time, advertisers will go to where the highest ROI is, and right now (and in my opinion for the foreseeable future) that is at Facebook (and Google).
As Sheryl Sandberg said on the conference call:
“First, in the immediate days of the concern, we heard from a handful of advertisers who paused spend, one of whom has already come back. And we haven’t seen a meaningful trend or anything much since then. Advertisers ask the same questions people are – that they want to make sure their and their customers’ data is protected. And I think we are able to answer those questions in a compelling way.
“In terms of ROI on the platform, the ROI is really determined by the ability of advertisers to put the right ad in front of the right person and in the right format. And I think we’re seeing impressive growth in all of those areas. We have more advertisers using the ability to target their ads to the right person. We have more advertisers experimenting with different formats; Stories on Instagram are very promising ones and we’re seeing some nice experimentation there. And we have more advertisers really embracing the measurement that helps close the loop and helps them make their ads more effective. I think in terms of the ROI we are able to offer our marketer the signs are strong and we also continue to see there’s a lot of room for improvement.”
In short, advertisers will eventually overcome inertia that exists in the ad industry and find the place where the ROI is highest. And I think it’s pretty clear that the ROI is highest at the two firms that have grown the largest in the digital advertising world.
And there is a big runway ahead still. As Sandberg also pointed out (basically laying out the investment thesis for Facebook for us):
“We certainly thought about lots of other forms of monetization including subscriptions, and we’ll always continue to consider everything. Ads for us is a very natural fit for our business, and we have a lot of runway ahead of us… so we have 80 million businesses using Facebook on a monthly basis, of which 6 million are advertisers.
“On Instagram, we have 25 million Instagram business profiles, of which 2 million are advertisers. Even if we just convert people who are advertising on Facebook into Instagram, that’s a lot of growth opportunity. Then you can start thinking about Messenger and some of the other platforms that we have.
“What’s I think interesting and strong about our potential business growth is that we’re able to do this across these services. As I mentioned before, running an ad that has a click-to-Messenger ad that goes into Messenger is just an early example of what’s possible. And I think if you look at the large base of businesses who use us without paying, the growing base of businesses who do pay us and then the runway we have and services that are 1 billion plus that we’re really not monetizing – I think a strong focus on ads continues to be the best investment that we can make.”
I think Sandberg is a great executive, and I think she’s right on the money with those comments in my view.
I’ve talked a lot about the importance of culture over the past few years, and most recently in a presentation I did at Markel. But it’s also important to consider that culture has to be guarded, otherwise the advantages it provides will be fleeting.
When it comes to Facebook, Zuckerberg is focused on the long term. I think the changes he made to News Feed and small things like banning crypto ads indicate that he does in fact prioritize user experience over near term profit. This is essential for the long term dominance of a social network like Facebook.
This comment, in a response to a question on payments, illustrates how Zuckerberg is most concerned not with maximizing the profit in the short run, but staying focused on creating the most value for users and businesses on the platform:
“I think that this is going to be a really big opportunity. And again, like I said earlier, the point here isn’t to charge for payments; it’s that messaging can be a more transactional medium than Feed. I think what you’re going to start to see are people interacting with Pages, maybe follow a Page on Facebook or Instagram. You see content from that page. You can click through or tap through to a message thread and then you can either get customer support, or complete a transaction, or do a follow-on transaction. And that will be very valuable for businesses. We view the payment in that context not as the goal, but as something that’s helping the business and the person succeed at having the transaction or doing what they’re trying to do. And that’s going to make people’s experience better, so that way we can just do that in line. And it’s going to make businesses – it’s going to make the experience of being on Facebook as a business more valuable, because you can complete the transactions there.”
Just like the focus that Tencent has on the user experience, the priority at Facebook seems to be to use payments as a way to enhance the experience, which makes the platform as a whole more valuable, which ultimately will lead to more earning power.
The company will earn somewhere around $22 to $24 billion this year, which is roughly $7.50 to $8 per share. Facebook has no debt and about $15 per share of net cash (some of which is being used for a modest buyback program). At $175 per share, this is only around 20-21 P/E (ex-cash) for a business that earns massive returns on capital and is currently growing revenues and profit at around 50%.
Again, the growth will slow down significantly at some point in the near future, but even so, the stock is priced as if it’s going to grow at single digit rates like other large-cap blue chips.
The risk that I’ve always been concerned about with Facebook is looking out and trying to predict what consumers will be using in ten years. But I’ve become comfortable that the focus that Zuckerberg places on the user combined with the huge resources and incredibly smart engineers that Facebook employs will ensure that the company can adapt and capitalize on any changes that inevitably occur in this industry. Facebook might look different in ten years, but I think they’ll remain a major player in social media, communication and technology.
Some other brief notes/comments on the earnings report:
- 49% revenue growth (mobile ad revenue was up 60%)
- 63% operating income growth
- 46% margins (up from 41% last year)
- 39% increase in ad prices (pricing power still looks tremendous, and while my guess is ad prices moderate on Facebook, they likely have a lot of untapped pricing power on Instagram)
- 8% increase in ads shown (the growth rate in the number of ads shown increased, and this was attributed to more and more ad volume going to mobile as well as more ads getting loaded on Instagram)
- 2.2b MAU’s (+67m in Q1 alone, which is roughly 1/5th the size of Twitter’s entire userbase)
- 1.45b DAU’s
- Users were up 13% yoy
- 18 million businesses communicating with their customers through Messenger
- On WhatsApp Business; Zuckerberg: “This quarter, we released WhatsApp business, which lets small businesses create a presence and offers better tools for messaging. In just a few months, more than 3 million people are actively using WhatsApp Business. It’s a hit and it’s growing quickly.”
It’s a great business with long-term oriented management, a lot of potential growth, and it’s available at what I think looks like a very cheap price.
Disclosure: Saber Capital owns shares of FB and GOOG.
John Huber is the portfolio manager of Saber Capital Management, LLC, an investment firm that manages separate accounts for clients. Saber employs a value investing strategy with a primary goal of patiently compounding capital for the long-term.
John can be reached at firstname.lastname@example.org.