Facebook’s Folly?
Disclosure – Clients of Farrer Wealth hold the securities discussed below. The below is not investment advice, and is for discussion purposes only.
Even for Facebook’s standards, the last several weeks have been noisy. From the whistle blower, to further leaked memos about the company, a name change, to the Zuckerbergs being sued for racial/sexual discrimination, it has been far from dull. However, the most interesting revelation, in our view, was the company’s Q3 earnings call. The call gave us several points to ponder, and below, we discuss how it may affect our view of the company.
Overview of Earnings:
For those who didn’t manage to review Facebook’s earnings yet, below is a quick snapshot.
Revenues grew by 35% yoy
Operating Income grew by 28%, slightly hampered by higher G&A expenses
The company announced it ended the quarter with over $58 billion in cash after buying back $14.4 billion in shares over the quarter. The company also increased its stock repurchase authorization by $50bn (~5% of market cap)
Daily active users and monthly active users grew by 6% yoy. As of this quarter, over 2.9 billion people use a Facebook property (Big Blue, WhatsApp, Instagram) monthly. Considering there are only 4.72 billion people with internet access, this is a 62% penetration rate. Further, considering that there are 7.8 billion people on the planet, it implies there are several billion people Facebook has yet to capture (3 billion remaining multiplied by Facebook’s penetration rate).
As you can see, the core business still seems to be humming along nicely, and to quote Mark Twain, the news of Facebook’s death is “greatly exaggerated.” That said, one of the key causes for concerns for earnings this quarter, and a cause for concern for several direct response advertising-based models, were the effects of Apple’s iOS 14 changes. There is no doubt, as the company had warned for several quarters, that these changes had a detrimental effect both on targeting and attribution thus making the calculation for return on ad spend (ROAS) difficult for advertisers. Facebook has been proactive dealing with these issues, and as Sheryl Sandberg stated:
There are 2 big challenges coming from these iOS changes. The one is targeting and one is measurement. I'm taking the second one first. On measurement, we think we can address more than half of that underreporting by the end of the year and make more progress in the years ahead. …Targeting is a longer-term challenge. Our direct response products are built on user-level conversions. And as a result of the iOS changes, we don't see the same level of conversion data coming through. So we have to rebuild our targeting and optimization systems to work with less data. So this is a multi-year effort.
It seems that measurement could be dealt with within the next several quarters, while targeting will remain an issue. There is also no doubt, however, that the iOS changes will hurt in the short-run with Facebook’s guidance for Q4 revenues pointing to just a 16.6% yoy growth, the slowest Q4 growth since the company went public. While as per Sandberg’s comments, the company is proactively trying to solve the problem, it does seem the business needs to cement its core business, and per the below, the company is making large bets in this space.
The Exciting Future:
“Our three product priorities remain our focus on creators, commerce, and building the next computing platform.” – Mark Zuckerberg, Q321 Facebook Earnings Call
Given the difficulties with the iOS update, there were two portions of the call that were a cause for excitement. First was the re-emphasis on the importance of shopping to the platform. In our discussions with advertisers, we’ve noticed a desire to move some of their spend off Google and Facebook and into other avenues where ROAS can be better measured. This is where Facebook Shops comes in, and as Zuckerberg stated in the earnings call:
“As Apple's changes make e-commerce and customer acquisition less effective on the web, solutions that allow businesses to set up shop right inside our apps will become increasingly attractive and important to them. We built solutions like ads that can dynamically point to either a business' website or their shop on our platform, depending on what will perform better for them. And that will help more businesses navigate this challenging dynamic environment. Building a full-fledged Commerce platform is a multi-year journey. Marketplace is already at scale, and lots of people rely on it, especially now with supply chain issues that make it harder to get new products. Shops are getting more developed, and we have an exciting program planned for this holiday season where we're working closely with a number of the businesses that have invested the most in shops to identify what works to find new customers and grow their businesses even faster. And our plan is to then scale those solutions more broadly in 2022.”
The potential of this business is highlighted by technologist Ben Thompson in his recent post when he analyzed the benefits of selling on Facebook’s platform.
“The answer for those advertisers is straightforward: sell directly on Facebook’s platform, where everything is first-party data, which means that tight feedback loop can be preserved; here too, Facebook has accrued trust with investors because the company has been building out Facebook Shops since the month before ATT was even announced. Facebook Shops still has a long way to go, but Facebook can much more credibly point to it as a way around ATT than a company like Snap can.”
The second exciting growth area was with Reels. Given the extraordinary success of Tik Tok, it's no surprise that Facebook is trying to play catchup. In fact, what we found quite impressive was the tenacity of Facebook to not give up on a segment that many participants feel they’ve lost. As Zuckerberg mentioned, “We are retooling our teams to make serving young adults their North Star rather than optimizing for the larger number of older people.” Now, this is no easy task considering the head-start Tik Tok has on Facebook (the former has over one billion users, 60% of whom are between the ages of 16-24). However, given Instagram’s success on Stories, the company has had a positive track record on making new types of technologies and delivery platforms highly successful on their services (remember Stories was in response to Snapchat). To me, this shows that there is a lot of fight left in the company to regain lost market share as well as continually push for a better product. Doubling down on a winning product (Instagram) is, in our view, a good use of capital.
However, none of the above is going to come cheap with Dave Wehner stating capex for 2022 slated at between $29 billion and $34 billion (see the sheer scale of the expenditure in the chart below), a lot of which will be spent on an “an investment in our AI and machine learning capabilities, which we expect to benefit our efforts in ranking and recommendations for experiences across our products, including in feed and video, as well as improving ads performance and relevance.”
Source: “The Science of Hitting” blog
Now that capex is not only going toward supporting the core business, but is also going toward supporting Mark Zuckerberg’s passion project, building the metaverse.
Facebook’s Folly?
The biggest head scratcher moment for us was when Mark Zuckerberg dived headfirst into the metaverse without the safety harness. Now, don’t get me wrong, the first time I tried VR, I thought it was a game changer. I felt it would change the way we communicate, interact, date, do business, etc. However, the change has been slow. It’s a bit like cryptocurrency, it has significant potential, but day-to-day use cases have been limited. So far VR/AR has mostly been used in entertainment (for gaming or for turning your face into a cat during a family reunion zoom call). So, to hear that Facebook is going to spend $10 billion in 2021 and that the high level of spend will likely continue for several years, was certainly jarring.
The problem is that Zuckerberg is not doubling down on a working product, or trying to fix an issue (i.e. with ad targeting), but developing a brand new product. And it’s not just a new product we can imagine, say like an audio platform or even a flying car. It’s one we really don’t have any sort of benchmark for what it could look like. There’s an entire range of outcomes, (see image below), that could occur.
The issue is that the “metaverse” is a catchall and no one can be sure of what it might look like. On one hand after spending dozens of billions of dollars, if all Facebook could come up with is another Xbox-type system used mostly for gaming, then that would be quite a waste of capital and time, and shareholders would be rightfully incensed. However, if Facebook pulls off a miracle and starts to create something close to a Ready Player One type universe (for those who haven’t read the book/watched the movie, here is the trailer), then any sort of projection of valuation of the company is impossible.
Now, I think here we must give Zuckerberg a bit of credit and assume that Facebook will probably land somewhere in the middle of the above spectrum. The Connect 2021 presentation pointed to more complex and interactive games on Oculus, use of avatars for meetings/interactions, and virtual shopping as the starting points (so starting to the left of the spectrum). However, Facebook did not sugar-coat the difficulty here, and said there were at least 12 major breakthroughs that needed to happen before they could realize their vision for the metaverse. In Zuckerberg’s view, it should all be worth it, and stated “We hope that by the end of the decade that we can help one billion people use the metaverse and support hundreds of billions of dollars of digital commerce. And I think if we can do that, then this will be a good investment over the long term.” The adage “trust but verify” comes to mind here, and for that, Facebook will be splitting out reporting for Facebook Reality Labs, which will allow investors to understand how revenues and associated costs are growing for the metaverse project, as well as understand the key metrics for the core Family of Apps business.
$10 billion of expenditure a year (at minimum) is a huge number. Just looking at Google’s “other bets” it would take three years of operating losses 2018-2020 to get to a figure over that $10 billion in expenditure. Remember, this is an expenditure which Facebook is making in just one year (and might ramp it up in subsequent years). This does make us wonder if Zuckerberg is telling us that the moat around the Family of Apps is thinner than we think, and that a large bet on the metaverse is a way to shift the story away from the core business. There is significant evidence for this, as he has stated both through internal memos and externally that the core business reliance on Apple’s and Google’s platforms is unsustainable.
Overall Thoughts:
As mentioned, the earnings call has given us a lot to think about. The key portion that gives us pause is the metaverse bet. If we take a step back and think about the possibilities of that investment, it's quite easy to conclude that there are numerous outcomes. If we just look at that business on a standalone basis, it is in the very early stages in the S-curve of innovation.
There is also no guarantee of success. Thus, I would imagine any investor would have to lower their IRR projections on their investment in Facebook just due to the uncertainty of outcome. This also means that Facebook requires a new set of investors. Current investors, I think, were expecting certainty, and Zuckerberg’s metaverse bet is anything but. Facebook now needs investors who will be willing to give management a long rope and not look to see rewards from Reality Labs anytime soon (a Twitter user called Facebook a startup with $40 billion in profits, and I found this quite apt). In fact, I wouldn’t be surprised if we saw Cathie Wood’s ARKK ETF (or the likes that focus on innovation) buy back into Facebook shares.
The positive is that, for now, the core business seems to be doing just fine, despite the iOS changes. The market is assuming a ~68bn EBITDA for 2022, which is only slightly higher than the projection for 2021. This is probably realistic considering the increased costs due to Reality Labs. If we assume a 15x EBITDA multiple considering growth should pick up again in 2023 and reduce the number of shares that $50bn in repurchase would buy, we get close to a ~$400/share fair value. This implies that despite all the uncertainty, Facebook is still cheap. However, considering Facebook’s historical growth, and strong margin profile, its current valuation multiple also tells us that the market is discounting its terminal value. A lot is riding on the metaverse bet succeeding, and Zuckerberg is strongly implying that there is indeed a problem with the terminal value of the business if Facebook does not dive headfirst into the metaverse. So, for current and would-be shareholders, Facebook is becoming more of a “jockey” bet than it has been over the past several years and should change the thesis of most. Do note though, a bet against Mark Zuckerberg has never gone in the bettor’s favour.
We hope you’ve enjoyed reading our thoughts on Facebook’s latest earnings. We wish the best for your portfolios as 2021 wraps up its final quarter – happy investing!
Note: Much of this post was written before the Connect 2021 presentation, thus, forgive me for referring to the company as Facebook and not Meta