We took a substantial position in Facebook this week after it fell to less than $200 per share.
It is not our first go-round with the company. We originally bought the stock in 2018. At that time, we thought it was strange that such a high-quality company had fallen to less than 20x earnings. In our 4Q18 letter, we wrote:
We have watched Facebook from afar for some time. We have long been impressed at the pace they have grown the business, with revenues increasing from $5 billion to about $55 billion over the past six years. That growth has fallen to the bottom line as well, with profits multiplying from $1 billion to $20 billion.
This analysis turned out to be accurate.
Users quickly forgot -- or perhaps never even noticed -- the Cambridge Analytica scandal. They did not delete Facebook and certainly did not delete Instagram. Revenues grew from $56b in 2018 to $118b last year, with profits roughly doubling to almost $40b. Meanwhile the share count decreased slightly.
Up until the fall of 2021, the stock performed well, roughly tripling from the $125 trough to the $375 peak. It even briefly crossed the trillion dollar market cap level.
But since then the stock has gotten crushed, dropping all the way down to $185 per share. This is the same level the company saw in mid-2017 when the firm was doing a third of the revenue and half the profit. Adjusted for net cash, the company now trades at less than 12x earnings, a level the stock has never previously reached.
Let’s go through the reasons why the company has lost favor with investors.
In 2014, Mark Zuckerberg decided to acquire Oculus, a virtual reality headset business that had been funded on Kickstarter. After spending $2b on the acquisition, he said:
Mobile is the platform of today, and now we’re also getting ready for the platforms of tomorrow. Oculus has the chance to create the most social platform ever, and change the way we work, play and communicate.
Thus, the rationale for the purchase was a grand vision for a new computing platform. Facebook has received a fair amount of criticism for this purchase, with analysts wondering when it would pay off and noting a “lack of buzz” around the product.
Furthermore, unlike with a photo-sharing app, the road to success in virtual reality is long, and the required investments are enormous. This new platform bridges both hardware and software and requires an array of new technologies, as Zuckerberg explained in the Facebook Connect 2021 Keynote:
It’s going to take about a dozen major technological breakthroughs to get to the next-generation metaverse and we’re working on all of them: displays, audio, input, haptics, hand tracking, eye tracking, mixed reality sensors, graphics, computer vision, avatars, perceptual science, AI, and more.
The massive investments in metaverse R&D resulted in Facebook losing over $10b on Reality Labs last year -- nearly 20% of the rest of the company's profits. These losses have been widely panned, and were likely a substantial contributor to the decline in stock price.
We are less bearish on the long-term implications of this spending than other analysts.
First of all, if the metaverse investments don't work out, Zuckerberg has every incentive as an owner-operator to scale them back. The management team clearly understands this: the CFO said at a conference recently, "To the extent that we can drive good results with these investments, we'll be pushing them harder. And to the extent that we're less successful on those, we can moderate them over time."
Thus we expect these investments will either start contributing to earnings or they will be curtailed. Therefore it makes sense to value the “Family of Apps” segment separately from the money-losing Reality Labs. On that basis, the stock looks even cheaper: “Family of Apps” operating profit has grown from $28b to $56b in just the last two years, implying a 9x EV to EBIT multiple. This is a massive discount to the ~20x EV / EBIT of the overall stock market, and ascribes no option value to the Reality Labs segment.
Second, we think Zuckerberg deserves the benefit of the doubt that the money spent on Reality Labs is not being wasted. Not only is he one the great CEOs of our time, growing a business from nothing to $40b in profits in less than two decades, but he is also one of the best capital allocators. The WhatsApp and Instagram acquisitions -- which cost about $20b total -- were roundly criticized at the time. Today they are irreplaceable components of the company’s growth path. Instagram is regularly put forth as one of the greatest acquisitions of all time.
He may be misjudging the metaverse opportunity. But if he is correct, the money that Facebook is spending on this R&D today gives them a major head start on the computing platform of the future. And even if he is wrong about the scale of the opportunity, and VR turns out to be merely a new gaming platform rather than a new computing platform, the opportunity is significant.
Below is a list of the current gaming platform owners and our estimate (or market value) of their worth:
If Facebook succeeds in building the next important gaming platform, it could very well be worth $100b or more, leaving aside the potential value in other plausible AR / VR applications such as social networking, vocational training, and ecommerce.
Of course, Facebook will not be the only company striving to create this platform. HTC, Samsung, Google, Sony, Snapchat, and Apple are all current or prospective competitors. But in addition to its lead in R&D, Facebook has a big lead in terms of commercial success. The Oculus Quest 2, released in 2020, shipped more than 10m units in 2021.
In contrast, Sony has still not released the Playstation VR 2, despite the original Playstation VR being 5 years old and requiring a cord to function. Oculus has released two new cable-free headsets since then.
HTC, another key competitor in the VR space, only generated $200m of revenue in 2021 and had negative operating cash flow. Unfortunately for them, HTC may go bankrupt before the VR market really takes off. The firm’s market cap is just $1.6b, which is roughly what Facebook spends on Reality Labs in two months.
Apple has shipped nothing and Google discontinued the Google Daydream in 2019.
Besides the large investments in Reality Labs, another issue looming over Facebook’s stock is the rise of TikTok, which was mentioned multiple times during Facebook’s last earnings call.
As the story goes, younger users are flocking to TikTok, and Facebook Blue and Instagram will wither. To us this seems like a clear example of “narrative bias” at work, whereby investors become entranced by a simple story that doesn’t actually fit with the underlying facts.
TikTok is not the first app to challenge Facebook.
First, it was Instagram. Much to the dismay of future regulators, Facebook simply bought them out. Zuckerberg then put the full weight of the company behind the photo sharing app, and today Instagram is the premier way that consumers under the age of 40 connect with their friends.
Yet despite Instagram's runaway success, it did not replace Facebook the way that Facebook replaced Myspace. Even if we only look at North America, Facebook Blue retains 195m monthly users and is probably growing ad revenue. You would think this would bury the idea that new social networks can only have success at the expense of incumbents, but it seems some investors are still falling prey to this 15 or 20 year old narrative.
Next came Snapchat, an app that harnessed the power of ephemeral messages to huge success among a younger generation of users. Probably because he couldn’t “buy it” for a number of reasons, Zuckerberg decided to “build it” instead. They copied Snap’s most important feature, disappearing stories, and planted them right at the top of the Instagram app. This was successful, and Instagram retained its place as the dominant social platform among younger users. Notably, this was not at all fatal to Snapchat, which survives and thrives to this day.
The current threat is TikTok. TikTok has been on a tear, with app usage of more than 80 minutes per DAU in 2021. While this is significant, data does not show that this is materially cannibalizing Instagram time. In one sense, this is not surprising: the original idea of Instagram was to share photos with your social graph, a use case which does not overlap at all with TikTok.
Facebook is also incorporating TikTok’s primary feature, the algorithmic feed of short-form videos, into Instagram. They call this “Reels” and display it prominently in user profiles and the search function. While there was a time when most Reels were repurposed TikTok videos -- including even the TikTok logo -- nowadays most prominent creators are making custom Reels just for Instagram. As they did with “Stories,” we think Facebook will utilize this new mechanic to drive substantial engagement. And when this is combined with the power of Facebook’s advertising technology, we think the likely outcome is more revenues for both Facebook and creators.
Apple’s Privacy Changes
The final issue that seems to be dragging down Facebook stock is the company’s guidance for a drop in 2022 ad revenue due to Apple’s ad tracking changes.
Privacy changes in iOS 14 (and upcoming changes in iOS 15) negatively impact the ability of Facebook to track users outside of the app. This makes it difficult to attribute advertising conversions. Facebook may know that you saw an Instagram ad, but they don’t know if you actually purchased that pair of shoes. Facebook estimates this will cause a $10b shortfall in 2022 revenue.
Think about that for a second. If not for this change, Facebook might have been on pace for $70b in operating profit in the Family of Apps segment for 2022 versus an EV of $500b.
While this is undoubtedly a short-term headwind, we believe it is fixable. We think that given enough time, and with all the data they have at their disposal, Facebook will figure out a way to better measure the amount of revenue that is actually “converting” for advertisers -- their expertise in ad targeting and attribution, after all, is one of the main reasons why Facebook has consistently improved ad revenue per user since its IPO. Facebook will also press to move more transactions to first-party platforms like Facebook Shops where the conversion loop remains intact.
The CFO seems to agree, issuing the following commentary at the Morgan Stanley conference on 3/10:
We've got a multi-pronged strategy to help mitigate those headwinds. And in the near term, we're continuing to make improvements on AEM that I talked about. Over the medium term, we're -- we see opportunities to move clients more towards onsite conversions such as Click to Messaging ads, lead gen ads, and Shop ads. And then over the longer term, we're working to rebuild our ad stack and employ machine learning and AI to be more effective at ads with less data.
All three of these issues will hinder Facebook’s growth in 2022. That's okay with us: the stock is cheap enough that even if Facebook profit growth stagnates, it is still an attractive investment.
With that said, we think it is very likely that Facebook will continue to grow profits at a healthy rate in the long term. We see major opportunities for earnings growth in Reels, improved ad targeting, and the mitigation of losses -- and potential profits -- from Reality Labs. If we are correct, the current enterprise value of $500b on 2022 earnings of $35-40b is far too low.
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