Investment Thesis
Facebook is benefitting from multiple tailwinds in the digital advertising and social media industry. They have strong user growth and increasing average revenue per user. Facebook has a flywheel and will continue to benefit from its scale. They target ads better than their social media competitors, thus, able to charge higher prices. Facebook has strong optionality with its recent investment in Oculus. Facebook is a founder-led company and CEO Mark Zuckerberg is only 37 years old.
Industry Overview
Social Media Market Share
Source: Smart Insights
Social media companies provide a platform for content creators to share content with content consumers. Social media companies occasionally serve ads to consumers enabling them to profit. Meta Platforms, formerly known as Facebook, (FB) owns four of the five largest social media companies (YouTube is owned by Google (GOOG)). The social media industry should benefit from continued growth and digital advertising trends. Click here for more information on social media trends.
Facebook User Growth
Source: FB Q3 Earnings Report
Facebook’s family of apps (which will be shortened to Facebook for the remainder of the article) has many misconceptions about their audience. A popular one is “no one uses Facebook anymore”. Facebook’s family of apps has 2.81 billion users which have grown by 10.6% last year. (FB earnings report) Facebook’s family of apps’ user base is growing faster than the industry average of 9.9%. Another misconception is that “only old people use Facebook”. On the app Facebook alone, less than 5% of Facebook users are aged 65 and over and over 60% of Facebook’s active users are under 35 years old.
Competitive Advantage
A normal network has two sides each reinforcing the value. Uber is a clear example. As more riders come onto the network, it gives a greater incentive for drivers to come onto the network and vice versa. Networks are difficult to replicate.
Facebook’s Flywheel
Source: Author
Facebook has a three-sided network which is even harder to replicate. Facebook has content creators, content consumers, and advertisers each reinforcing the value of each other as shown above. Each user belongs to at least one group and can belong to multiple. The more people from each group that are on the platform, the more valuable the platform is for the other groups. For example, the more content creators a social media platform has, the more valuable it is to the content consumers. This creates a flywheel effect and benefits Facebook, the biggest player in the social media industry.
Tik Tok Slow Down in User Growth
Source: Statista
The biggest platforms benefit most from this effect as their network is more valuable. Metcalfe’s law states that a network is exponentially more valuable with each additional user. This is evidenced by Facebook’s reaction to Snapchat and Tik Tok’s recent challenges. Snapchat and Tik Tok both had wildly successful features on their platforms in Snapchat “Stories” and “Tik Toks”. Facebook released their version of Snapchat stories called Instagram stories. Instagram Stories became more successful than Snapchat Stories because of their larger user base. Tik Tok’s challenge was more recent and is still playing out. In August of 2020, Facebook released Instagram Reels in response to Tik Tok’s challenge. Tik Tok’s user growth slowed from 85% to 11% (shown above). Facebook can replicate challenger’s new features and it will become more valuable on their app because of their vast user base.
Also, Facebook has more data than its competitors. This allows them to tailor ads, promote content, and connect people more efficiently than their competitors. Facebook’s average revenue per user (ARPU) is more than doubled Snapchats emphasizing their ability to target ads. Facebook’s ARPU will continue to increase as they collect more data and improve the tailoring of their ads. Costs will stay essentially the same, allowing margins to expand.
Optionality
Non-Oculus
Facebook has lots of optionality opportunities to further monetize its products. “On the monetization front, we're just starting to roll out ads in Instagram” David Wehner CFO. Facebook should be able to connect their datasets between Instagram and Facebook eventually allowing Instagram to have similar ARPU to Facebook.
Also, Facebook is underreporting their conversions after Apple’s change on identifier for advertisers (IDFA). “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. We estimate we're underreporting iOS web conversions” Sheryl Sandberg COO. When Facebook corrects this, advertisers’ willingness to pay will increase along with ad prices. Click here for more information on IDFA.
Oculus
Oculus Market Share
Source: Counter Point Research
Facebook is making a push into the metaverse world through their subsidiary Oculus. In their last earnings call, they stated they would spend $10bn on the metaverse. There are many industrial uses for the metaverse beyond just video games. For example, Boeing announced they were going to design their next plane in the metaverse. They will be able to design the plane for cheaper and keep track of the changes more efficiently. Many other design cases will be used in the future. Oculus recently teamed up with zoom (ZM). This will allow 3-D virtual meetings around a boardroom. Oculus headsets can connect to your computer and bring that into the meeting giving users a sense of reality. There are still flaws with the Oculus hardware as they are too bulky. Oculus is trying to slim down the headsets and they have announced a partnership with Ray Bands to make wearing them cool.
Console Sales by Year
Source: JackSoslow
This year, Oculus Quest is going to outsell Xbox consoles. Oculus needs to gain enough users on its platform to attract developers. As Facebook acquires more users, more developers will create apps. This will benefit the users, thus creating a flywheel effect. Oculus has about 75% market share in the VR hardware segment. Currently, one-third of paid apps have generated more than $1 million in revenue. This is a great incentive for developers to enter their ecosystem rather than other metaverse ecosystems or video game consoles. Oculus’s competitive advantage rests on its network effects.
Management/Capital Allocation
Source: Validea
Facebook’s CEO and founder, Mark Zuckerberg, is 37 years old. Founder-led companies significantly outperform non-founder-led companies. Since Mark Zuckerberg is young, Facebook has a lot more time being a founder-led company. Mark Zuckerberg has made three extremely bold decisions in his life. His first bold decision was dropping out of Harvard to start Facebook. His second bold decision was in 2012 when he bought Instagram for $1bn when Instagram had zero revenue and twelve employees. Analysts claimed that it was a young CEO making a stupid mistake. In the last quarterly earnings call, he announced he would invest $10bn into the metaverse this year and will increase the investment each year. Analysts did not like that decision either calling it a “science project” or “a nerd with unlimited resources”. Analysts should learn not to doubt Mark Zuckerberg.
During that same earnings call, Facebook announced an additional $50bn share repurchase bringing the total to $57.97bn or approximately 6% of the outstanding float. This shows how strong Facebook’s cash flow is and their commitment to not diluting their existing shareholders.
Valuation
It was surprising that analysts freaked out about Facebook’s virtual reality investment of $10bn when they are already spending close to that. “Nearly 10,000 people are working in its group developing augmented and virtual reality devices, or nearly one-fifth of Facebook’s total global workforce, according to internal organizational data reviewed by The Information.” Facebook’s SG&A and R&D expense equals nearly $44 bn. It can be estimated that 20% of that has been going towards virtual reality equaling $8.8bn. Evercore analyst Mahaney estimates that Oculus Quest will sell eight million units at an average price of $300 coming to $2.4 billion in revenue. This means Facebook is losing about $6.4 bn on their virtual reality investments per year. Facebook’s core business’s true profitability and margins are being masked by their Oculus investment. Their core operating margins should be about 5.5% larger than they currently are.
Facebook Revenue Projections
Source: Author Data from Facebook Investor Relations
Unfortunately, Facebook does not release some revenue drivers needed for projections so some of these figures are estimated. Facebook releases the average active people for the last month of each year, but not the average number of users over the entire year. The Family DAUs Average line item was estimated to be the average of the last month in the previous year and the last month in the current year family DAU’s to approximate the whole year. The annual advertising ARPP is advertising revenue divided by Family DAUs Average. Both Family DAUs Average and Annual Advertising ARPP growth are expected to slow as Facebook reaches saturation. The other revenue line item includes Oculus, Facebook Marketplace, and other smaller businesses. Oculus growth is expected to slow considerably in 2022 as they are not expected to release a new headset next year. 2023 growth should accelerate considerably as they release Oculus Quest 3.
Facebook Margins
Source: Author Data from Facebook Investor Relations
Facebook’s gross margin should decrease slightly as a larger percentage of their product mix is hardware (Oculus). Operating margins will increase because limited additional expenses are needed for each additional sale from Facebook’s core business. Stock-based compensation (SBC) is included because it is an expense that dilutes current shareholders. Depreciation and Amortization are expected to slow. Since Facebook’s growth should slow down considerably by 2027, a 6X 2027 EBITDA multiple is appropriate for its current share price. This would imply Facebook has a 57% upside from its current price.
Edited on 12/27/21
Disclosure: I/we have a beneficial long position in the shares of FB either through stock ownership, options, or other derivatives.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.