Facebook (META $FB)… unfriended by investors

Facebook has two business lines:

1. Family of apps
2. Meta platforms- Hardware and software

Family of apps: FB is in the business of digital advertising. However, the core offering is different on both sides of the Facebook network. For their users, it is a social networking site. Let us talk briefly about this first. Facebook has three applications: Facebook, Instagram and whatsapp (together called family of apps in the post). Let us look at the user data across the family of apps:

To put the numbers into perspective, globally there are 4.95 billion people with access to the internet. Out of that 1 billion is in China. That leaves 3.95 billion people outside China who use the internet. 3.6 billion of those 3.95 billion (92%) people are on the Facebook family of apps. And 2.9 billion of those 3.95 billion (73%) use the Facebook app.

There is a concern over growth in the number of users in Facebook. The reason is as following:

For the first time in the history of the company, they reported a Q-O-Q decline in the number of DAU on the FB app (not family of apps, in the family of apps, DAU increased from 2.81 to 2.82 billion between Q3 and Q4). A decline of 1 million users. During the same period (between Q3 and Q4) the MAU in FB app has increased by 2 million…

Now we are talking about a business with over 90% market penetration. It is absurd to expect users to grow significantly every quarter. The more relevant metric to measure at this stage of the business is user engagement. – or DAU/MAU.

FB published this number for the first time in 2004 (FB got listed in 2012) when it had a user base of 70K users. What was the number then?

It was 68%. A GOLD standard for the industry. What is the number today on the FB app? 66%- still a GOLD standard for the industry. And for the family of apps? 79%- WHOA! Beat that.

This should lay to rest any concerns about user engagement on their platforms. Engagement has been the same while users have grown from 70K to 3 billion (almost everyone with internet connection).

Also combine this with the following data:

Again, note to self: out of 3.7 billion downloads (comprising top 10% of app downloads globally), 1.6 billion (or 44% is FB family of apps). And TikTok has 1.2 billion monthly active users (much smaller base compared to FB).

While the above numbers clearly show us the competitive advantage a business like the FB family of apps possesses, what is the source of this competitive advantage? I will take a cue from Pat Dorsey here- it arises from Network effect. And as more users that join the network, the number of engagements and datapoints grow exponentially, thus increasing the strength of the network in a non-linear fashion. (Also at their current size, the switching costs are tremendous for every user.)

Historically, extreme strong network effects have broken due to either or a combination of the following factors:

1. Bad user experience – Myspace and Orkut were extremely popular social networks in the 2000s. Specifically in Brasil. However, After News Corp acquired them, they filled the page with advertisements, which led to users thinking- “Hmm, let’s try out this new thing called FB”.  Now FB is a master at providing great user experience, and has never compromised on that- which is clear from the engagement metrics we saw.
2. Abusive pricing – Businesses like Bloomberg have abused their pricing power which has led to a slow decline in their monopoly. But this is not relevant for FB/ this discussion.

It is a safe assumption that the FB moat has only widened over time. And there is no chink in the armour (as the market currently believes).

Now coming to the other side of the network. The digital advertisers. Digital advertising revenue of FB was 114.7 billion in FY21. Global digital ad spends in 2021 was 492 billion (23% of total market is FB. The largest player is Google with 209 billion (42% of market) in ad revenue in 2021).

The market expected to grow at 13% globally between now and 2025 by various agencies who are in the business of forecasting. Now we do not have to believe the numbers. Just agree to the fact that the market is growing.  Fair ask? Let’s move on.

So, we have learnt that FB has a very wide moat and very high market penetration- none of which shows any weakness. We also learnt that they operate in a growing industry with 23% market share – second largest player.

So, is there a terminal value risk for Facebook? That the company sees a declining user base or engagement over the next decade? I think the chances are very very slim.

Financials and valuation:

Now we will briefly look at the financials, and here I will not dig deep into it like I generally do with the other analysis – because we do not need to. 

VALUATION 1:

FB has gross profit margins of 80%. Operating profit margins of 40% and net income margin of 33%.

The Current market capitalisation of the business is 510 billion USD. They have 48 billion in net cash.

Management has given a growth guidance of between 3%-11% for FY22. Let us assume that revenues grow 3% and CFO falls from 58 billion in FY21 to 52 billion in FY22. Is this assumption believable? We do not need complex projection models to agree to this!

Net cash at end of FY22 is 100 billion. Market cap- net cash is ~400 billion. And the business is generating ~50-55 billion of CFO without assuming any growth.  

Or, (Market cap- cash)/CFO = 8.

For a business which has 80% operating margins and grown revenues at 24% between FY17 and FY21. – Even commodity and energy companies trade at higher valuations.

VALUATION 2:

Let us look at valuations from a different angle:

400 billion is the market cap adjusted for cash. Valuation per user is 111 USD (400 billion net market cap/ 3.6 billion MAU). Profit per user is 16 USD. (Operating profit from family of apps- 57 billion / MAU- 3.6 billion)

Think of the investment case in the facebook family of apps business as construction of an advertisement billboard.

Now the question is: would you spend 111 USD to buy all the ad billboards in a city which collectively generates 16 USD annual profits for you? – A 15% annual return?

Before you answer yes/ no, the following facts need to be considered:

1. The billboard has a market penetration of >90%. And due to their tremendous network effects, the market penetration (business moat) will only get stronger with time, although very slowly from here on.
2. Everyone is spending a lot of time looking at your billboard- The engagement metrics are the best in the industry since 2004. Nobody at even 1/10^th this scale comes even close in terms of user engagement. – Think what app have you spent most time on since getting a smartphone? (I do not know anyone who’s answer is not Whatsapp+ Insta+FB)   
3. The billboard is here to stay, nobody is taking it down: There is close to ZERO risk of terminal value- again arising from huge network effects and very high switching cost for consumers.
4. Smaller billboards will pop up here and there at regular intervals, but most likely will become irrelevant/ vanish equally fast (if not, they will get acquired by FB): Any threat arising from competition can be mitigated because- Competition will be of smaller size, hence have no financial muscle (relate to the newspaper industry. Only the top 2-3 papers were able to attract advertisers and the long tail of newspapers below them gradually died… advertisers want reach, always!- we are talking 3.6 billion here). And new popular features can be replicated and offered to their users by the more than able team of developers working for Facebook.
5. More ads can be shown to onlookers, either by making them stare at your board for longer periods or by increasing the number of ads per second or per square foot: There is no clear trend in price per ad. (-5% in 2019, -10% on 2020 and +30% in 2021). However, the number of ads has been increasing steadily (34% in 2019, 33% in 2020 and 13% in 2021) – resulting in growing ad revenues.

OTHER FACTORS WHICH ARE BOTHERING THE MARKET:

I have not talked about a few things:

1. Apple and Android ad policy changes: The policy changes have certainly affected the revenue growth of FB for FY22 to the tune of 10 billion USD.  However, it only affects a small part of the entire value chain that leads to generation of ad revenue. Hence the management still expects revenues to grow by 3%-11% in FY22 despite a 10 billion USD hit. This is only possible because the business of Facebook is hugely under-monetised to maximize user experience.  (The above valuation assumes no growth in revenues and degrowth in CFO in FY22).
2. Meta platforms. I look at this as an optionality. There are two possible outcomes. Meta project fails and is shut down after 2-3-4 years. Or it starts to generate users and eventually revenues. If it fails, we still get the family of apps business at the dirt-cheap valuation shown above. If it succeeds, then the revenues and cash flows grow and adds to the valuation.
3. Other optionality: in 2020 FB launched Shops. The “creator economy” is also very large and growing steadily. Both of these optionality present significant monetarization opportunities for Facebook.

It is a situation where HEADS I WIN BIG. TAILS I WIN SMALL. The chance of capital loss with investing in FB stock right now is very low. There is only upside from current prices. (This is a comment on how much the business is worth and not on where the stock price is headed in 5 months.)

CONCLUSION:

In my opinion, Meta Platforms ($FB) stock is a blind buy at current prices, because of the undervaluation. I would value the business at 2-2.5X current price based on a DCF valuation with very modest growth assumptions and pessimistic opinions about the future prospects of their new ventures. If the company continues to buy-back shares like they did in 2021, the upside is even more.

I like these opportunities presented by the markets- negligible chance of capital loss, very high probability of moderate upside and an optionality of significant growth in capital.  

P.S. This is not a stock recommendation. Do your own research before investing.