As I covered in my case study post, when companies face transition periods, investors often shoot first and ask questions later. This often results in leaving significant money on the table.
Investors talk themselves out of investing in great businesses for a variety of reasons, but I usually boil short-term blips down to this internal statement: “This [current trend] may get worse in the near term, perhaps also longer term, so I’m not comfortable investing yet”
Investing will always have uncertainty and that’s the risk. But that is also precisely why the returns are higher for those investors that can see through the fog of negative headlines or short-term roadblocks and make superior results.
I think Facebook today is in such a situation. The company is facing negative headlines on a variety of fronts, but mainly related to how we will deal with privacy in this new age.
My investment thesis looks through the fog and comes down to the following points:
- Facebook is a dominant platform with 2.5 billion unique users
- Advertising via social media platforms is still in its infancy
- The ROI advertisers receive from using social media platforms is much higher than traditional methods, which will grow the pie
- Expect high growth from FB as it monetizes Facebook and ramps Instagram, video, Whatsapp and FB messenger
Before I get to the positives, my guess is that you are likely reading this and saying, “yeah, yeah blah blah, I’ve heard that story before. But what is Facebook going to do in a more privacy concerned market?”
One big concern, is the new legislation in the EU called GDPR (General Data Protection Regulation) which went into effect in May of 2018. The purpose of the legislation was to give consumers more control over their personal information. You probably have noticed the pop-ups asking if you are OK with websites collecting cookies and this is why that exists. GDPR applies to all companies processing and holding personal data of consumers residing in the EU, irrespective of the company’s location.
This has created uncertainty for digital advertisers as it creates additional friction in the process (i.e. users must opt-in, which may mean less data is available). However, I think Facebook is practically embedded with users’ daily lives which is a strong benefit. In other words, users are already proactively sharing personal data on a daily basis. I assert that Facebook’s platform then is one of the best positioned to deal with this new regulation. I think Facebook and Google could likely update their terms of service which would permit Facebook to continue their existing path. In any case, if users do not accept, the downside is that Facebook will show non-personalized ads. Worth less to advertisers, but still worth something.
In addition, similar to my discussion on why “sin stocks” outperform, I think this entrenches Facebook’s leadership position going forward, meaning that it will be much harder for new social media platforms to launch. Just like when tobacco advertising was outlawed, it effectively barred new brand entrants, more onerous restrictions on data may make it difficult for new platforms to launch and “steal” users / vie for advertising dollars.
Bottom Line: Transition periods can be painful, and more regulation likely is coming, but in assessing whether this is a lot of noise or whether the business model is impaired, I go with the former.
Back to the positives
I’ll make this brief, as I tie much of the positives into the growth / valuation discussed below, but I think there is a chance that not only are investors being overly punitive on FB, they are missing the long positive road ahead of its platforms.
At this point, I think we all can see the value of Instagram as the Company’s next growth engine. It has become just as ubiquitous with millennials as Facebook was and is. The interesting turns are how the company has monetized the business. Advertisers are obviously involved now, and the ads placed represent high return on investment for them. In addition, some polls have showed that people, if they had to choose, enjoy ads that are more personalized to them, rather than random ones that do not apply.
Now I have seen shopping on the platform, which is so early in its stages, I do not think Wallstreet understands the opportunity. Facebook can now move from just an ad platform to possibly taking a modest skim off of items sold on the platform, similar to eBay’s business model.
Lastly, Facebook has just launched ads on Whatsapp, the messaging platform with 1.5 billion users. Is this priced into the stock today? I’d argue not. Most sell-side models break out the company’s revenue into Facebook Ads, Payments, Instagram, and Oculus. Turning the switch on for Whatsapp could be a large incremental opportunity that is not accounted for.
Now to get back to what I entitled this pitch: Growth can pay for a lot of sins.
With Facebook growing at 17% per year on the top line from 2018-2021, that growth can offset a lot. Of course, you have to bank on that occurring, but let me run through some numbers.
Even with assumed margin headwinds from additional investments in securing data and privacy initiatives (I model EBITDA margins moving from 66.5% of sales in 2017 to 60.0% of sales by 2021), the company grows EBITDA at a ~17% rate. Despite some capex spend to support growth, the company generates good FCF and as you can see, that cash builds over time (the company is already in a net cash position).
This means we are essentially buying FB for 7.2x 2021 EBITDA, which is very low. What multiple should the company trade at at that time?
I would argue for a very high multiple driven by the company’s high return on invested capital (ROIC). If you want to learn more about the relationship between ROIC and EV/EBITDA multiples, I highly suggest you read Michael Mauboussin’s recent article here and also this baseline one here for more. In it, he explains that what matters is investing in companies that generate a positive return on newly invested capital, in excess of their weighted-average cost of capital. It makes intuitive sense to me… if I am continuously investing new capital in projects that don’t earn my cost of capital, that destroys value.
As shown, Facebook is clearly earning well in excess of its cost of capital. This makes sense given how much operating leverage the company has. It is similar to an old newspaper model which also has substantial operating leverage — a newspaper with 1 advertisement slot that widens it to 2 slots will earn very large incremental returns on that second ad slot sold. The same is true of Facebook and its various platforms.
There are limits, of course. With return metrics like these, we should hope Facebook reinvests every dollar possible into its business and see stellar return prospects, but that is not always possible.
(note, NOPAT = Net Operating Profit After Tax)
Either way, I think Facebook is grossly undervalued at current levels. Currently, the median S&P 500 company trades at 13.7x EBITDA. Do I think a company that earns nearly all the capital it invests back in one year as better than average? You bet I do. If Facebook trades at just 10x EBITDA in 2021 (which is closer than you think), that foots to $215 stock under my estimates. That is ~33% upside, or ~10% CAGR.
Although I do not think the company is worth 10.0x, I think using a 10.0x multiple accounts for a couple things . It helps handicap for whether or not I am wrong on my thoughts on the stock performing amidst all of this political uncertainty. However, on the high end, you can see the result looks very, very attractive.
The bottom line is, it is very hard to see over the medium-to-long term how you lose money in a company growing earnings as fast as Facebook is and at the quality it is. This ties back to my thoughts on growth vs. value stocks (i.e. Facebook is a growth company, but still is a value).
What are your thoughts?