Tag: Facebook

Will Coronavirus Kill the New Media Tech Giants? $FB $GOOG

We’re all locked inside. And that means we’re all watching Netflix, shopping Amazon, and perusing Facebook & Instagram and googling places we wish we could visit. That means all of these companies will benefit from the virus, right?  Facebook and Google must be killing it with advertising revenue.

Facebook just put out this somewhat misleading press release. In a gist, it says app usage is skyrocketing…

But….

“Much of the increased traffic is happening on our messaging services, but we’ve also seen more people using our feed and stories products to get updates from their family and friends. At the same time, our business is being adversely affected like so many others around the world. We don’t monetize many of the services where we’re seeing increased engagement, and we’ve seen a weakening in our ads business in countries taking aggressive actions to reduce the spread of COVID-19.


Both Facebook and Google make money off of small-and-mid-sized businesses. While having a lot of users allowed them to begin charging businesses for ads, it doesn’t necessarily mean they are making money off all the users. More on that later.

The interesting thing about them is that they have been fast growing through the past ten years, but weren’t really around in the past. Therefore, the business model hasn’t really been tested through a real recession.

Advertising is cyclical. This makes some intuitive sense. When business is going well, you have extra funds left over that can be used for generating more sales. Or competition is higher because there is room for it and so you need to maintain market share. YOU may even be the new entrant trying to gain that share.

In a downturn, cuts have to be made. If I am a restaurant, I can’t really sacrifice much on food costs or labor or else my customers may have a bad experience.  If I also have a feeling that consumers don’t really want to spend money right now (e.g. unemployment is going up) then why not cut my advertising spend? It ripples through the chain.

As the saying goes, “Half the money I spend on advertising is wasted; the trouble is I don’t know which half.” This has historically resulted in cuts to spend since CEOs don’t feel like they are getting the bang for the buck.

Here is a snapshot of “old school” advertising companies’ peak-to-trough in the Great Financial Crisis (GFC).

Note, for the TV broadcasters I am using 2-yr average results given election years play a factor in results.

I also use gross profit given incremental margins matter so much in advertising. Quick Segway: If I have an existing network of 10 billboards in a town and 9 of them are on rent, you can see how getting that last billboard on rent would result in meaningful profit to the bottom line. My sales go up ~11%, but my costs barely go up. True in nearly all advertising and very true for Facebook and Google. Ok back to the main points.

What Can We Expect from the Tech Behemoths

I highly doubt many people are truly thinking about Facebook or Google’s earnings declining at all in 2020, but it’s something worth pondering.

Facebook on its Q4’19 earnings call stated there are now, “140 million small businesses that use our services to grow.” Google, in its filings, specifically discusses how its targeted ads let small businesses connect with customers.

If the virus ripples through our economy, taking down small restaurants and bars, local gyms, and people pull back on buying cars from their local auto dealer — that could clearly impact Facebook and Google’s results. With most restaurants closed right now, why would I advertise as much?

Unfortunately, it’s impossible to see where Facebook and Google make their money by segment. It’s much easier to know that Yelp generates most of its money from restaurants looking to promote themselves in a competitive field. Not true for the tech behemoths though.

We have some financial history with Google, given its IPO was in 2004. The problem is that it was secularly growing during the GFC. Google does $162BN of revenue today. It did $16.6BN in 2007 at the “market peak”. It kept growing through the GFC, though growth did slow to just 8.5% in 2009 over 2008.

Sell side estimates currently expect 16.7% growth in 2020 for Google… on much larger numbers. Facebook is expected to grow 20%. These may prove aggressive.

Impact from the Virus

I do not think it is out of the realm of possibility that we could see sales growth slow meaningfully for the tech giants. This will lead to a reset of expectations, though admittedly, the two ad tech giants trade for reasonable multiples (believe FB is 12x earnings ex-cash). My larger fear is the reset of investors’ view of the business as whole — they may no longer be bulletproof.

That said, if I am in charge of an ad budget, this may accelerate my shift away from traditional media and to Facebook and Google. People are at home, shopping online, then why not. Plus, its super-high ROI advertising spend. In other words, I don’t pay Google unless someone clicks on the ad, so I’m only paying if the ad works.

This dynamic may finally get rid of the adage I mentioned above – I now know if my ad is working. And because of this we could see more resiliency out of the new advertising names and it could be a bloodbath for traditional names. However, it still holds true that I’m not going to buy an ad, or at least as many, when I’m struggling to pay payroll or rent.

Separate Challenges for Google

Google has been expanding in the travel space, in fact encroaching on ground owned by Booking’s Kayak or Expedia. Booking said in its latest 10-K:

Some of our current and potential competitors, such as Google, Apple, Alibaba, Tencent, Amazon and Facebook, have significantly more customers or users, consumer data and financial and other resources than we do, and they may be able to leverage other aspects of their businesses (e.g., search or mobile device businesses) to enable them to compete more effectively with us. For example, Google has entered various aspects of the online travel market and has grown rapidly in this area, including by offering a flight meta-search product (“Google Flights”), a hotel meta-search product (“Google Hotel Ads”), a vacation rental meta-search product, its “Book on Google” reservation functionality, Google Travel, a planning tool that aggregates its flight, hotel and packages products in one website and by integrating its hotel meta-search product into its Google Maps app.

 This is a problem for Booking and Expedia because they use Google to generate leads for their own sites. While Google may eventually consume these businesses, they also represent non-trivial amounts of their revenue.

Booking stated,

 Our performance marketing expense is primarily related to the use of online search engines (primarily Google), meta-search and travel research services and affiliate marketing to generate traffic to our websites.

How much was “performance marketing” expense?  $4.4BN in 2019 for Booking and $3.5BN for Expedia.

I bring all of this up for a reason: While Google may eventually compete away these businesses, but today they matter. And those businesses are likely being crushed by the lack of travel demand right now, which will mean less spending with Google. These are just two companies, but ~5% of sales for Google. Now imagine every hotel chain, restaurant, airline and so on also pulling back… Now weave in the incremental margin we discussed earlier…


This virus is truly something we haven’t seen before. It permeates everything we touch. Long-term, I think Facebook and Google are amazing businesses to own, but don’t be surprised if 2020 is a hiccup and expectations are reset.

Buying Growth Pays for a lot of Other Sins: Why I am going long Facebook $FB

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.  FB Shopping.PNG

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.


Valuation

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).

FB Cap table

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.

FB ROIC

(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.

FB Price Target

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?

-DD