Tag: Facebook

Featured March 24, 2020April 24, 2020

Will Coronavirus Kill the Media Tech Giants?

Reading Time: 5 minutes

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? I’m not so sure that advertising revenue is going to hold up that well from Coronavirus. Are Facebook and Google’s revenue at risk from Coronavirus?

Facebook 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.”

This tells me revenue is at risk. Both Facebook and Google sell ads… and those ads are sold to small-and-mid-sized businesses which have seen an unprecedented impact from Coronavirus. The tech giants have been growing superbly well as they take share in advertising, but weren’t really around in the past downturn. 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 ad revenue. 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 promoting 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 — 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 revenue for Google. Now imagine every hotel chain, restaurant, airline and so on also pulling back… Now weave in the decremental 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. It’s quite possible they suck up ad revenue that is lost from radio, TV, etc., but it also could be a very large hole to fill.

Security Analysis October 1, 2018April 25, 2020

Growth Pays for a lot of Sins: A Case for Facebook Stock

Reading Time: 6 minutes

As I covered in my case study post, when companies face transition periods, investors often shoot first and ask questions later. This happens even when the company is growing well (i.e. its a “growth stock“). This often results in leaving significant money on the table. I think this is the case with Facebook stock.

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 thesis for Facebook stock looks through to the future 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.

That is what I mean by growth paying for sins — eventually investors will have to look at Facebook’s growth in earnings and want a piece of Facebook stock.

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.

Facebook Stock Valuation

Now to get back to what I entitled this pitch: Growth can pay for a lot of sins. And that makes Facebook stock attractive.

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 Facebook stock 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 stock 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?

-DD

Featured, Investment Philosophy September 16, 2018April 26, 2020

Case Studies of Overreaction in the Market $AAPL $FB $IPI $LULU

Reading Time: 8 minutes

Investors are notoriously short sighted. But how often have you capitulated at the wrong time on an investment simply because (a) the headlines get worse and worse and/or (b) your losses are mounting (or your gains are shrinking)?

Any experienced investor has these cases. Equally as bad is not acting when your diligence and work suggests the value of the company is not impaired or that the news is bad, but they will make it through.

I wanted to highlight a few examples I’ve taken note of over the years and are hopefully recent enough to be relevant. My goal is for us to remind ourselves of these cases and to profit from similar cases if they are to occur again in the future, which they always do.

Case Study 1: Facebook IPO

I remember the Facebook IPO well. Mostly because it was one of those where I knew the business would be fine and had large run way ahead of it, but yours truly talked themselves out of buying it.

It was 2012, so not too long ago, and this was going to be one of the largest IPOs in recent history of a large tech company. The IPO was also extremely over-hyped. Yelp had IPO’d just recently and popped 64% on the first day of trading. Everyone I talked to that was outside of the finance realm was going to buy into Facebook (which scared me, since if everyone is a buyer, what value is there to be had) and they knew nothing about how the company made money (which scared me again). The stock IPO’d at $38 (after a technical snafu delayed trading). The stock traded poorly and the underwriters on the deal actually downgraded their growth estimates for the company.

Then, the lock-up period on the stock ended a few months later that released 133MM shares, which was a large increase in float compared to the 180MM that had been sold in the IPO. Fear began to build around this “technical” factor, as 1.2BN shares were going to free up thereafter. With so much supply and tepid demand, who would support the stock??

People were concerned about these short term factors, but completely missed the point. FB filed the IPO with $4BN in LTM Revenue and actually was very profitable – with 24% net income margins. The stock bottomed at $19 / share, which foots 9.5x estimates of EBITDA over the next 12 months. The thing about that multiple is that FB would go on to grow EBITDA from ~$1.2BN to $27.4BN in the LTM period.

Let’s say you bout in the IPO and sat through the pain… you would have experienced a ~50% loss, but would’ve turned into a 325% gain up to now.

Case Study 2: Apple and the death of Steve Jobs

This one will be quick because I think everyone knows the story. Apple had essentially made a comeback of a life time when Steve Jobs came back, after being on the verge of bankruptcy. Now, everyone knows it as the $1 trillion dollar company that has a well entrenched customer base that refuse to change phones, even when the prices exceed $1,000 per phone.

But there were several times in which people thought that the death of Steve Jobs would again impair Apple’s business model. What people forget is that men and women can have lasting impacts on firm culture, even after their deaths or departures.

Steve Jobs dies in late 2011, but it wasn’t until 2013 really that people became concerned about innovation. The company was still launching iPhones and iPods, but it wasn’t launching the NEXT thing (I guess people were expecting microchips in their heads). And that brought about serious fear in the company’s outlook and led people to anchor on quotes like this one from Larry Ellison, the CEO of Oracle.

“Well, we already know. We saw — we conducted the experiment. I mean, it’s been done. We saw Apple with Steve Jobs. We saw Apple without Steve Jobs. We saw Apple with Steve Jobs. Now, we’re gonna see Apple without Steve Jobs.”

As shown in the chart above, the stock fell 40% from its highs. But you already know what happened next. Customers didn’t frantically leave, Apple kept improving and innovating, and is still a dominant player in the space.

What actually came to be was an interesting cycle. Apple had an upgrade cycle that was becoming evident every 2 or so years. In the lulls of those cycles (i.e. the low periods when less people decided to upgrade), the headlines would be overly negative. Again, we would hear about the lack of innovation in the company and actually, despite seeing a rebound in 2014-2015, the headlines came back in 2016 and Apple’s stock got crushed again. Articles like these, appropriately titled, “Apple’s Core Problem Is That It Can No Longer Innovate“, were so proliferate it was hard not to buy in.

Again, that turned out to be a lot of noise and Apple’s stock today sits at ~$230 a share.

The question is, now that we are in the next lull cycle, will the market learn from these last mistakes?

Case Study 3: Intrepid Potash

I wanted to provide another example of overly negative sentiment, but this time related to cyclical downturn + headlines of bankruptcy risk. There were plenty of examples of this with the 2016 oil downturn and there are actually even a few I had the choice from related to just overly concerned bankruptcy risk, but I wanted an example that maybe you haven’t heard about.

Intrepid Potash (ticker:IPI) is a US potash producer, which is used as a fertilizer for crops. IPI’s capacity was relatively high on the cost curve, meaning there were mines in the world out there that could produce the same commodity for cheaper, giving those producers an advantage if prices fell.

Well, prices did indeed fall. By a lot. Back when corn was $8/bushel in 2010/2011 time frame, fertilizer prices also benefited. Farmer incomes were solid allowing them to spend more on fertilizer and other inputs. When corn supply caught up with demand (driven by higher ethanol demands), the price collapsed and potash has fallen with it, as shown in the chart below.

All the potash and other fertilizer producers stocks fell as well. This obviously makes sense because the earnings of these companies looked to be significantly impacted, at least in the near term. To make things worse, in the “good times” several major potash producers announced they would be adding capacity. Well, it takes about 5 years for that capacity to come online and guess what… it came on right at the worst time.

In my opinion, this is a classic example of a cyclical (not secular) downturn in a commodity. Demand for food should move up +/- 2% each year with a rise in population, which will in turn increase demand for corn. Increased demand for corn, in turn, will increase demand for inputs, like potash. In the short term though, the price of commodities can be highly volatile due to mismatches between supply and demand and could be low for awhile before the new supply is absorbed by slowly increasing demand.

Being higher up on the cost curve was a problem for Intrepid. IPI’s realized potash prices went from a peak of $541 / ton to $200 / ton. While the company was able to take some costs out, its COGS / ton moved from ~$225 / ton to $175 / ton. Obviously, that means margins earned on each ton sold were squeezed significantly and that’s before S,G&A and capex are taken into account as well.

That’s when the negative headlines came out. You see, fundamentals were bad and there was no sign of a turn around. Worse still, the company was about 6.5x levered and the company was in breach of its covenants. Headlines at that point came out about the company filing for bankruptcy. However, all you had to do is go to the filings and see that the lenders to IPI were a group of Agricultural focused banks. These banks understand that Ag has cycles, though it may not cycle with the general economy, and they likely wouldn’t want to force bankruptcy on IPI and take the keys. IPI after all was still in an OK liquidity position at the depths of a pretty bad cycle (and it was clear the banks were issuing extensions to help the company). I also liked that the CEO of the company was buying stock en masse during these times. Lastly, the company was public, so it could issue stock if it needed.

And that’s actually what the company did. I found it surprising, but instead of pressuring the stock further, it put liquidity / bankruptcy concerns at rest and stock went from $1 to over $3 on the news. The company issued $58MM of equity and moved on and instead of the stock falling from dilution, it shot up 300%.

The stock still has well to go before it recovers to the levels seen before, but keep in mind we’re still what I would call trough fundamentals, given where potash and corn prices are.

Case Study 4: Lululemon

The last case study is Lululemon, the athletic wear retailer, ran into a few PR snafus during 2014. First, the company’s leggings were found to be shear and even at some points see through. Instead of the CEO saying, “mea culpa… we’re working to fix these quality issues and will provide refunds to those who purchased products not up to our standards,” he blamed it on customers being too “big” to fit in the products.

The CEO and founder then stepped down. Lululemon at the time seemed to be in peril. Retail is littered with companies who have been left behind as consumer tastes changed.

But that is the thing. Customer perception of the product remained favorable. In addition, it was a brand focused mainly on women at the time and has now started to gain entry into men’s fashion as well. That would mean an untapped market for the company to provide extra growth. Lastly, at the end of 2013, the company had 254 locations in the US and Canada. Compare that to a more mature company, like the Gap, which had 3,700 locations at the time and you can see there was a long roadway ahead before the brand matured. Lululemon now has 415 locations and is still growing.

Holding on, or buying in, to the stock would’ve been the right call as the company has continued to have positive momentum and the stock chart below shows that.

My goal of this post was for you to read these case studies and see if they apply to any other companies you can think of now. Hopefully you take note of these situations as well, so you can apply these scenarios to future ones. The goal is to profit from lessons learned, especially regarding mismatches in negative sentiment and actual fundamentals. Some of these sentiment changes occur over and over with the same companies (Apple and Facebook), but I’ve recently seen these examples in other companies as well.

Any companies you follow now that seem to be on this trend?

-DD