More than 2.4B people across the world (32% of the world’s population) are using Facebook (FB) apps (Facebook, Instagram, Messenger and WhatsApp) on a monthly basis, making FB the world’s largest social media network.
Network effects, switching costs, economy of scale and low capital intensity are the key features defining the business model
Facebook has built a strong network and is protected by high barriers to entry which have been strengthened over time. Indeed, by investing in new technologies and by developing new apps, FB has been able to increase users’ engagement, the number of users and the time spent on its platforms. As a result, the network becomes more valuable to both, users and FB, as more content is available.
Besides, even though users can easily sign up for another social media network, users tend to be sticky. Indeed, opting for a new platform means that all existing content and connections would be lost.
Finally, the fixed-cost structure and the scalability of the business model generate sizeable economies of scale. For instance, in 2018, FB had industry-leading EBIT margin of ~45% despite investing 10.3B in R&D, while Twitter had significantly lower operating margin (~15%) despite spending only 0.5B in R&D.
In addition to be protected by barriers to entry, the business model is also asset-light, which allows FB to generate strong cash flows that can be reinvested into the business.
FB will remain an industry winner
First of all, the online advertising market is a duopoly shared between FB and Google which is very complicated to disrupt. Then, online presence is paramount, that is why marketers desire to increase their presence. As a result, online advertising is the fastest-growing advertising market because advertisers will invest an even larger portion of their budgets to digital marketing going forward. More specifically, mobile marketing will be the focus because of the ability for advertisers to target users at any moments of the day. All these trends bode well for FB.
The increasing investments made by FB in the last few years have resulted in an increasing user engagement which allows FB to generate more data than anyone else. These data combined to excellent targeted marketing tools make FB a must for advertisers.
Finally, FB is able to adapt very quickly to new competition thanks to its R&D capabilities and its large users base. As a result, competitors have not enough time to gain market share and are rapidly copied. For instance, FB needed only 6 months to copy the Snap’s stories feature.
Investors focus too much on the number of users, especially in the US and forget about the opportunity of price increases across the different regions.
We agree that the US and European markets are mature, but FB can still increase the number of users in less developed markets (lower penetration rate). Given that users ex-NA and Europe account for 74% of MAUs, the total number of users should keep growing over time.
Furthermore, FB can also increase its revenue by increasing the price of its ads (ARPU). Indeed, North America and Europe account for 72% of revenue while they account for only 26% of MAUs. As a result, there exists significant opportunities to increase ARPU in the coming years in the different regions. Even in the US, ARPU can still increase because advertisers are willing to pay more to target more efficiently the same number of users (as highlighted by the strong increase in ARPU in the last few years).
Besides, FB has also an opportunity to monetize its under-monetized communications apps (Messenger and WhatsApp). For example, FB could launch Libra , a new cryptocurrency (if approved by the regulator), as well as a digital wallet (Calibra) that could also help to monetize these apps. Indeed, they could be an alternative payment infrastructure for people with no bank accounts. Furthermore, if successful, FB could boost its market place business by leveraging its cryptocurrency and digital wallet in order to attract more merchants and increase the number of transactions.
The company is trading at a discount to peers despite industry-leading operating margins, higher growth profile (double-digit topline growth and EPS growth) and higher ROIC (>40%) than peers.
Looking at the broader market, FB trades at 18.3x its forward earnings while the S&P 500 is a 17.1x. However, in addition to have a better growth profile and to be more profitable than most companies included in the index, the company has $ 41B of cash on its balance sheet which is clearly undervalued while using the P/E approach.
Indeed, we believe that investors does not value FB properly by using the P/E ratio. For instance, in 2018 interest income was $ 661M. Using the 18.3X P/E ratio, the cash position is valued at only $ 12B instead of $ 41B (as reported on the balance sheet).
Consensus expectations already reflect the more difficult business environment: revenue growth deceleration (~20%) as well as margin deterioration (from almost 45% to 36%) due to R&D investment, content creation and data security, reducing the risk of future disappointment.
Additional regulations restricting Facebook to collect and use users’ data, which would impair the ability of Facebook to attract advertisers as well as the price paid per ad. Besides, more regulations mean higher compliance costs. However, stricter regulation could strengthen barriers to entry. In the worst case scenario, regulators could demerge the company.
An increasing usage and engagement with other social networks (Snap, Twitter or new innovative players) would probably come at the expense of Facebook. For instance, teenagers prefer to use Snapchat or Instagram to the flagship brand Facebook.
An economic downturn could reduce marketing budgets, thus Facebook’s revenue. However, given Facebook’s leading position and its targeted marketing tools, advertisers will wait the last moment to reduce the budget allocated to Facebook.
Additional tax on digital revenue (e.g.: GAFA tax)
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.