Facebook - Embracing Uncertainty

Embracing Uncertainty

Volatility and uncertainty breed opportunity. In this case, opportunity comes in the form of the megacap growth stock Facebook (FB). Jittery February markets, CEO Mark Zuckerberg’s announcement of changes that reduced user time on the platform, and anticipated higher spending to secure the network’s longer-term future have culminated to constrain share price growth in FB stock despite another round of record results reported earlier this month.

My thesis is that Facebook will overcome these challenges to post meaningful growth in 2018 and beyond, and those on the sidelines could miss the next major leg up in the trajectory of the stock of this high-quality business as those issues resolve over the coming 12 to 18 months.

What I’ve done is to shift my own focus from the uncertainty of the changes in the year ahead to certainty about what I know about the business today and what I foresee in the future. And what I see is a high-quality business franchise with a wide competitive advantage, rapid growth in its core business, and a business model with optionality for new ways to monetize its user base for years into the future. With that in mind, prospective investors should be aware that the headline story of slowing growth and rising costs at Facebook is not a new one.

Expectations Management

Like most companies in the innovative and fast-changing technology space, Facebook faces challenges on an ongoing basis. When I first wrote about the company in November 2016, the narrative was of declining ad load capacity that would “play a less significant factor in driving revenue growth after mid-2017,” according to CFO David Wehner, who followed by saying that it would be an “aggressive investment year” for operating expenses.

Despite those challenges, Facebook went on to produce 47% revenue growth and operating margin expansion from 45% to 50% which drove 55% earnings per share growth. Meanwhile, the share price advanced from $118 at the time of my first writing to a high of $195 before falling back to $176 today, a gain of 49% over 15 months. And the current headlines may well be offering an opportunity to profit from a similar situation today.

Such warnings and subsequent outperformance are nothing new for the company and its management team. An examination of the past four years of its public history reveal that the trend has been in force since its earliest publicly-traded days:

April 23, 2014: Then-CFO David Ebersman warned that ad revenue growth, then at 82% year over year, would "slow meaningfully going forward." A true statement but Facebook has still maintained revenue growth of 44-55% every year since 2013.

October 28, 2014: New (and current) CFO David Wehner forecasted a rise in non-GAAP spending by 50-70% in 2015 in a “significant expense year” (mirroring his November 2016 comments). 2015 saw the operating margin decline from 40% to 34.7% and EPS growth was constrained to 17%. FB stock still climbed from $78 at year-end 2014 to $105 at year-end 2015.

July 29, 2015: Wehner warned that Facebook’s annual revenue growth rate (39%-42% in Q1-Q2) will continue to decline throughout the year. Instead, Facebook finished strongly to post 44% full-year growth.

November 2, 2016: As noted earlier, Wehner set expectations for slower revenue growth due to lesser contributions from ad loads, and also noted “aggressive investments” of 40-50% growth in GAAP expenses. Ultimately, 2017 ended with 31% growth in operating expenses and operating margin expansion to 50%.

Along the way, consistent warnings on revenue growth and investment spending have generally paled in comparison to actual results, with expense growth trailing revenue growth in all years except 2015, and the share price barreling forward with 35-104% returns in all years except 2016.

WB 1 - Table - Growth Metrics.PNG

While some of those trends may not hold and margins may compress in 2018, a longer-term view of Facebook should take into account the excellent execution, high-quality business model, focused and effective management team, forward-looking investments, and potential for a growing franchise beyond the coming 12 months. 

How I Think About Facebook

In the spirit of shameless cloning espoused by Mohnish Pabrai (who holds shares of top competitor Alphabet (GOOGL)), I’ve added to my existing position in Facebook and elevated it to my Prime Portfolio.  In doing so, I’m cloning the actions of a collection of hedge funds of which 156 own shares of Facebook, 20 more than the next most widely-held stock.  Its holders as of December 31, 2017 include notable names such as Stanley Druckenmiller (9.6% of portfolio), David Tepper (9.1%), Julian Robertson (4.7%), and Dan Loeb (4.3%).

As background, I’ve committed to building a portfolio of franchise quality businesses in a concentrated portfolio of my highest-conviction holdings. Before making an addition to the Prime Portfolio, I ask the following questions:

  1. Is the business simple and understandable?
  2. Is the business a franchise?
  3. What are the business’ prospects 10 to 20 years into the future?

I’m looking for easy-to-understand businesses with a track record of success, promising future prospects, and great odds of compounding earnings over a long time horizon.

Is the Business Simple and Understandable?

Many people reading use Facebook daily or otherwise on a frequent basis. Facebook attracts a large and diverse audience, collects data useful for advertising purposes, and provides a platform for advertisers to reach their target customers with timely, appropriate, and highly effective marketing. In terms of simplicity and understandability, Facebook should rate as high as just about any other company for most readers. To supplement its franchise platform, the company also operates the Instagram, WhatsApp, and Messenger services.

Is the Business a Franchise?

Warren Buffett has defined a franchise business as one whose product or service is needed or desired, with no close substitute, and unregulated profits. Say what you will about Facebook’s social media services, but personal connection is without question one of the most fundamental human needs and, although it’s not a direct alternative for face-to-face interactions, Facebook and its related platforms are how most people seek to meet that need in the online world. Facebook’s worldwide audience of 2.1 billion monthly active users which make up ~28% of the worldwide population provide compelling evidence that its service is highly desired around the globe.

Some may already be aware that Facebook owns the top four most-downloaded apps in the world during 2017: WhatsApp, Messenger, Facebook, and Instagram.

1 - Top-Downloaded Apps.png

Source: Techcrunch and SensorTower

Consumer mindshare can be a powerful driver of business performance and durability. And with more than 2 billion monthly active users and four massively scaled mobile and internet platforms, Facebook has consumer mindshare in spades. The value to advertisers of this large audience, intimate user knowledge, and growing network effect can’t be understated. An article from Value Investors Club explores this dynamic. The piece explains that the culture of innovation among the company’s engineers has led to introduction of new features and functions that keep its users highly engaged, while at the same time Facebook accumulates a deep understanding of them. These factors make the simple-to-use and highly effective ad targeting tools a boon for marketers, who compete against one another to drive ad prices higher in what becomes a virtuous cycle of revenue growth for the Facebook franchise.

In its 2017 10-K Annual Report, management alludes to this immense pricing power by explaining that a 29% increase in prices per ad was the main driver of revenue growth in 2017. This followed a 5% increase in ad pricing in 2016. The report offers the quality, relevance, and performance of Facebook ads as one key factor in the higher pricing. Pricing power, it should be noted, is another hallmark attribute of powerful business franchises.

The same article as cited above provides select quotes about the value of Facebook advertisements from informal interviews with a selection of 18 digital advertisers:

"We’re very positive on the efficiency of Facebook compared to all other paid media."

"The CPM [cost per thousand ad impressions] that clients are spending today can be much higher (emphasis mine) and they will be happy with the results."

"Facebook is just getting started. It is phenomenally effective (emphasis mine)."

All the signs from the company’s management, advertising industry insiders, and analysts point to one conclusion: Facebook is a franchise-quality business with massive consumer mindshare, perhaps the worlds largest audience, the world’s largest network effect, and meaningful pricing power. With that established, the main question to resolve is how durable the Facebook franchise will be.

What Are Facebook’s Prospects 10 to 20 Years Into the Future?

The future of Facebook will depend on growth within the current franchise, efforts to monetize secondary platforms, and plans to grow in virtual reality. While it’s difficult to know exactly what will transpire going forward, Facebook has several key attributes to carry it successfully into the future. Plus, one can imagine that having close to one-third of the world’s population as a captive audience provides for substantial business optionality and upside potential that could come from areas we can only begin to envision today as the company further leverages its user base and network effects.

In order to realize that vast potential, management is investing heavily in the company’s future. In 2017, it spent $7.7 billion, or 19% of revenue, on research and development. Its typical range has been 21% to 27% during the previous five years, which compares favorably to competitor Alphabet's 13% to 16% annual amount since 2013. The elevated level of R&D spending at Facebook conceals its full earning power to some degree and also better positions the company for the future at is it seeks to leverage its present revenue streams while creating new ones.

WB 2 - Table - R&D.PNG

The company has suffered negative headlines, criticism, and a declining stock price based on expected changes to the news feed content and increased investments in security. But if the worst that can be said about management is its aggressive actions to invest in improving its product quality for users and protect its franchise against competition and potential government regulation, then I’d disagree that it isn’t in the best interests of Facebook and its shareholders to tackle these issues before they become larger problems. 

I’m a long-term investor. I’m looking beyond the next twelve months to the next five years. Management appears to have consistently demonstrated a similar mindset, which is why I consider our interests to be aligned. At its current valuation, FB stock can be purchased at 24 times 2018 earnings estimates and 20 times 2019 estimates, a modest price for a company which possesses such a strong franchise and for which the trailing growth rates (which, it should be noted, are expected to decline) are more than double these multiples.

My personal goal is to double my capital every five years, which can be accomplished by earning approximately 15% annual returns. My expectation is that an investment in Facebook stock has a reasonable chance of clearing this hurdle. I expect to hold FB stock for five years, then reevaluate near the end of that time frame. 

Portfolio Allocation

Facebook now occupies a spot in my Prime Portfolio and maintains a 12% weighting. As mentioned earlier my initial purchase of Facebook stock was at $119. Ignoring that earlier purchase, and since initiation of my dual-portfolio system in late June 2017, I’ve added Facebook shares at $152 and $183, bringing my cost basis to an average of $167 for the latter two purchases. Prime maintains a 45% cash position as I continue to gradually build out the portfolio and add new funds over time. I seek to add companies with strong and durable competitive advantages in a concentrated portfolio of 8 to 12 stocks with low turnover and long holding periods in my Prime Portfolio. I currently view Brookfield Asset Management (BAM) and Facebook as top candidates for a higher weighting in the portfolio, and maintain a watchlist of approximately 50 franchise or near-franchise quality companies that I’ll add at the right price or as my understanding of the businesses and comfort with their current valuation and future prospects increases over time.

2 - Prime Portfolio.PNG

My Action Portfolio makes up 35% of my investable capital and is a system of side bets of smaller positions in higher-growth, higher-risk companies. As a result, most of the holdings possess greater potential for explosive growth, as evidenced by 30%-plus gains since last June in half of the positions.

3 - Action Portfolio.PNG

If you know of other franchise-quality businesses, outstanding capital allocators, or companies with durable competitive advantages, then please share your thoughts on them or on my recent addition of Facebook. I'll look forward to your comments, and as always: Be Virtuous!

Disclosure: Jason Rowland owns shares of Facebook (FB) and all stocks in both The Prime Portfolio and The Action Portfolio.

Disclaimer: I am not a registered investment advisor. I receive no compensation from any of the companies of which I own shares and of which I write about. The strategies discussed are designed to suit my own investment objectives, not those of any other individual. They are for illustrative and educational purposes, and they are not guaranteed to be effective. It is possible that not all material information will be discussed about each security highlighted on the site.

All investments involve risks. All information on The Virtuous Cycle website is general analysis and my own interpretations of available information. It is neither financial nor investment advice, nor is it a recommendation to buy or sell any security based on an individual's specific investment goals or financial situation. Individuals must do their own due diligence and determine how each investment fits into their own investment and financial plans prior to making their own investment decisions.