|Shares Out. (in M):||2,992||P/E||30||23|
|Market Cap (in $M):||531,978||P/FCF||40||29|
|Net Debt (in $M):||35,400||EBIT||20,754||28,862|
Facebook is a network effect business with few competitive threats as the world’s largest social network. Increasing free user generated content reinforces the network effects, allowing the company to take market share of the $600b+ advertising market. I believe that management’s persistent commentary about headwinds from News Feed ad load limits reaching a peak in Q2 2017 has been more about managing the stock price and will be a non-event for Q3 2017 with Facebook delivering a 2H 2017 revenue growth rate of 45% vs. Street consensus forecast of 38%. This is an additional ~$1b in revenue that translates to a full year GAAP EBIT of $21.0b vs. consensus estimates of $20.4b. Management has also been sandbagging expense growth guidance in the prior 2 years, albeit easy to do in the context of >90% incremental margins and high growth. Facebook’s high market cap (#4 globally) and headline risk around future regulation, political ads, fake news, etc. may be factors supporting current mispricing. The bottom line – Facebook is executing. Facebook’s software development teams continue to build new tools that make it easier for marketers to target ads that, along with increasing advertiser competition, drives the price per ad higher (+6%, +5%, +14% and +24% in the 4 most recent quarters). Facebook also has additional ad inventory coming that mutes the impact of News Feed ad load. CMOs continue to arm themselves with marketing and ad technology to measure the ROI on Facebook ads and other digital ad spend. I forecast Facebook trading at 17X 2018 EV/EBIT with high confidence that sustained growth will be supported by both e-commerce and digital transformation trends. Given the cash generating ability and capital light nature of the business model, this is a low multiple for a growth company with an excellent moat.
Business Model Overview
Facebook offers a free place for individuals, affinity groups and businesses to express themselves and share information on one of four properties: Facebook, Instagram, WhatsApp and Messenger. Facebook and Instagram are the focus in this report. Facebook is the top app in the U.S., with more downloads than the Chrome Browser. It is a library of daily activity for 1.3b daily active users (+17% y/y) and 2.0b monthly active users (+ 17% y/y) globally including about ~64% of the US population. The majority of users access Facebook via a mobile device where the average user in the U.S. is spending 50 minutes per day on the platform. Seventy million businesses are listed on Facebook and 5m of them advertise on the platform. Instagram has 15m businesses listed with 2m advertisers (vs. 1m in March 2017).
Facebook owns 7 data centers and leases 2 facilities. The company has 20,700 employees and is based in Menlo Park, CA.
FB largely monetizes Facebook and Instagram today. Facebook is a free website and mobile app for personal and business use to form connections and groups to share text updates, text comments, location, photo and video content. The News Feed is the central viewing area that serves as a personal newspaper crafted by proprietary software every few minutes. This flow of information provides updates on activities of people in the user’s social network. Instagram is a photo-based sharing service where individuals and businesses can post high quality photos and short comments. Instagram has 800m users (500m DAU), up from 400m users only 2 years prior. Users typically “follow” or subscribe to an Instagram feed, thereby forming one-way connections. Instagram and Facebook have a common advertising system so marketers can easily target the same user on both platforms.
While the 20th century heralded the age of mass advertising communication by T.V., radio, and newspapers, the old paradigm is being rapidly supplanted by one-to-one advertising communication enabled by smartphones and social networks. The company monetizes this attention by helping businesses sell targeted and native advertising to Facebook and Instagram users who natively build profiles about themselves. The primary determinant of advertising ROI is targeting the right message, to the right person, at the right time. Facebook Ads Manager is a self-service ad submission, targeting and analytics tool that allows businesses to advertise and measure the returns on ad spend (ROAS). Facebook also has a Marketing API that allows advanced digital agencies to directly connect to the platform and run programmatic campaigns. Brands uniquely benefit from the platform because they can more easily measure how individuals engage with emotionally driven brand advertising.
WhatsApp (1b DAU, 1.3b MAU) and Messenger (1.2b MAU) are not yet monetized. Facebook only recently released an SDK to allow firms to build applications and chat bots for these messaging tools. Tencent’s WeChat in China has been transformed into both platform and mobile portal for ecommerce and is delivering ~$7 in ARPU on ~1b MAU. It is too early to tell how Facebook will monetize these networks.
Facebook also helps deliver ads across the internet. Facebook Audience Network (FAN) delivered a >$1b run-rate by serving ads to apps at the end of 2016. Facebook Connect is a universal login that allows ID-based tracking (superior to cookie based tracking) so that marketers can follow Facebook users even when they navigate away from the Facebook app or across multiple devices. The ability to follow users around the web is critical for establishing which ads are attributed to desired actions (i.e. purchases, form completions, etc.).
Moat / Opportunity
“Hacker culture” results in the rapid release of targeting tools which leads to advertiser competition and helps drive prices per ad higher –
The ability of software firms to produce new features and functions typically declines as the size of the code base and the number of engineers increase. However, Facebook’s “hacker culture” is consistently executing the release of new features that improve user engagement and keep users on the Facebook platform. There is also significant innovation for targeting tools via the Power Editor ad tools that drive monetization rates (i.e., ARPU). These features are released with very high frequency often without documentation or even notice. Facebook marketers are generally able to deploy these new tools because they work out of the gate and the reward from using new targeting techniques on Facebook can be lucrative given the scale. This dynamic sharply contrasts to the broken innovation cultures at Twitter, Yahoo and to a lesser degree at Snap and Yelp where large audiences are under-monetized because self-service advertising tools are less developed and marketers struggle to test and learn about the platform to increase return on ad spend (ROAS).
Facebook knows more about its users than any other direct advertising medium, and the associated targeting ability combined with advertiser competition is driving prices per ad higher. Facebook allows marketers to target individuals by age, gender, geography, relationships, interests groups, lifestyles, etc. – and marketers know that this information is not inferred from behavior, but is rather directly shared by Facebook users.
Examples of ad targeting that drive ad prices higher:
Custom audiences (CA) tools have been extremely effective. Marketers upload proprietary customer lists (names, phone numbers, email, address, etc.) into Facebook where up to 60% of these customers can be matched to Facebook users. Custom audiences then become substitutes for email and direct mail, serving as powerful methods to retarget high value customers. Custom audiences can also be created to track offline activity. Once someone sees an ad, Facebook can evaluate if that person visited a store. There are a variety of targeting tools being developed around this use case. Given retail footfall challenges, these tools are being actively deployed.
Facebook allows marketers to create CA to target certain users based on their location in the sales funnel via prior interactions with ads, native content, links or even shopping carts. For example, Facebook is beta testing ways to build an audience based on people who have shared a link to certain content. A “Dwell time” metric in beta testing seeks to target users who spent a certain amount of time looking at an ad (without clicking on it) and then retargeting them again in the future. This is similar to tools in YouTube that allow marketers to retarget 6-second bumper type ads to the same users that previously watched an entire longer form ad from the same brand without skipping it.
Lookalike audiences are also extremely effective. These audiences are constructed by a Facebook algorithm to find people most like another CA. Facebook has sufficient scale and data at 2b MAU to accomplish feats that marketers could only dream about in the past.
Rich content drives price per ad higher for Facebook and Instagram. Richer ad formats with video and photos are experiencing rapid growth and always command higher CPM from marketers due to better engagement. Brand marketers have only recently focused on developing video content for social media platforms. The strategies and formats for successful social media are vastly different from TV ads which dominate the digital assets of many brands. The gradual shift away from $190b global TV market is likely to continue. Video consumption is an increasing activity on mobile devices and marketers want to deliver commercials. Nielsen, Social Code and other data providers are now able to match in-store purchases to ID-based profiles at Facebook/Instagram to demonstrate brand lift and campaign efficacy. Facebook has target rating point (TRP) buying which allows advertisers to plan, buy and measure video with Facebook the same way they do with TV, including verification via Nielsen. The long-standing trend of TV viewership being crowded out by other digital media makes social media attractive to brand advertisers. According to Alan Gould, CEO of Nielsen AG (2010) “Facebook has the opportunity that Google only wishes it had – the ability to build a credible proposition for the largest brand advertisers”. Early reports from Nielsen as to Facebook’s impact on brand lift are encouraging. I heard from a Target executive who highlighted that too many campaigns start with a TV commercial in mind first but should instead focus on the data to tell them where a concept should go to choose the right media mix. I spoke with one creative ad agency that tests 8 forms of content on social media first before considering investing in TV distribution. Dana Anderson, former CMO of Mondelez, noted that the media world has changed so fast that it is no longer possible to buy one commercial and achieve an objective. Nanigans provides a quarterly report on about $700m in annual ad spend (~1.8% Facebook revenue). In Q2 2017, they report a 49% increase in click through rate for ads. This is resulting from a combination of factors that are allow marketers to deliver relevant ads that have increasing rich and dynamic content that users like.
I have spoken with more than 18 participants in the digital advertising, either by phone or at industry conferences. They are almost uniformly supportive of the thesis that Facebook delivers a high level of ROI to marketers.
“We’re very positive on the efficiency of Facebook compared to all other paid media”.
“The CPM that clients are spending today can be much higher and they will be happy with the results”
“Facebook is the new network like ABC or NBC”.
“Anybody who is in the whole marketing game and doing digital marketing and have a company, up to at least 70% of the budget is going towards Facebook for sure. You cannot do without Facebook because it’s very, very good at targeting as you get really good results. It can be expensive but if you optimize it effectively, you get some really great results.”
"Facebook is just getting started. It is phenomenally effective."
Facebook is bringing new inventory online that reduces impacts from ad load limits in the News Feed-
Facebook does not segment Instagram revenue but digital ad agencies indicate clients have high interest in Instagram and are achieving positive results. I expect this inventory will be increasingly valuable, particularly if marketers allocate incremental digital budget dollars to Instagram instead of substituting Facebook budgets. Instagram had a 75% y/y growth rate in MAU in Q1 2017. As of March 2017, ads are now available in the wildly successful Instagram Stories (Snapchat clone) with 250m DAU.
Instant Articles allows publishers to deliver original content inside Facebook that improves load times and provides inventory for native ads in line with content. Publishers have been lukewarm about the results but Facebook is now testing even subscription services with revenue sharing that appears favorable to publishers.
The newer Canvas and Collections ad types allow advertisers to build small microsites inside an ad to increase engagement with multiple products and services.
Facebook Live content grew by 4X in Q1 2017 with 20% of all Facebook videos being live. Ad breaks can be inserted into this content similar to the way ads are inserted into longer form YouTube videos.
Facebook Groups are largely ad-free but are likely to begin to include ads soon. The average Facebook user is a member of 30 groups with 2-3 of these groups which are considered “meaningful” to that person. In June 2017, Facebook announced that about 150m users were in meaningful groups with a goal of getting 1b people to join meaningful groups.
Facebook Search is actively in development and will likely eventually offer a Google Adwords style bidding models with the exception that result sets will be delivered with social context (i.e. AAA Plumbing is liked by 3 friends of mine who can provide trusted referral information).
Messenger inventory is also coming online and didn’t go global until July 2017.
Rapid increases in business penetration and lower organic reach are additional drivers of price increases –
To date, about 5m businesses advertise (vs. 3m in April 2016 and 4m in Dec 2016) on Facebook while 70m businesses manage their business pages on Facebook and freely benefit from the viral nature of the network when happy consumers “like” products/services. When businesses produce content on Facebook, a subset of the people that “like” that business will see the content in their News Feed. Such views are considered “organic” views and businesses consider it a form of free advertising. The rate at which the News Feed is delivering organic posts from businesses continues to fall as the amount of branded content has increased and the Facebook algorithm needs to be more and more selective of what it chooses to display in the News Feed. Typical brands have seen their organic reach decline dramatically over the years with some brands declaring that organic reach is all but dead. Marketers now characterize Facebook and Instagram as a “pay-to-play” mediums where businesses need to pay Facebook to promote their own content in the News Feed to increase reach. As the number of advertisers increase, the auction model leads to price increases. This is analogous to what has been occurring at Google over the last few years with organic search results being replaced by ads, directly benefiting ad clicks volume.
Software tools are improving and the CMO role is becoming more and more data driven–
The last 5 years have witnessed considerable advancements in advertising technology (adtech) and marketing technology (martech). The 5,000 adtech and martech firms (as depicted in the LUMAscape) is easily discounted as some sort of venture “bubble” but my view is that these tools are wringing inefficiency out of a notoriously inefficient ad industry that is still wedded to relationship-based (e.g. sports tickets, steaks, martinis) ad agencies that have been overcharging for decades for advertising that does not work very well. The whining from public ad agency heads about the dominance of Facebook and Google has reached a crescendo for a reason.
Relative to digital products like Google Adwords or even standard TV campaigns, social media marketing is more complex with numerous layers of user engagement and more types of creative content. New software tools are empowering firms to measure and analyze the abundance of data in social networks to even include how users respond to campaigns. Many firms are still building out their internal digital teams and data warehouses to make this type of analysis possible.
The upshot of these technologies is that marketing and advertising investments can be flexed according to efficacy. Fully measured campaigns can be thought of as variable costs rather than fixed costs. I have repeatedly heard leading CMOs highlighting the importance of their relationship to CFOs. Increasingly these data are enabling real-time marketing strategies via marketing automation technology. Programmatic ad buying continues to gain traction as marketers seek customers across a variety of digital platforms. Pepijn Rijvers, CMO of Booking.com, is the largest single buyer of keywords on Google Adwords. Rijvers recently said: “I think regarding that capacity to capture and analyze data for the marketing industry, there is still an enormous opportunity ahead of us. I think that in the 10 years to come we will see quite a lot of disruption and innovation in the marketing science arena particularly”. I think CMO/CTO skill sets are still playing catch-up to digital marketing while undergraduate and even graduate programs struggle to deliver marketers with sufficient data management and statistical analysis skills. These are factors that have caused digital ad spend growth to lag the attention shift to mobile devices in the last several years. The CEO of the media agency WPP characterizes the gap by citing that agencies only invest 6% of campaign money in digital even though digital is 25% of consumer’s time.
Consumer “attention” to mobile is increasing faster than ad spend –
Attention is the finite currency for marketers. To state the obvious, mobile is taking attention share because it is “mobile” – people have more time to consume media wherever they are since mobile devices work better on even faster networks. Mobile devices take attention share away from T.V., books, interpersonal interactions, etc. If 10 hours per day are sleeping and other non-discretionary activities, there are 14 hours of available attention per day. In the U.S., average daily time on mobile devices has increased from 93 minutes in 2011 to 300 minutes in 2016.
While mobile ads were virtually non-existent in 2011, today U.S. mobile ad spending was $46b or only 23% of all advertising spend according to Comscore, much less than the 36% (5 out 14 hours) of available attention spent with mobile devices. This gap will eventually close and could even overshoot if digital marketers can achieve higher returns on ad spend compared to TV or other mediums that more difficult to measure.
Capital Allocation & Management History
I have a bias that favors founder led businesses and Zuckerberg continues to lead the strategic direction of the company and is focused on responsibly growing the size and quality of the Facebook community. Thefacebook.com was founded in Zuckerberg’s undergraduate dorm room in 2004 to provide simple connections between Harvard students to share basic interests and course lists. It was quickly expanded to other colleges and eventually opened to the public in 2009. Zuckerberg had several opportunities to cash out but he thought he was “not going to have a better idea in his life so he thought he should stick with this one”. Microsoft offered $15b in 2007 and he declined the offer. He would have netted $4b at the age of 22. The disinterest in personal wealth is consistent with his recent pledge to give away 99% of his shares eventually which are valued today at $71b.
From inception, the historical focus of the business has not been revenue generation. As Mark Zuckerberg described to investors in the S-1, “Simply put: we don’t build services to make money; we make money to build better services.” The primary focus has been to build a platform that is reliable, sticky and enjoys network effects. For a young founder of a fast growing business, Zuckerberg is unusually long-term oriented. Zuckerberg played a key role in isolating the Facebook community from bad, untargeted advertising which would have generated near term revenue but also would have hampered the development of the social network and may have made it more susceptible to competition. This ethos persists today. From the moment the application was launched in 2004, the primary use of cash raised from early round investors was to invest in software and server architecture to deliver a responsive website with few outages – issues that had limited competing social networks at the time. Facebook has not suffered usability issues and has likely over-invested in its server and data center capabilities. Recently, even Google agreed to adopt Facebook’s OpenCompute project as a useful open-source data center architecture.
Other than the acquisition of FriendFeed in 2009 ($50m), Facebook grew organically through 2011 where invested capital of $3.2b was used to build the network to 845m monthly active users (MAU) at a cost of $3.77 per MAU. In 2011 average revenue per user (ARPU) was $3.15 per year which increased to $15.98 in 2016. Thus, the early investments in building the network have been shown to a prudent use of capital. The increase in ARPU has been almost entirely organic and is a key valuation driver going forward.
Aside from 3 smaller technology acquisitions in 2012-2013, Facebook’s most important acquisitions have been Instagram, WhatsApp and Oculus Rift. Instagram was acquired for $715m ($300m cash/12m class B shares/11m unvested class B to vest over 3 years). Although Instagram revenue is undisclosed, Street estimates are for $4b revenue in 2017. This is amazing growth considering Instagram only launched ads in 2014 and highlights the ability of the ad platform to cross sell other products. There are many well designed ads in Instagram and agencies report that advertisers are happy with their results thus far.
The most controversial acquisition to date was Oculus Rift in July 2014 for $1.9b (78% in stock). This virtual reality (VR) hardware product does not appear to complement the existing business model. Facebook believes that VR is a significant new social networking and gaming platform. VR developers using Rift in the past year have expressed considerable excitement about the platform. I can’t value Rift at this time and Facebook has no experience with successful hardware distribution.
Also in 2014, Facebook acquired messaging platform WhatsApp for $17.2b (73% in stock - 178m shares). Since the WhatsApp acquisition, its number of active users has more than tripled from 450m to 1.3b. WhatsApp was charging $1 per year after providing the first year for free. They pivoted from this pay model and the platform is now free for users. In general, communication services such as Messenger and WhatsApp will be more difficult to monetize from an advertising standpoint. They are likely to charge businesses fees for using the platforms for marketing and customer communication. These products are potentially large call options.
Other smaller acquisitions were completed for $485m in 2014. This included LiveRail, which was an ad exchange platform (supply side platform; SSP) that focuses on mobile video and allows publishers to expose their inventory to automated demand-side platforms (DSP) who then bid for that inventory. Facebook acquired LiveRail to improve LiveRail targeting capability with Facebook data. LiveRail as since been shut down.
There were no material acquisitions in 2015, 2016 or 2017 YTD.
Zuckerberg was mentored by Don Graham of The Washington Post. Graham almost invested in 2005 but Accel Ventures came in with a higher offer. Graham was a Director from 2009-2015 when he was required to roll off due to reaching 70 years of age. Although Zuckerberg has 60.1% of voting control, the Board is high quality: Sheryl Sandberg (COO), Marc Andreesen, Erskine Bowles, Susan Desmond-Hellmann (CEO Gates Foundation), Reed Hastings (Netflix), Jan Koum (CEO WhatsApp), and Peter Thiel. The key executive team all has 5-7 years tenure in their respective roles.
In the U.S., eMarketer forecasts that Google and Facebook, taken together, will garner 63.1% of the incremental dollars invested in digitals ads in the U.S. in 2017. Current and forecast market shares are shown below: