'Watch' As Facebook Climbs Another 50%

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About: Facebook (FB), Includes: NFLX
by: The Investment Strategist
Summary

Industry trends have been shifting into streaming and video on demand services.

With 1.5 billion users and growth potential overseas, FB is well positioned to gain a substantial market share of the VOD market through Facebook Watch.

After a recent 15% pullback, we are still very bullish on the stock.

Facebook (FB) is shifting from its tried and tested News Feed based revenue model and focusing more on other avenues such as Facebook Watch, the newly launched content streaming platform of the social media giant, and Facebook Stories. The initial launch of the video on demand platform has not been able to gain traction, but the massive user base, increasing revenue per user on a global scale, and Facebook's massive cash balance can put Facebook Watch in the driving seat of the content streaming industry. Facebook Watch should not be analyzed as the next big venture of the company, however, but rather as another feature that would help Facebook build on its loyal user base - which they can continue to monetize in the future.

Overview and industry analysis

Since the devastating earnings call in July, Facebook shares have dropped a staggering 40%, but company fundamentals are little changed.

While analysts believe Facebook would be better off focusing on the News Feed based model which has generated billions of dollars so far for the company, I believe Facebook Watch provides the opportunity for the company to grow and capture a greater share of the streaming industry. More importantly, I believe Facebook Watch will encourage users to spend more time on the platform rather than shifting to more popular alternatives such as YouTube or Netflix. A higher number of hours spent on Facebook should translate into higher revenue for the company as advertisers would be inclined to market their products and services on FB as opposed to other social media giants.

Facebook's economic moat is built on the network effect, and Messenger, WhatsApp, and Instagram are all contributing toward a higher user retention with the platform. Due to the nature of the industry in which Facebook operates, higher competition does not become a concern as long as it does not affect the number of hours spent on the platform as users, of course, can maintain multiple social media profiles.

Despite regulatory concerns, Daily Active Users (DAUs) have grown steadily over the last couple of years, and despite slowing active user growth in the U.S., Asia-Pac user growth is very high potential - as we pointed out in a previous article.

(Source - Company presentation)

Facebook, in my opinion, is a business that focuses on adding value to its users first and then implements strategies to monetize the loyal user base that it builds. It is how the company first started and Facebook Watch is another such tool that should not be valued based on the ad revenue that it is generating at the moment but rather by the value that it adds to its users.

Eventually, the value-add to users will translate into higher ad spending. Digital ad spending worldwide is forecast to grow substantially as companies are allocating a significant portion of their advertising budgets to purchase digital ads that can be targeted to a specific audience based on demographics, interests, and age group.

It is apparent, therefore, that as Facebook grows its DAUs, it will be positioned to take advantage of higher ad spending.

Lastly, Facebook's Average Revenue Per User (ARPU) has been increasing over the last couple of years and is expected to grow for at least the next half a decade as the company monetizes Facebook Stories and WhatsApp, while the growing demand for digital ads should increase Facebook's Cost per Impressions (CPM).

(Source - Company presentation)

Other Opportunities

The global video on demand (VOD) industry is also forecast to grow at a compound annual growth rate of 9.3% until 2026 and such a robust growth estimate is exemplary of the yet another opportunity that exists within the industry.

Yet another potential growth driver is evident from the trend in popularity of live videos, with daily active users of 1.5 billion to penetrate more into the live video streaming industry.

(Source - Transparency Market Research)

(Source - Neil Patel)

According to a study conducted by Cisco, video traffic will be 82% of all consumer internet traffic by 2021 and live internet video traffic will account for 13% of internet video traffic, which assumes a growth rate of 1,500% from 2016 to 2021. In addition, Content Delivery Network (CDN) traffic is forecast to account for 71% of global video traffic.

Bull case for Facebook Watch

Facebook is by far the largest social media platform on earth and the company has used innovative features to keep its users engaged with monetization typically following a later stage of the new feature launch. Facebook is now trying to penetrate into the growing video on demand industry to establish a presence. With its massive user base, it naturally positions the company in an advantageous position as users would automatically be encouraged to use Facebook Watch, which, in turn, will keep them engaged with Facebook more than any other social media platform.

Cash is King

Facebook's robust balance sheet can be used to fund the growth of its content streaming platform and it has billions of dollars available to create original content. At the moment, Facebook is still trying to figure out the best possible approach to penetrate the content streaming industry but once they do, Facebook has all that it takes to become a major player in the streaming industry - provided they can deal with all of the side issues it has to deal with.

The total cash balance of $40 billion certainly gives Facebook the flexibility to invest in the content streaming industry and when combined with an existing audience of more than 1.5 billion users, certainly makes a compelling case to do so.

It is also generating healthy free cash flow, which could provide needed ongoing funding to invest in its video streaming platform, which we know from the likes of Netflix (NFLX) and others is a high investment endeavor with no guarantees.

(Source - Author prepared)

Personalization

As identified in the industry analysis segment, personalization is a strong pillar on which the content streaming industry is built. Facebook has an enormous database that can be used to identify interests of users with accuracy and provide Facebook with a massive competitive advantage. Existing players in the industry will fall behind Facebook in understanding consumer interests and behavior as Facebook has access to years of data for all its users. The level of personalization Facebook can bring to the table will lure viewers away from existing players to Facebook Watch, presuming quality content would be available.

As we mentioned in a previous article, the importance of users in Asia-Pac is tantamount to the company's future success. It has close to 561 million daily active users in the Asia-Pacific region, which not only will be a key driver of future revenue growth but might be vital to the survival and growth of Facebook Watch.

The Asia-Pacific region is not dominated by other content streaming providers and Facebook's wide economic moat will put them in a position to build a strong viewer base around its video streaming platform. Netflix and Amazon Prime (NASDAQ:AMZN) have laid down plans to gain viewership through localized content such as Indian dramas, but, in my opinion, users in this region are more likely to stick with Facebook Watch if they produce original content. Users in this region almost always prefer to have advertisements integrated into content rather than to pay for a subscription to gain access to content. On this note, if Facebook Watch can operate like a traditional player in the cable-TV industry, gaining traction in this region will be more likely.

Sports

Facebook has signed a few deals to stream live sports events, which can drive traffic to its Facebook Watch platform, as well. Live sports streaming was the one thing that cable-TV providers relied on as OTT services like Netflix, Hulu, and Amazon Prime continued to steal viewership through original content production. Facebook Watch brings a third dimension to the cut the cord movement as users would be inclined to stream sports events online than to pay for a cable-TV service provider.

Facebook is taking on the news broadcasting industry as well and has already signed a few deals to broadcast funded news shows. It is no surprise that Facebook has been one of the go-to sources of news in recent years as millions of users were redirected to news reporting websites such as CNBC, Bloomberg, and Fox through Facebook. With the newly signed deals, Facebook now has the opportunity to lead these millions of viewers to its own Facebook Watch platform and the effect of this will be palpable as more agencies sign up with Facebook to curate news.

Funded news shows on Facebook Watch

Risks and challenges

  • Facebook will be exposed to immense competition in its journey of becoming a go-to platform for content streaming. Established players in the industry such as Netflix, Amazon Prime, and Hulu are spending billions on original content creation and these companies enjoy the luxury of being the first players to penetrate this market. Millions of people have already subscribed to these services and the exclusivity of the content they stream will persuade users to stick to existing platforms. However, Facebook Watch is free to air and this should incentivize users to simultaneously use Facebook Watch along with existing subscriptions.
  • Facebook Watch will fail to contribute meaningfully to the company bottom line for some time to come. Building a loyal user base around its content will be time consuming and it might take a couple of years at least to establish a strong presence in this segment despite the billions of users who are active on Facebook on a daily basis. Billions of dollars should be invested to produce original content on a consistent basis and to strike deals to broadcast live sports events, which would, in turn, compress margins in the years to come. The short-term outlook of the company, therefore, might be adversely affected and analysts might continue to downgrade Facebook.
  • YouTube and its newly released YouTube TV feature will be in direct competition with Facebook Watch. YouTube is by far the world's largest crowd-sourced video platform and has been in existence for years, which has helped them build a loyal user base. The newly launched YouTube TV platform competes with traditional cable-TV service providers for viewership and has already gained some traction. Facebook Watch will have to compete with YouTube's crowd-sourced platform, YouTube TV and cable-TV providers as well, which might make it difficult to emerge as the winner in an already crowded space.
  • Focusing on company-specific metrics, it would be a huge challenge for the company to shift its focus from the more reliable News Feed oriented structure to a News Feed plus video-based structure. The relatively new concept is experimental and the management believes it would take years to complete a smooth transition, during which period the company might experience lagged growth in revenues and profits.

As Mark Zuckerberg warns:

But I want to be up front that even assuming that we get to where we want to go from a feed-only world to a feed plus Stories world, it will take some time and our revenue growth may be slower during that period like it was while transitioning our products to mobile.

Our Take

Facebook's massive active user base, strong balance sheet, wide economic moat, and capable management will act as potential enablers for success in the content streaming market, but Facebook Watch will be competing with companies already successful in the space as well as new entrants, both from the current group of FANGs and potential upstarts as well.

Dynamically changing social media and streaming habits will help Facebook Watch gain traction in the future as the ability of a service provider to personalize content will play a key role in building a loyal user base. This is where we think Facebook has an advantage.

Eventually, Facebook's ability to provide users a streamlined, personalized viewing experience should help stabilize user engagement in the platform and the company can continue to effectively monetize its massive user base.

As I mentioned in previous articles, Facebook could boost revenues by $9 billion with no user growth at all. But the added bonus is the potential for Facebook to increase revenue per user using new features such as Facebook Watch, in addition to increasing its revenue per user in certain regions where that figure already has upside based on the current product offering.

The recent pullback in the share price gives us even more conviction of the stock's potential return over the next couple of years. While analyst price targets have come down recently, they are still 47% above the current price. We believe the potential is even higher, as revenue/user internationally rises to levels more comparable to those in the US. Our price target remains at $213.

Disclaimer: This article is meant to identify an idea for further research and analysis and should not be taken as a recommendation to invest. It does not provide individualized advice or recommendations for any specific reader. Also, note that we may not cover all relevant risks related to the ideas presented in this article. Readers should conduct their own due diligence and carefully consider their own investment objectives, risk tolerance, time horizon, tax situation, liquidity needs, and concentration levels, or contact their advisor to determine if any ideas presented here are appropriate for their unique circumstances.

Disclosure: I am/we are long FB. 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.

Additional disclosure: Long: BXP, CIO, MNR, KIM, RPAI, SPG, MAC, STOR, O, IRT, APTS, AVB, UMH, AMH, AHT, SELF, GMRE, HCP, SBRA, PCH, AMT, CCI, CORR, CONE, QTS, IIPR, BXMT