Facebook Is Undervalued

About: Facebook (FB)
by: John Huber

As I mentioned in a note to my investors earlier this week, the spirit of the Holiday shopping season has been extended to certain parts of the stock market, with a number of bargains to be found.

In terms of interesting ideas to be excited about, my watchlist is beginning to rival the ever-growing wish list that my kids have diligently been preparing for Santa.

I wrote a letter to Saber Capital investors this week with some thoughts on Facebook (NASDAQ:FB), which IU think is one of these opportunities, and one of my firm's recent investments.

Here is the link to the note I sent to investors: Facebook Is Undervalued

I thought I'd post the Facebook thoughts here as well:

"A simple rule dictates my buying: be greedy when others are fearful."

Warren Buffett wrote those words in an op-ed during the fall of 2008, which was certainly a time of fearfulness. The simple philosophy has been a foundational part of his investment approach for his entire career, and regardless of how often it gets repeated, it remains as useful and as valuable today as it was when Buffett first coined the phrase decades ago. Human nature doesn't change, and the stock market continues to provide opportunities to be greedy when others are fearful.

As I've outlined before, there is no informational edge in most large-cap stocks, but there absolutely is a time-horizon edge for those who are willing to thoughtfully analyze what most people want to avoid out of fear of what the next year might look like.

Currently, fear is creating an opportunity with Facebook. The stock, at $140 per share, is currently trading around 18 times earnings (16 P/E excluding net cash). This is a company that grew its revenue by 49% last year, and while growth will obviously slow from that level, Facebook is one of the most profitable businesses in existence and still has a very long runway ahead. If you have the ability to look out two or three years, this is the time to be capitalizing on that fear.

"Best Business Model Ever Created"

Facebook has one of the best businesses in the world. In some ways, it operates like a traditional media company that provides content to readers and collects advertising revenue from businesses who want to reach those readers. But the key difference is that Facebook has the largest readership base in the world (2.3 billion people), and the readers themselves provide the content for free. This is why John Malone once said Facebook has the "best business model that's ever been created".

The result of billions of readers providing free content for each other is a massive network effect and a business that can serve each incremental ad at a very low marginal cost. The company's 85% gross margin leaves a lot of meat on the bone that it can spend on hiring new engineers and developing new technology that is needed to maintain and grow the business. But even after paying the engineers, growing the headcount, spending over $9 billion on R&D, and paying the tax bill, shareholders are still left with around 40 cents of profit for each dollar of revenue.

Facebook reinvests these earnings into data centers, technology, and the occasional acquisition, but even so, the cash in the till has been piling up, and now exceeds $40 billion and counting ($14 per share). Facebook has spent $10 billion on buybacks in the last year, and this will likely accelerate in the coming years.

A Durable Moat

All of Facebook's properties have huge network effects, and the great thing about networks is that as they grow, their moat widens. The sheer size of the network acts like a magnet to get people and businesses to join, and it acts like gravity to get those participants to stay. It's hard to leave a place that all of your friends and acquaintances are a part of. And for the same reason, it's hard for a business to leave a place where all of its customers are. The strength of the network compounds exponentially as it grows.

Facebook's network of 2.3 billion people is much stronger than Twitter's (NYSE:TWTR) 300 million or Snap's (NYSE:SNAP) 200 million. And for those who compare Facebook to MySpace: keep in mind the latter had 75 million users at its peak in 2008, roughly 3.3% of Facebook's current user base. So far in 2018 alone, Facebook has added 142 million users, a sum that is nearly twice the number of users that MySpace ever had in total.

Facebook's huge user base doesn't mean the network is invincible, but it is much more durable than many people believe.

Growth Potential

Facebook's business is still growing fast (33% revenue growth last quarter), and despite the company's large size, the runway is still long. Benedict Evans, a partner at the VC firm Andreessen Horowitz, recently pointed out that roughly $1 trillion is spent each year by businesses that are trying to reach customers who are asking the question: "What should I buy?":