With Facebook's (FB) latest earnings report, bears were proven wrong again. The stock has now recovered back to $200 on the back of strong revenue growth, which we predicted in our last article. Instead of recapping the earnings beat, we'll instead take a look at some common misconceptions that bears had and may still have about Facebook. Note: When we mean Facebook, we are including Instagram and WhatsApp and all of Facebook's fully owned subsidiaries
Misconception 1 - Facebook will suffer significantly from bad press:
This is a really, really common misconception. Many bears believe that Facebook will lose significant amounts of users or advertisers due to bad press.
However, that's not how Facebook works. Unlike traditional companies, Facebook doesn't make money by providing the best service, but rather by getting people to stay engaged and remain on the site. Facebook doesn't need to please people - how many people become happier and more fulfilled after using Facebook? Despite Facebook being detrimental to the productivity and happiness of the majority of people, Facebook has become the largest social media company in the world and has generated significant profits in the process.
So why do people stay on Facebook despite hating it?
The main reason is Facebook knows how to exploit how our minds are wired. Facebook is literally built to keep users on there as long as possible using a technique called A/B testing. This method splits the audience into two groups to test how they would react to something on the screen. Facebook uses this method to see what users are REALLY doing.
Controversy is not new to Facebook. Over 10 years ago, when Facebook introduced the News Feed, a group called "Students against News Feed" was formed, garnering hundreds of thousands of members within a day. This is how Techcrunch reported it:
A site calling to boycott Facebook on September 12 has also been put up, as well as a petition to have the features removed. Other sites are popping up as well. There seems to be no counterbalancing group or groups in favor of the changes.
Sounds eerily familiar to the #DeleteFacebook movement today, right? But wait, so why is News Feed still on Facebook? The answer: People's actions speak louder than words. People continued to use Facebook for record amounts of time even as they protested News Feed. This applies to today's controversies. Think about it: If bad news were really hurting Facebook, would Zuckerberg really be sitting back and doing nothing?
Data released by Facebook also tells a different story: ARPU and user count have both been trending upward. This shows neither advertisers nor users are leaving Facebook.
Misconception 2 - Regulation hurts Facebook:
This is a common misconception that bears have. With politicians calling for tech companies to break up and with increasing negative sentiment towards companies like Facebook, fears of regulation have plagued Facebook for a while.
However, these fears are deeply unfounded and have very little merit. We're not saying that Facebook definitely will not be broken up, just that it would be very unwise to do so. This is because Facebook is what's known as a natural monopoly, in which the largest company in the industry reaps the lowest costs. The large pool of users Facebook has allows it to have much lower costs than the competition, like Snapchat (NYSE:SNAP), which is currently unprofitable.
Another fear of regulation is that regulation would drive up Facebook's costs. While this is true, regulation also allows Facebook to widen its moat and strengthen barriers to entry.
Source: Google images - A classic moat from the medieval ages
Facebook is also incredibly valuable to consumers. A study conducted by UK researchers found that Facebook users valued the platform at close to $1000 annually (Credit to @jayvaidya). Why would any lawmaker break up a company that provides this much value to consumers?
Misconception 3 - Facebook has lost the trust of consumers:
Facebook may have been mired in scandal and controversy, but that doesn't mean consumers no longer trust it, which is what most bears are claiming. Users are not only growing steadily as shown above, but we observe that even as controversy has escalated, all of our contacts continue to not only use Facebook and its services, but to also use them to send sensitive content.
If Facebook has made some consumers more wary, it is actively working to rebuild that trust. Management mentioned significant investments in privacy, security and transparency to help regain the trust of users in their Q1 2019 earnings call. Facebook has also banned controversial personalities like Alex Jones recently, which should give consumers more confidence in letting their kids use the platform.
Misconception 4 - WhatsApp and Messenger are next to worthless:
Bears have criticized Facebook's inability to monetize WhatsApp and Messenger for months now. However, we believe it is a mistake to be pessimistic on Facebook based on this.
There are teams of coders and designers that are working on a solution to this every day. It's not impossible to monetize a messaging app without turning away users. Facebook has already made progress with the introduction of WhatsApp story ads and stickers. Although ARPU will be lower than from Facebook and Instagram, bears shouldn't underestimate the amount of earnings that can be generated from this.
In fact, we recently noticed that Google (NASDAQ:GOOG) (NASDAQ:GOOGL) had monetized their Gmail app, which we had thought was near impossible. Basically, they put up sponsored ads occasionally at the top of the promotion or social inboxes. It doesn't seem far fetched for Facebook to implement the same ads in WhatsApp.
Source: Google images
It's hard to say how much this controversy has affected people's perception of Facebook's valuation, but we believe Facebook is underpriced compared to peers like Google or Apple (NASDAQ:AAPL) due to the controversy. Facebook grows revenue faster than Google yet trades at a similar P/E multiple. We believe Facebook should trade at a slight premium, or 33x P/E, to account for its higher growth, which would mean it's slightly undervalued at its current price.
In the end, FB has made an addictive product that billions of people use every day. Despite all the scandals and controversy, we're willing to wager that the majority of users will continue to use Facebook. Facebook clearly has a lot of value to its users and that should help fuel its long term growth.
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.