Facebook: Controversial, Yet Inevitable

Summary

• Apple's iOS policy changes continue to haunt Facebook as the reduction in social media giant's ability to provide targeted ads reduces advertising ROI for digital marketers and business owners.
• However, the rise of influencer marketing (Instagram), e-commerce, and the potential monetization of WhatsApp should allow Facebook to grow its revenues at a brisk pace for many more years to come.
• Mark Zuckerberg realizes the power of gatekeepers (such as Apple and Google), hence, Facebook's push for AR/VR (metaverse) dominance.
• Facebook's stock is massively undervalued, and it remains one of the best buys among large-cap tech stocks.
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Introduction

Facebook (FB) is an undervalued cash cow, and I have said this repeatedly in the last eighteen months after exploring each of Facebook's business lines (BTM's research notes on FB). After a spectacular price rally (+40%) since the start of 2021, Facebook's stock dipped by more ~10% in September, with fears about the impact of Apple's (AAPL) iOS 14.5 policy change on upcoming Q3 numbers dominating the investment narrative. On 4th October 2021, Facebook suffered a global outage (news source) [a day after a whistleblower (Francis Haugen, former Product Manager at Facebook) openly bashed Facebook's policies around misinformation in a critical interview on 60 minutes], and quite unsurprisingly, Facebook's stock plunged by another -6% (down to $325 per share). The fact that Facebook's long-time CTO is transitioning away from his role is somewhat problematic. Furthermore, Facebook's AI labeling a video of black men as Primates was outright disgusting, despite an apology from the company. In a nutshell, Facebook is mired among a sea of negative news, and the price action indicates that investor sentiment is now firmly bearish on the social media giant. With all of this being said, Apple's platform changes are likely to be the primary driver of this recent downdraft in Facebook's stock, along with a broader tech selloff caused by a rapid rise in treasury yields. All the other bits of negative news are likely to be temporary noise (like it has always been in the past).

With bond yields being as low as they are now (from a historical standpoint), and considering the weakness in global economic recovery, I don't believe the consensus media narrative - "a rise in 10-yr Treasury yield to 3% would trigger a significant corrective move in large-cap tech stocks like Facebook" - holds any weight, whatsoever. And so, we will focus our analysis on assessing the potential impact of Apple's iOS platform changes on Facebook's business fundamentals to see if this dip in Facebook's stock is a good buying opportunity for long-term investors. Furthermore, we will carry out a brief financial statement analysis and determine Facebook's fair value and expected returns to make an informed investment decision.

Understanding The Impact Of Apple's Platform Changes On Facebook

The last time I wrote on Facebook (back in July), I highlighted the risk of Facebook's revenue and margin coming under pressure due to policy changes from Apple:

The bigger threat to Facebook's business comes from platform changes made by tech-rival Apple. With the iOS 14.5 release, Apple is set to force apps like Facebook to explicitly ask user permission to get access to their data. Such platform changes could affect Facebook's ability to provide targeted ads, and this could lead to lower ad pricing. Therefore, Facebook's revenues and margins could come under pressure. We will be monitoring this situation over the upcoming quarters.

Source: Author's note - "Facebook: One Trillion Dollars And Counting"

According to a report from Bloomberg, nearly 75% of Apple users have denied tracking permission to Facebook. Henceforth, Facebook has lost some of its ability to provide targeted ads. Furthermore, Facebook is now providing limited data to digital marketers, who are facing reduced ROI on their advertising budgets. Amidst this chaos, Facebook's long-time Chief Technology Officer, Mike Schroepfer, has announced his plans to leave his current role at the company. Many investors are concerned about Facebook's pricing power, and rightly so; however, Facebook's Q2 numbers and forward guidance indicate that Facebook does command monopolistic pricing power in the digital ads industry after all. With more than 1.9B DAUs, I wouldn't expect anything less.

Source: Facebook Q2 2021 Earnings Presentation

According to Facebook Q2 earnings report, the company will continue to garner higher ad prices in the rest of 2021:

Advertising revenue growth in the second quarter of 2021 was driven by a 47% year-over-year increase in the average price per ad and a 6% increase in the number of ads delivered. Similar to the second quarter, we expect that advertising revenue growth will be driven primarily by year-over-year advertising price increases during the rest of 2021.

Although Facebook's management is expecting growth to continue next quarter, albeit at a slower pace, they are seeing headwinds from Apple's platform changes making a more severe impact next quarter.

In the third and fourth quarters of 2021, we expect year-over-year total revenue growth rates to decelerate significantly on a sequential basis as we lap periods of increasingly strong growth. When viewing growth on a two-year basis to exclude the impacts from lapping the COVID-19 recovery, we expect year-over-two-year total revenue growth to decelerate modestly in the second half of 2021 compared to the second quarter growth rate. We continue to expect increased ad targeting headwinds in 2021 from regulatory and platform changes, notably the recent iOS updates, which we expect to have a greater impact in the third quarter compared to the second quarter.

Therefore, Facebook is setting up for a critical Q3 earnings report, which will now face greater scrutiny amidst the whistleblower controversy. During this period of uncertainty, several investors are bailing on Facebook; however, I see this as an opportunity to start a long position (or add to an existing long position). Let me tell you why I am taking the contrarian stance here.

The Facebook Family Of Apps Is Strong Enough To Weather The Apple Policy Storm

Facebook has always been a controversial company with dubious business practices, but Frances Haugen's revelations were very damaging for the social media giant. In recent memory, regulators have targeted Facebook with multiple lawsuits as a part of their crackdown on Big Tech companies; however, not to much avail. The consensus takeaway in media suggests that Facebook is in big trouble due to the data and internal company reports revealed by the whistleblower, which suggest Facebook has prioritized profits over public safety. Facebook is being compared to big tobacco, and its platforms are being deemed addictive and life-threatening. However, I think that Facebook does more good than harm, and the company's issues (namely, hate content, teen suicide, etc.) are solvable problems that would have a modest impact on its financials. If Mark Zuckerberg acts now and prioritizes public safety, Facebook's brand will improve drastically, and the stock will shoot up to its fair value (removing the permanent discount). People often take things for granted, but I can't imagine a world bereft of Facebook.

Facebook's family of apps, i.e., Facebook, Instagram, and WhatsApp, were down for around six hours the other day, and all other social media was flooded with messages about it. As Facebook went offline, I realized the true value proposition of its services - the ability to connect with friends and family. During this period, millions of small businesses (dependent on Facebook) lost their ability to reach consumers and conduct business activities. So, activists can shout slogans like - "Shut off Facebook" - all day long, but these apps are too vital for billions of people (and millions of businesses). The network effects that Facebook's family of apps have created give the company an impenetrable moat, and most people will continue to use these apps regardless of the controversies surrounding the social media giant's business practices. In my opinion, Facebook, Instagram, and WhatsApp offer great net positive value to billions of people across the globe. Therefore, I can confidently say that - "Facebook is controversial, yet inevitable."

Source: Facebook Q2 2021 Earnings Presentation

Now coming back to the more pertinent issue, i.e., Apple's platform changes affecting Facebook's ability to provide targeted advertising to marketers and small business owners. In Q2, marketers didn't shift their advertising budgets away from Facebook despite the prices going up and ROI going down. However, they might shift their budgets over coming quarters and years. Since Apple's platform changes are not just affecting Facebook, marketers will not necessarily go over to rival apps. The rise of influencer marketing is evident, and the lack of targeting data may force digital marketers to switch more of their budgets towards influencer marketing in the hunt for higher ROI.

Instagram is Facebook's most valuable asset, and we have discussed this platform in the past (Author's research note on Instagram). I think that the influence of Instagram on Facebook's overall business is set to grow even further than what is suggested by the chart below.

Source: Important Instagram stats you need to know for 2020

Seven years on from acquiring WhatsApp in a $22B deal, Facebook is yet to monetize the peer-to-peer messaging platform. The massive profits from Facebook and Instagram Ads businesses have allowed the social media giant to give away WhatsApp as a free service to its 2B+ users. However, if Facebook's revenue and margins come under pressure, the management could quite easily choose to monetize this incredibly powerful asset through ads, subscriptions, and/or business services (like payments). With an installed base of more than 2B users, WhatsApp's full monetization could add several billion dollars to Facebook's annual revenue and profit figures.

Let us also look at the big picture here: Facebook operates in a duopoly with Google in the global digital advertising space, which is believed to be worth ~455B in 2021, and expected to grow to $645B by 2024. Hence, it is fair to say that Facebook remains at the center of a powerful secular growth trend.

Source: eMarketer

Furthermore, data from eMarketer suggests that Facebook's market share will continue to grow over the next two years, with Google (GOOG)(GOOGL) ceding ground to emerging competition in the digital advertising arena.

Source: eMarketer

Facebook (and its family of apps) is not just a social media app, it is an empowerment platform that powers millions of businesses through its suite of services (advertising just being one of those services). The introduction of Facebook Shops and subsequent integration of payment services is critical progress being made by the company on its path of becoming a true e-commerce giant. Although Facebook's numbers are mostly advertising revenues, multiple new business lines (e-commerce, financial services, AR/VR) are growing exponentially in stealth mode. For now, Facebook is not getting enough credit for business diversification; however, I think these business lines will be a significant part of its top line by 2025.

I firmly believe that Facebook's family of apps and the ecosystem Facebook has built around these apps will enable this beast of a company to survive and thrive amid policy changes from gatekeepers such as Apple. Mark is only 37, and so, Facebook is unlikely to lose the visionary leadership of its co-founder anytime soon. With his mind fixated on creating the next great computing platform (metaverse) via Facebook Reality Labs, I think Mark's long-term ambition is to make Facebook the most dominant internet company on this planet. The ride will undoubtedly be rough with tons of ups and downs; however, Facebook has miles to go. With massive shareholder wealth creation on the horizon, I think this dip in Facebook's stock could prove to be an excellent buying opportunity.

Investing 101: Don't Fight The Financials.

One of the primary tenets of our investment strategy is to "avoid emotional investing", and we do so by cutting through all the noise around companies with a laser-sharp focus on business fundamentals and financial statements. Despite management warnings about the potential impact of Apple's policy changes, Facebook continued to grow at a swashbuckling rate in Q2 2021. As we saw earlier, the strength of Facebook's results was attributable to its pricing power. In Q2, Facebook's operating margins came in at 43%, which led to a 101% y/y jump in net income. Hence, it is fair to say that Facebook is delivering massive operating leverage.

Source: Facebook's Q2 Earnings Release

With the Q3 numbers set to come out in the second half of this month, we are set to learn more about Facebook's pricing power in a challenging business environment (the company can no longer provide targeted ads on most Apple devices (installed base of ~1B) as it has done in the past). I think Facebook's family of apps is strong enough to weather this policy storm, and the company should churn out yet another positive quarter. However, we will see how it plays out in a few days.

While we wait patiently ahead of a critical earnings report, Facebook's investors have nothing to worry about when it comes to its balance sheet. The company has more than $65B of cash and short-term investments, with zero debt, i.e., no bankruptcy risk.

YCharts

Amid all the noise surrounding its business practices, Facebook continues to generate massive amounts of free cash flow from its business. As the company further monetizes high-value assets like Instagram and WhatsApp, Facebook's free cash flow will continue to compound at double-digit growth rates for the foreseeable future. If Facebook's AR/VR products win mass adoption, investors are in for a treat.

YCharts

Facebook's capital return program is expanding rapidly, and it effectively puts a floor to the stock. Currently, Facebook has around $25B of capital authorized for its stock buyback program, and this program is likely to grow in size over the coming years. I will explore Facebook's capital return program in detail some other day, but for now, let's keep going.

According to consensus analyst estimates, Facebook's revenues could triple by the end of this decade. These estimates factor in a ten-year CAGR growth rate of ~11%; however, if Facebook comes to dominate the metaverse, we will be looking at much higher growth rates (somewhere in the ballpark of ~20%).

Source: Seeking Alpha Earnings Estimates

Although I am eagerly awaiting Facebook's Q3 numbers to assess the impact of Apple's policy changes, I wouldn't be surprised to see another strong quarter from this beast of a company. As we learned today, Facebook has monopolistic pricing power due to the billions of eyeballs it reaches every day. In my opinion, Facebook will remain a cash cow for the foreseeable future.

Facebook Is An Undervalued Cash Cow

To determine Facebook's fair value, we will employ our proprietary valuation model. Here's what it entails:

• In step 1, we use a traditional DCF model with free cash flow discounted by our (shareholders) cost of capital.
• In step 2, the model accounts for the effects of the change in shares outstanding (buybacks/dilutions).
• In step 3, we normalize valuation for future growth prospects at the end of the ten years. Then, using today's share price and the projected share price at the end of ten years, we arrive at a CAGR. If this beats the market by enough of a margin, we invest. If not, we wait for a better entry point.

Assumptions:

Forward 12-month revenue [A]	$128.5 billion
Potential Free Cash Flow Margin [B]	35%
Average diluted shares outstanding [C]	~2.887 billion
Free cash flow per share [ D = (A * B) / C ]	$15.57
Free cash flow per share growth rate	10%
Terminal growth rate	3%
Years of elevated growth	10
Total years to stimulate	100
Discount Rate (Our "Next Best Alternative")	9.8%

Click to enlarge

Here are the results for fair value (step 1 and 2):

Source: L.A. Stevens Valuation Model

As you can see, Facebook's fair value is ~$578 per share. The stock is trading at ~$325, which means Facebook has to climb +77.5% to realize its fair value. By utilizing conservative growth and margin assumptions, we have ensured that we have ample margin of safety in this investment.

To calculate the total expected return, we simply grow the above free cash flow per share at our conservative growth rate, then assign a conservative multiple, i.e., 35x, to it for year-10. Thereby, we create a conservative intrinsic value projection by which we determine when and where to deploy our capital.

Here are the results for expected returns:

Source: L.A. Stevens Valuation Model

According to the above set of results, Facebook's stock has the potential to grow from ~$325 to ~$2,212 at a CAGR of ~21% in the next ten years. Since the expected return for Facebook is much greater than my investment hurdle rate of 15%, I rate Facebook a strong buy at $325.

Risks

• After a stellar Q2, Facebook's upcoming third-quarter numbers could turn out to be disappointing as growth decelerates (mostly due to tough comps). If the impact from Apple's platform changes is higher than expected, the stock's drawdown could go deeper.
• With Facebook now struggling to provide marketers with adequate advertising data and targeting capabilities, a possible breakup of Instagram would be damaging. The family of apps needs to stick together for Facebook to maintain its dominance in the digital advertising world.
• Failure to monetize WhatsApp could curtail Facebook's future growth trajectory.
• Facebook's whistleblower controversy has revealed damaging information about the company and its leadership, which is shown to prioritize profits over public safety. A big fine is probably the best outcome for Facebook; however, the company may face new regulations that could erode some of its business fundamentals.

Other previously highlighted risks:

• Facebook is facing looming antitrust regulations along with other big-tech companies. However, FTC's case being tossed out in the federal courts is a big win for Facebook. The social media giant operates in a triopoly with Google and Amazon in the digital advertising world, and these three companies have a combined market share of ~60%. Hence, government agencies will likely fail to prove Facebook as a monopolistic business.
• The bigger threat to Facebook's business comes from platform changes made by tech-rival Apple. With the iOS 14.5 release, Apple is set to force apps like Facebook to explicitly ask user permission to get access to their data. Such platform changes could affect Facebook's ability to provide targeted ads, and this could lead to lower ad pricing. Therefore, Facebook's revenues and margins could come under pressure. We will be monitoring this situation over the upcoming quarters.
• Facebook's AR/VR and financial services (Novi) business lines are moonshot investments at this point, and if these businesses fail to achieve mass adoption, Facebook's growth trajectory could be curtailed.
• Digital advertising is probably one of the strongest secular growth trends in the world; however, a slowdown in this industry's growth could lead to lower-than-expected growth rates for Facebook. If the company fails to meet our revenue and profitability projections, our stock price targets may not be met.

Concluding Thoughts

If Facebook can successfully diversify away from its ad-heavy business and turn into a digital advertising, e-commerce, financial services, and AR/VR conglomerate, Facebook's shareholders could probably ~6-8x their money with this stock over the next decade. I understand Facebook is a controversial company, and many people consider it a vice investment; however, it is a must-own stock due to an unparalleled, asymmetric risk/reward on offer.

Key Takeaway: I rate Facebook a strong buy at $325

Thanks for reading, and happy investing! Please share your thoughts, questions, and/or concerns in the comments section below.

Analyst’s Disclosure: I/we have a beneficial long position in the shares of AAPL, FB either through stock ownership, options, or other derivatives. 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.