Facebook Is Still A Great Business

Summary

• In recent years, Facebook has established itself as a high quality business.
• The recent pandemic and boycotts have brought new challenges to the business.
• Both these challenges are unlikely to significantly affect Facebook's long term prospects.

There are two things I look for in a stock before investing: 1) a great business and 2) an attractive share price. In the following, I will analyse whether Facebook (FB) meets the first of these criteria in light of recent events.

By the start of 2020, Facebook had managed to establish itself as a high quality business despite its involvement in a seemingly endless list of controversies. As the year has progressed, Facebook has had to face two major challenges that has left some doubting whether Facebook still deserves to be called as a great business. The challenges are of course the Covid-19 pandemic and the recent boycotts in support of the #StopHateForProfit campaign. I believe that these doubts are unwarranted. Although Facebook’s short-term financials may be slightly affected, neither threaten the fundamental quality of Facebook as a business.

Facebook before the pandemic (and the boycotts)

The high quality status that Facebook had been able to achieve before the pandemic is clear to see in its financials. Over the past three years, Facebook’s revenues have grown year-on-year by 47%, 37% and 27% respectively and, if one ignores the $5bn fine Facebook paid in 2019, this impressive growth is also shown on the bottom line. Over the last five years, the company has also achieved a solid cash conversion rate averaging 114% and an equally solid average return on capital employed of 21.1%. On top of that, they have been able to achieve these results while maintaining a pristine balance sheet currently showing over $60bn in cash and marketable securities and no debt.

Facebook also enjoys a clear competitive advantage over the other players in the digital advertising market with the possible exception of Google and Amazon. This comes from the sheer number of users across its “family” of platforms (Facebook, Instagram, WhatsApp and Messenger) which, as of Q1 of 2020 stood at 2.99bn monthly active users (MAUs) making it the largest social media company in the world by far. As a result, Facebook and (and thus its advertisers) have access to more potential customers and more user data with which ads may be targeted more effectively giving it the ability to offer advertisers a far superior product than its competitors. This has ultimately allowed Facebook to gain a significant market share in the digital advertising market which, in 2019, was estimated to be 22.1%, and has allowed it to operate at exceptionally high margins averaging 28% over the past five years.

Lastly, the quality of Facebook’s business also lies in its potential for future growth. One growth driver that Facebook is currently benefitting from and will continue to benefit from in the future is the expansion of the digital advertising market. As advertisers continue divert spending away from non-targeted to targeted ads, total spending in this market will continue to increase. Indeed, in recent years, the digital advertising market has enjoyed huge growth with total spending increasing over 15% last year. Of course the pandemic is likely to bring this period of growth to an abrupt halt with spending in the industry expected to decline this year. But in the long run, this sectoral trend is expected to to persist as the effects of the pandemic subside leaving room for future growth and, thanks to its competitive advantage, Facebook has placed itself in the best position possible to capture any such growth.

Another growth driver that will benefit Facebook in the future is its push into ecommerce. This year, Facebook has made two significant steps to expand its presence in this space. First was the launch of Facebook Shops allowing businesses to create digital storefronts on either Facebook and Instagram. While these shops will be powered by third-parties such as Shopify, BigCommerce and Woo, they will grant Facebook yet more access to data and new streams of revenue with Facebook earning a commission each time a customer uses its check out option. The second step was Facebook’s deal with Reliance Industries in India to buy a 9.99% stake in Jio Platforms for $5.7 billion. As part of the deal, Facebook plans to give its over 400 million WhatsApp users in India access to digital catalogues allowing them to buy everyday grocery items directly through the app. As such, Facebook has positioned itself to benefit hugely from the ecommerce boom in India. With both of these initiatives, it is still far too early to tell exactly what impact they will have on Facebook’s bottom line in the future but, given Facebook’s already enormous user base, they present an exciting and potentially lucrative opportunity for the business going forward.

Challenge 1: Covid-19

The first test Facebook had to face this year was the Covid-19 pandemic and the accompanying global economic recession. Considering that advertising is heavily cyclical and Facebook generates around 98% of its revenues from advertising, the company initially appeared to be heavily exposed to the economic downturn. These concerns were fuelled further after the company reported earnings for Q1 of 2020 on April 29th when it was revealed that the average price per ad had already decreased by 16%. With the performance of the global economy predicted to be worse in Q2 that in Q1, we can only assume that this downward pressure continued well into the second quarter acting as a major headwind for revenue growth.

Having said this, Facebook has managed to show remarkable resilience during the pandemic. While analysts have certainly watered down their forecasts for 2020, they still expect the company to grow revenues by about 10% this year due to the fact that Facebook has been able to add to its user base during the recession. Indeed, as people have been stuck indoors, they have been spending more and more time on social media. This resulted in an increase of MAUs across all platforms by around 100 million during Q1 and a sharp increase in user engagement especially in regions hit hardest by the virus. As such, the company has been able to sell more ads with impressions increasing 39% in Q1 while keeping demand from falling through the floor. By the look of these results, it seems clear that, despite initial concerns, the virus is unlikely to have a large and lasting impact on Facebook’s business. Even if results for this year are worse than analysts expect, the improvement of its competitive position during the pandemic means that Facebook is well placed to benefit when the economic effects of the virus do eventually subside (even if it takes longer than many of us ever anticipated) and advertising demand rebounds.

Challenge 2: The Boycott

A potentially far greater challenge to Facebook than the Covid-19 pandemic is that of the recent boycotts of Facebook by advertisers supporting the #StopHateForProfit campaign. Currently hundreds of advertisers have paused or scaled back ad spending on Facebook in protest of Facebook’s stance on various issues such as hate speech and misinformation. Participating advertisers include huge names such as Starbucks, Coca Cola and Unileaver and it was also recently revealed that Walt Disney, Facebook’s largest US advertiser in 2020 has also scaled back ad spending this year although not officially joining the boycott. This had led to some concern over, not only the impact on Facebook’s revenues but also its reputation.

However, these concerns are overblown. Not only are most of the boycotts temporary, with the majority of participating companies only halting ad spending for the month of July, but Facebook’s ad business is far too diversified to be threatened by a few hundred (admittedly large) companies temporarily pulling spending. Currently, Facebook has over 8 million advertisers across all its platforms with over 76% of these being small and medium sized businesses. The Wall Street Journal estimates that the top 100 companies are account for such a small proportion that if all of them decided to stop spending on all of Facebook’s platforms for an entire year, it would only reduce Facebook’s revenues by 9% and Oppenheimer analysts estimate that, so far, the boycotts have only cost the company around $150 million or under 1% of the total revenues brought in during Q1 of 2020.

Aside from the minimal financial impact, Facebook’s brand is also unlikely to suffer significantly. Despite the widespread outcry and the failure to pacify the leaders of the boycott, Facebook has continued to attract new users to its platforms. As already mentioned, Facebook was able to increase its user base substantially in Q1 and, unless something extraordinary happens, Facebook will likely report an increase in users when they release Q2 earnings. The harsh reality is that, rightly or wrongly, everyday users of Facebook’s social media platforms simply do not care enough about the boycotts to delete their accounts. This was also true during the Cambridge Analytica scandal in 2018 when, despite its widespread condemnation, Facebook was still able to add users and perform exceptionally well. Unless the participants of the boycott are able to convince users to delete their accounts en masse, the company will likely continue to perform exceptionally in the future.

Conclusion

Facebook was a great business before these two events and remains a great business after considering their effects. Both the pandemic and the boycotts are likely to have a small impact on Facebook’s short term performance but they are not enough to dent Facebook’s long term prospects. Not only are these challenges likely to be temporary (Covid-19 could be around for a while but it won’t be around forever), but neither have also been able to reduce Facebook’s competitive advantage. Namely, the billions of users across the company’s platforms. So long as Facebook is able to maintain its large user base, it will be favourably placed to take advantage of the long term secular trends that will drive growth in the future.