• Elena Lam

Facebook (NASDAQ: FB) | Deep Dive

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Key Points

  • Facebook is the world’s largest social networking company

  • Monthly active users (MAUs) across its family of apps totaled 3.3bn in 4Q2020

  • Facebook derives 97.9% of overall revenue from advertising but it is leveraging its extensive user- and advertiser-base and expanding into related verticals like e-commerce and virtual reality

  • With cash and cash equivalents, and marketable securities totaling US$62.0bn and robust free cash flow generation, Facebook displays strong financial strength

  • However, current concerns surrounding privacy, antitrust and taxation have caused Facebook shares to be priced very attractively

  • Facebook's current P/E of 26x shies that of peers like Google (36x) and is even lower than the S&P 500 (39x)

  • Many investors are ignoring the optionality from new use cases like Shops and Oculus that can eventually become multi-billion dollar incremental monetization opportunities

  • DCF-backed fair value estimate of US$305.62, representing a possible upside of 18.3%

Company Overview

Facebook, Inc. is the world’s largest social networking company that develops social media applications for people to connect through various devices, share opinions, ideas, photos and other activities online. Its key products include Facebook, Instagram, Messenger, WhatsApp and Oculus.

The acquisition of Instagram and WhatsApp in 2012 and 2014 respectively, has allowed Facebook to build a complete ecosystem with various platforms having their own niche in the consumers’ social media experience.

Monthly active users (MAUs) - defined as a registered and logged-in user of who visited at least one of these family products through a mobile device application or using a web or mobile browser in the last 30 days as of the date of measurement) - across its family of apps totaled 3.3bn in 4Q2020. This means that almost half of the world’s population uses at least one of Facebook’s apps.


Advertising remains the key revenue driver

Facebook’s revenues are largely driven by advertising which made up 97.9% of overall revenue in FY2020. Advertising revenue is generated by displaying advertisements on Facebook, Instagram, Messenger, and third-party affiliated websites or mobile applications. Marketers pay for these advertisements based on the number of impressions or actions taken by users.


Ad revenue is driven by both supply and demand dynamics. Supply refers to the number of users on the platform and their engagement which determines the number of ad spaces available for sale to advertisers. Daily/monthly active users (DAUs/MAUs) can be used as a proxy for supply. Demand refers to how much advertisers are willing to spend on ads which can be represented by average revenue per user (ARPU).


Facebook has experienced a steady increase in the number of MAUs worldwide, with less mature regions like Asia Pacific and Rest of World (includes all users in Africa, Latin America, and the Middle East) experiencing the fastest growth.

Note: While ARPU includes all sources of revenue, MAUs only includes users of Facebook and Messenger. The share of revenue from users who are not also Facebook or Messenger MAUs is not material.


Users in different geographies are also monetized at different average rates. The ARPU and revenue in the US and Canada are relatively higher due to the size and maturity of the digital advertising markets.

As a whole, the US and Canada still account for the majority of Facebook’s advertising revenue (48.2%) largely due to the much higher ARPU compared to other regions.

Advertising aside, other revenue streams include revenue from the delivery of consumer hardware devices and net fees received from developers using Facebook’s payments infrastructure and more.


Key Financials

Facebook has been experiencing healthy revenue growth over the years albeit at a decreasing rate. The declining y-o-y growth is mainly attributed to slowing MAUs growth. This is a result of user growth approaching a steady state in Facebook’s core markets of the US and Canada as internet and social media penetration rates approach their peaks.

Gross margins have been relatively steady albeit on a subtle downtrend over the years. This is largely attributed to growing data center capacity and technical infrastructure to support user growth, increased user engagement and the delivery of new ad surfaces.


EBITDA, EBIT and net margins have also declined in recent years as Facebook expands headcount across its engineering, technical, marketing and sales, administrative departments and more as it ramps up initiatives especially in research and development and security. Notably, the US$5bn FTC settlement expense caused a much larger decline in margins in 2019.

Compared to peers, Facebook boasts the highest gross and net margins.

Facebook also displays strong financial strength. Operating cash flow generation has been strong over the years, leading to robust free cash flow. The company has cash and cash equivalents, and marketable securities totaling US$62.0bn at the end of 2020 and no debt.

Investment Thesis

We expect Facebook’s revenue to expand at a CAGR of 13.5% to reach US$162bn by 2025. This growth is anticipated to be supported by: (1) tailwinds from growing online ad spend, (2) consistent product innovation to boost ad prices and user engagement, and (3) commission revenue generated from Facebook’s push into e-commerce. While recent antitrust concerns have led to near-term volatility in Facebook’s share price, we believe that Facebook's long-term prospects remain bright.


Thesis 1: Tailwinds from Growing Online Ad Spend

Even though Facebook is approaching full penetration in key ad markets, we expect ad revenue growth to remain supported by an expanding user base in emerging markets and increasing ad prices in mature markets.


In emerging markets, on top of higher internet users growth, we expect to see Facebook penetration rates trending towards that of more mature regions. While MAUs in US and Canada and Europe are only projected to grow at CAGRs of 1.1% and 2.1% between FY20-25, MAUs in Asia Pacific and Rest of the World are forecasted to grow at 6.7% and 4.5% respectively.

Ad prices are also projected to continue their upward trend, especially in developed markets. According to a survey by Digital Marketing Institute, 67% of Chief Marketing Officers (CMOs) surveyed intend to increase their companies’ digital advertising budgets in years to come with increased reach (87%) and accurate audience targeting (88%) being cited as top two benefits of digital advertising over traditional advertising. We project that Facebook’s ARPU for existing products will grow in line with industry growth rates between FY2020-25.


We forecast that Facebook’s ad revenue from existing products (excluding Instagram Reels and Facebook Shops) will grow at a 5-year CAGR of 12.8% to reach US$154bn by 2025.


Thesis 2: Product Innovations to Revitalize Ad Revenue Growth

On top of sustained ad revenue growth from existing products, we believe that Facebook is bound for another growth uptick driven by engagement gains and monetization improvements in deeply penetrated markets from the release of new products.


New ad surfaces can be in the form of a new tab on Instagram or Facebook that users can scroll through to increase time spent on the app and hence ads viewed by users. If new ad surfaces boast higher interactivity with users in the form of more users turning on sound or more shares, Facebook will be able to charge advertisers higher ad prices.


For instance, the launch of Instagram Stories in 2016 increased the total time spent on Instagram per day per user by an estimated 25%. According to Mediakix, users spent an average of 15-21 minutes per day on Instagram prior to the launch of Stories. With Stories, the average time spent increased to 20-30 minutes per day. Additionally, Facebook’s strong execution led to the rapid adoption of Stories. While Snapchat had pioneered the stories model in 2011 and was once the dominant player, Instagram Stories had surpassed Snapchat within a year after its launch. It took Instagram Stories only 3 months to exceed 100 million daily active users (DAUs) compared to Snapchat’s 5 years. Instagram Stories currently boasts more than 500 million DAUs, double of Snapchat’s 249 million. We estimate that Stories contribute an additional US$1bn in annual revenue to Facebook.

Looking ahead, we expect a similar narrative to pan out for the newly introduced Instagram Reels. Reels is a service very similar to TikTok in which users can record and edit 15-second videos with audio, effects, and other creative tools. TikTok has taken the social media sphere by storm in the past year. It currently boasts an estimated 500 million DAUs, an average time spent per day per user of 52 minutes, and CPM of $10 in the US. We would like to point out that TikTok has been able to price ads higher than Instagram in the US. We think that it is due to TikTok’s better ability to captivate the attention of viewers. While it is reported that only 60% of users view Instagram Stories with sound on, we estimate that almost all TikTok viewers have sound on when using the app as music and sound is an essential part of the user experience on TikTok.

We expect the introduction of Reels to allow Facebook to attract a younger demographic onto Instagram. Our analysis revealed that while both Instagram and TikTok have similar DAUs figures, the user demographic differ significantly. The proportion of users between the ages of 13 to 24 is significantly higher on TikTok compared to Instagram.

By observing the differences in the DAUs by age, we inferred that there are at least 145 million users between the ages of 13 to 24 that use TikTok but not Instagram.

We assume that 20% of these 145 million users will start using Instagram with the launch of Reels and spend 10 minutes a day on the app (20% of TikTok’s average time spent per day of 52 minutes). For existing Instagram users, we conservatively predict that only 20% will begin to use Reels regularly. Further, as with the launch of Stories, we expect the launch of Reels to increase the average time spent per day of existing Instagram users by 5 minutes.


As each Reel is 15 seconds, a user can view 4 reels per minute. Assuming that the ad load for Reels is the same as Stories at approximately 20%, Reels is expected to generate an additional 1tn ad impressions in 2021. Given that TikTok’s CPM in the US is US$10, we revised the figure down by 80% since Facebook’s worldwide ARPU is only 20% of its US ARPU, giving us $2. This translates into additional ad revenues of $2bn from Reels in 2021 alone. From a valuation perspective, we expect Reels to add $13.50 to our final target price.

We acknowledge that our valuation of Reels is based on many assumptions. Nonetheless, we hope that our analysis provides a clearer picture of the potential of Reels and how it will drive monetization going forward. We will make adjustments to our model as the narrative develops.


Thesis 3: Significant Upside from Moving Down the Funnel with E-Commerce

Facebook’s push into e-commerce opens up a new revenue stream from transaction commissions on top of increased advertising revenue as businesses now have even more incentive to advertise on Facebook given the seamless integration.


Since the launch of Facebook Marketplace and Instagram Shopping in 2016 which allowed businesses to list their products on Facebook and Instagram, Facebook recently made its biggest move into e-commerce with the launch of Facebook Shops in May 2020. Facebook Shops is a service that allows businesses to set up a single store that customers can access via both Facebook and Instagram. Customers can also checkout and pay without having to go to a third party website.


With this move, we expect Facebook to be a beneficiary of secular trends in the e-commerce industry:

  • Rising e-commerce penetration. According to Grand View Research, the global e-commerce market was valued at US$9.1tn in 2019 and is poised to grow at a CAGR of 14.7% between 2020 and 2027. The pandemic has accelerated the offline to online shift by approximately five years with e-commerce growth estimated to be 20% in 2020. Even as the pandemic eases and growth normalizes, numerous long-term secular trends are expected to continue driving e-commerce. Rising internet and smartphone penetration, surging disposable income, product localization are amongst the key drivers of e-commerce globally.

  • Rising popularity of social commerce. Social commerce refers to the sale of products directly through social media. Given that social media now plays a big part in influencing consumers’ purchasing decisions, allowing consumers to checkout directly via social media and autofill payment and delivery details regardless of where they are purchasing their products from offers customers a much more streamlined process than traditional e-commerce. A study by Absolunet revealed that 87% of e-commerce shoppers believe social media helps them make a shopping decision and 30% of consumers say they would make purchases directly through social media platforms. According to Technavio, the global social commerce market is expected to grow at a CAGR of 31% between 2020 to 2024, more than double the growth of the overall e-commerce market.


In building towards a fully-integrated e-commerce platform, Facebook had launched the following key features and initiatives in recent years:

  • October 2016: Facebook Marketplace. The launch of Facebook Marketplace marked Facebook’s first move into e-commerce. Marketplace allowed users to buy and sell items locally but contained no features to facilitate the payment and delivery of products nor did Facebook take a cut from any transaction.

  • November 2016: Instagram Shopping. Businesses can now tag their products. Once a tag is clicked on, a detailed product view will open. However, customers will be redirected to the merchant’s website should he/she wish to make a purchase.

  • March 2019: Instagram Checkout. Users can now purchase a merchant’s products directly on Instagram, without having to be redirected to an external website.

  • November 2019: Facebook Pay. Facebook Pay is a payment service that allows users to store payment and delivery information on Facebook or Instagram and complete purchases without having to log in to a different website. It supports purchases made with Checkout.

  • May 2020: Facebook Shops. Facebook Shops was the real game-changer as it allows businesses to set up a single store that customers can access via both Facebook and Instagram. It is also integrated with Facebook Pay, making it easy for customers to shop directly through Facebook’s family of applications.

  • May 2020: Partnership with Shopify. Shopify merchants (more than 1 million) can automatically sync their products to Facebook and Instagram.

  • July 2020: Instagram Shops. Instagram Shops is an e-commerce hub that curates product recommendations for users. A new “shop” tab has also been added to the main navigation panel to allow users easy access. It is currently being tested in the United States with plans for a global rollout. We opine that the “shop” tab will reinforce shopping behaviour on Instagram and boost transactions.

  • October 2020: WhatsApp Shopping. With more than 175 million people messaging a WhatsApp business account daily, Facebook saw an opportunity to expand its shopping features to WhatsApp to allow users to buy products directly from chats. The introduction of a new shopping button that links to a business catalogue also services to improve users’ ease of browsing.


Going forward, Facebook hinted at the potential for further integration with WhatsApp and Messenger including the enabling of in-app purchasing within WhatsApp and the addition of a WhatsApp icon to Facebook Shops to allow customers to chat directly with businesses. Facebook is currently also testing ways to allow businesses on its platform to introduce loyalty programs to enhance customer stickiness.


While Facebook’s e-commerce capabilities are still in nascent stages, we believe that it has a clear advantage in establishing an all-rounded, fully-integrated e-commerce platform, providing businesses with the full suite of services from advertising to business communications via Messenger and WhatsApp, and checkout and payment capabilities via Facebook Pay. Additionally, we foresee synergies arising between e-commerce and Facebook’s traditional ad business. By allowing shopping and processing transactions on its internal platform, Facebook will be able to harness shoppers’ behavioural and purchase data which can be used to improve ad targeting given that the majority of advertisers on its platform are e-commerce players.


We forecast that Facebook Shops will generate an additional US$13.2bn in commission revenue by 2025. As of 4Q2020, Facebook has more than 200 million businesses utilizing its commerce tools (i.e., Pages, Marketplace, Instagram Shops, Facebook Shops, etc). We forecast that the number of businesses on Facebook will continue growing at the same rate of about 10% per quarter as Facebook becomes an even more attractive platform for businesses as it focuses more on e-commerce. As Facebook is still in the process of rolling out Facebook Shops, it is currently only available in about 30% of the regions that Pages is available in. We expect this figure to increase to 50% by 2025 as Facebook Shops is launched in more regions. We further assume that out of these businesses in the supported regions only 30% (given services account for ~70% of US GDP) are deemed eligible businesses selling physical products as Facebook Shops does not allow the sale of services. Since Facebook Shops target the same merchant profile as Shopify (small and medium businesses), we assume that GMV per business is approximately US$30,000 in any given quarter given that Shopify reported GMV of US$30.9bn and has over 1 million merchants on its platform in 3Q2020. As for the percentage of GMV processed via Facebook Checkout, we made the conservative assumption that it will slowly ramp up from just 5% in 2021 to 25% in 2025 given near-term headwinds due to consumer mistrust. Compared to Shopify which currently processed 45% of total GMV via its own payment platform, we believe that we are being very conservative. Lastly, take rates are set at 5% as Facebook announced that transaction fees of Shops will amount to 5% or a straight cut of US$0.40 for orders of US$8 or less.

Assuming an EV/revenue multiple of 8x, Facebook Shops’ terminal value would be US$105.6bn which gives us a present value of US$79.2bn. On a per share basis, we calculate that Facebook Shop is worth US$27.74. Comparing this to Shopify’s current market cap of US$146bn, we believe that our valuation of Facebook Shops is on the more conservative side given that Facebook has about double the number of businesses utilizing its commerce tools.


Thoughts on Recent Antitrust Actions

On 9 December 2020, the Federal Trade Commission (FTC) and Attorneys Generals (AG) from 48 states/territories in the United States filed 2 separate antitrust lawsuits against Facebook. The FTC alleged that the company is illegally maintaining monopoly power through years of anticompetitive conduct; its two main complaints are:

  • Anti Competitive Acquisitions. The FTC alleges that Facebook chose to buy Instagram and WhatsApp rather than compete with them, arguing that both acquisitions neutralize direct threats posed and make it more difficult for other social networking competitors to gain scale.

  • Anti Competitive Platform Conduct. The FTC also alleges that Facebook has imposed anti competitive conditions on third-party software developers. Facebook makes key application programming interface (APIs) - a software intermediary that allows two applications to talk to each other - available to developers only on the condition they never create features that may compete with what Facebook offers. If that condition is breached the developer’s app will no longer be allowed to interface with Facebook.

The State AGs, on the other hand, claimed that Facebook has been engaging in a buy or bury strategy that thwarts competition. Both the FTC and State AGs are calling for a permanent injunction in federal court that includes, among other things, the unwinding of assets (Instagram and WhatsApp), prohibiting Facebook from imposing anticompetitive conditions on developers, and requiring Facebook to seek prior notice and approval for future mergers and acquisitions.


Facebook responded with a statement arguing that the acquisitions of Instagram and WhatsApp were already reviewed and approved in 2012 and 2014 respectively and the FTC unanimously approved to clear the Instagram acquisition following an in-depth “Second Request.” Facebook also asserted that these lawsuits are “revisionist history” and had “no regard for settled law or the consequences to innovation and investment”. It is confident that “evidence will show that Facebook, Instagram, and WhatsApp belong together, competing on the merits with great products.”


While the FTC has the power to unwind Facebook, we believe an unwinding is unlikely

In addition to the points raised by Facebook, when Facebook acquired Instagram, Instagram had only 13 employees and 40 million users. Facebook had spent billions over the years to grow Instagram and WhatsApp into what they are today. It will be difficult for regulators to estimate how WhatsApp and Instagram would have fared as standalone companies. Both apps are also well-integrated into Facebook (i.e., shared data centers, staff, etc), making it very difficult for regulators to force Facebook to sell these assets. As such we did not forecast any divestiture in our model.


Previous precedent cases were last drastic than initially ordered

In 1974, the Justice Department required AT&T to divest Western Electric, its equipment subsidiary. AT&T, however, proposed its own breakup arrangement that resulted in the company being split into various units in 1982. In 2000, a federal judge ordered Microsoft to be broken up into two firms. An appeals court, however, reversed that order and accepted a series of less drastic remedies. Such cases show that a full unwinding will likely be a last-resort tool.


However, regulators have other tools to moderate Facebook

1. Anti-competitive fines. In July 2019, the FTC imposed a record-breaking US$5 billion penalty on Facebook, representing a penalty 20x greater than the largest privacy or data security penalty ever imposed and accompanied new privacy restrictions. The US$5 billion penalty was recorded under Facebook’s General and Administrative expense (G&A), causing its G&A as a percentage of revenue to rise from just 6.2% in 2018 to 14.8% in 2019. Resultantly, EBITDA margins declined from 52.3% in 2018 to 42.0% in 2019.


The EU also recently unveiled two new sets of proposals targeting big tech firms. Under the Digital Markets Act (DMA), large tech companies could face fines up to 10% of their global annual revenue for unfairly favouring their products over that of smaller competitors. The second set of rules, the Digital Services Act (DSA), will allow the EU to impose fines up to 6% of global annual revenues for failing to take down illegal content on their platforms.


We opine that the increased scrutiny on Facebook will likely lead to more privacy violations being uncovered in the future. Hence, we adopted a hyper-conservative projection and modelled the same G&A as a percentage of total revenue of 14.8%, implicitly building in a penalty every year. Additionally, we anticipate margins to remain compressed in part due to efforts to ramp up security and content moderation efforts.


2. Merger control. While reversing consummated acquisitions is difficult, regulators could block future transactions. This could have profound long-term consequences. Facebook could find itself vulnerable to the next industry paradigm shift if it is unable to develop internal capabilities to compete with the new shifts.


Thus far, Facebook has weathered all regulatory storms

Past scandals have caused drawdowns but Facebook has been able to recover time and time again. Its continued operational success, evident from its revenue and user growth, also indicates Facebook’s resilience to regulatory action.

All in all, we opine that regulatory actions will unlikely lead to major consequences such as a break up of Facebook, but fines and merger controls remain likely tools that policymakers will be able to utilize to reign Facebook.


Valuation

Based on our excel financial model, which is accessible to our Snowball Community members for download [sign up here], we derived a fair value/share of US$305.62 for Facebook using a Discounted Cash Flow Model (DCF) with the Exit Multiple Method as our primary valuation method. This represents an upside of 18.3% from the last closing price of US$258.33. We also supported our valuation with a DCF using the Gordon Growth Method, which yielded a fair value/share of US$310.99.

Key Assumptions:

  • WACC of 6.70% derived using CAPM

  • EV/EBITDA exit multiple of 15.2x, which is the 25th percentile peer EV/EBITDA multiple

  • FCF growth rate of 4.0% between FY25-30 and terminal growth rate of 3.0%

  • Margins to remain compressed at 2019 levels as Facebook continues to ramp up research and development and security, and to account for any potential penalties or fines arising from regulatory actions.

We estimated that Facebook's core advertising business alone (existing products + reels) is worth US$360.37. Regulatory action leading to fines and increased spending on security and content moderation is expected to have a -US$54.75 impact on Facebook's fair value per share. Hence, Facebook's advertising business alone excluding new high growth verticals like e-commerce and virtual reality is already worth US$305.62. We would also like to reiterate that we have been very conservative with our projections. Thus, for a strong cash generator with numerous high growth categories that are untapped, we opine that Facebook is undervalued at its current price of US$258.33. Its current P/E of 26x shies that of peers like Google (36x) and is even lower than the S&P 500 (39x).

Risks

1. iOS Changes Could Reduce Ad Targeting

Apple will be introducing a new privacy policy along with its iOS 14 update that will require iPhone users to opt-in to allow advertisers access to their Identifier for Advertisers (IDFA). IDFA is a unique identifier assigned to each iOS device. In the past, by tracking the IDFA, marketers will know what websites the device had visited and what content the device had interacted with to enable precise ad targeting. The update is expected to result in many users opting out from their data being collected, making ad targeting with IDFA less relevant.


However, this change is one that will disrupt players across the industry, not just Facebook. As IDFA traditionally allows for tracking of activity that occurs on third party websites, it could impact smaller players without a wealth of users on their own platforms disproportionately. With billions of users, we think that Facebook will be affected to a smaller extent as it is still able to track user activity across its family of apps. Another way of viewing this issue could be that the new policy makes Facebook's proprietary data more valuable than before as other platforms will no longer have access to user activity across Facebook's family of apps. Since it is an across the board decline in ad targeting effectiveness, advertisers will not be able to switch away from Facebook to other platforms. Hence, we opine that the impact on Facebook's ad prices will unlikely be drastic.


Furthermore, we view this as a short-term blip. Even if advertisers temporarily cut back on digital ad spending following a decline in targeting effectiveness, the long-term digital advertising narrative remains unchanged. Digital advertising is increasingly becoming an irreplaceable medium for businesses to reach potential customers and grow. We also expect incumbents to innovate to find new ways to gather consumers data. For instance, Facebook has been encouraging websites to insert a code that will report user activity and interactions to Facebook.


2. Transatlantic Data Transfer Ban

In September 2020, Ireland’s Data Protection Commission (DPC) sent Facebook an order to suspend data transfers across from the EU to the US following a ruling from the European Court of Justice that the EU-US data transfer standard is insufficient for protecting the privacy of European Facebook users. This stems from concerns that EU citizens had no effective way to challenge US state surveillance.


The ruling is set to affect numerous businesses and could potentially lead to damaging consequences for the European economy even though only Facebook has been singled out by regulators thus far. In response, Facebook filed a lawsuit against the DPC arguing that the regulator’s demand would essentially force Facebook to exit the EU region and urging regulators to “adopt a pragmatic and proportionate approach until a sustainable long-term solution can be reached”.


While the ban is premature and nothing has been finalized, if the regulator’s demand is upheld, Facebook would have to silo off the data collected from European users and possibly build EU-only data centers, essentially overhauling its operations. We are monitoring this case closely and will update the model accordingly when there are developments. As of now, the European Data Protection Board, the group in charge of all EU privacy watchdogs, is in the midst of creating a set of guidelines and a special taskforce to help companies ensure safe data transfers. The European Commission is also working with US authorities to develop a new arrangement to facilitate transatlantic data flows that complies with the European Court’s requirements.


3. Thinning Margins as Costs Climb

Dave Wehner, Facebook’s CFO, recently announced that total expenses for 2021 is forecasted to be in the range of US$68-73bn, representing a 27%-36% growth from the previous year, outpacing our projected revenue growth of 20.4%. This is largely attributed to infrastructure expansions to support user growth, increased user engagement, and the delivery of new products and services, along with investments in more software and technical talent to support research and development initiatives.


Going forward, we expect margins to remain compressed as regulatory headwinds continue to spur Facebook to spend on security, content moderation and even incur antitrust fines.


4. Consumer/Advertiser Boycott

Earlier this month, WhatsApp updated its privacy policy, reserving the right to share user data with the broader Facebook network. Users have to either accept the policy or cease using the app. Even though Facebook reassured users that the changes do not affect the privacy of private messages with friends and family, and instead relates to messaging businesses through the platform, WhatsApp downloads still plunged, with rival messaging apps like Signal and Telegram observing record downloads. Facebook’s share price also fell 8.6% in the week following the update as campaigns calling for a boycott of WhatsApp emerged.


However, such calls for boycotting Facebook is not new. In July 2020, over 1,000 companies boycotted Facebook in an attempt to pressure Facebook to do more to combat hate speech on its platform. But the efforts were insufficient to cause significant damage as Facebook still recorded a 22.1% y-o-y increase in ad revenues in 3Q2020. For one, 1,000 companies out of more than 200 million businesses utilizing Facebook’s commerce tools was an insignificant figure. Furthermore, it was reported that four in five boycotters had planned to return to Facebook the following month as Facebook is a major source of clientele for small and medium businesses.


We are of the view that such calls to boycott Facebook will unlikely result in severe damage. Majority of Facebook’s customers are captive customers who are closely attached to Facebook’s products and would face great difficulty switching to a similar product elsewhere without facing significant costs (e.g. preserving existing connections and media). Its sheer number of highly engaged users also makes it difficult for advertisers to ignore.


5. Competition

Facebook is up against a host of competitors both big and small across all its businesses. It faces competition from Google, the largest advertising platform; Apple’s iMessage, the most popular messaging service in the US; YouTube, the largest video platform; and Amazon, the largest online retailer. On top of that, emerging players like TikTok and Signal could cannibalize user time spent on Facebook’s apps.


While Facebook has successfully defended against competition over the years through consistent product innovation to remain relevant, there is no guarantee that it will retain its dominance in the social media space or be able to successfully penetrate the e-commerce market. Social media trends evolve very quickly and if Facebook does not respond in a timely fashion, it runs the risk of falling behind competition.


6. Digital Taxation

Globally politicians are increasingly of the view that tech giants enjoy a tax advantage as compared to more conventional companies. As a result, countries around the world, especially in Europe, have implemented Digital Services Taxes which are levied on gross revenues from the sales of a range of digital services. According to Avalara’s Digital Services Tax Global Tracker, which was last updated on 29 Oct 2020, countries such as France, Hungary, Italy, Poland and the UK have implemented varying digital services tax ranging from 1.5% to 7.5%. Other countries in Europe such as Norway, Slovakia, Slovenia, and Greece are reported to be in plans of implementing a digital services tax. Globally, other countries are expected to implement taxes ranging from 1.5% to 15%.

Our sensitivity analysis reveals that the fair value of Facebook fluctuates from US$288.91 to US$302.28 when the imposed digital services tax rate varies from 2.0% to 10.0%. However, it is also common practice to pass on increased costs to customers. For example, in France, the UK and Italy, Amazon charges merchants fees to cover additional taxes. Should Facebook choose to do so, the impact on its fair value would be immaterial.


At the same time, the Organization for Economic Cooperation and Development’s (OECD) talks on how to reallocate tax revenue from digital companies have been at an impasse since June 2020. We believe successful finalization of global tax policies by the OECD will shed greater clarity on tax policies that could directly affect Facebook. We also believe that there is a possibility of an international deal where US-imposed tariffs are withdrawn in-exchange for lower tax rates for American-based tech companies could be beneficial for Facebook.


Catalysts

1. Positive Traction from New Initiatives

Currently, many investors are not pricing in many of the new initiatives due to uncertainty surrounding Facebook’s execution. We believe that positive news (especially quantitative data) on new initiatives like Reels, Facebook Shops, or even Oculus in the upcoming quarters will likely lead to a re-rating.


We would like to note that Facebook reported other revenue of $885 million in 4Q2020, up 156% y-o-y due to strong sales of Oculus Quest 2, launched in October. The initial figure is very encouraging and we expect Facebook to report statistics such as the number of units sold or even Oculus revenue once they reach certain milestones.


2. Positive News on Rulings Involving Data Privacy, Antitrust or Taxation

Currently, a fair amount of regulatory risk has been priced into Facebook’s share price. While events like the transatlantic data transfer ban remain material risks that can have a big impact on Facebook, we are of the view that investors are overreacting to events like the WhatsApp privacy policy update given the 8.6% fall in share price following the update. On another note, many of the risks affecting Facebook (i.e., transatlantic data transfer ban, digital tax, iOS changes) are industry-wide risks that will impact tech giants across the board. We think that it is unfair that Facebook is the only company being punished.


Conclusion

In the near term, volatility can be expected as the antitrust investigation continues. In the long term, however, we see significant upside. We are of the view that the current concerns surrounding privacy, antitrust and taxation have caused Facebook shares to be priced very attractively. Facebook’s current valuation also only prices in its core advertising business without considering optionality from new use cases that can eventually become multi-billion dollar incremental monetization opportunities.


Thanks for reading,

Elena and Shawn



Disclaimer: We are long Facebook at an average price of US$268.72. This article is not an investment (buy/hold/sell or otherwise) recommendation, this is only for educational and discussion purposes. This article is not tailored to the specific circumstances of any reader. I/we/The Snowball do/does not purport to be in the business of providing financial advice and the contents of the article should not be regarded as such.


Cover Photo by Georgia de Lotz on Unsplash

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