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Holly LaFon
Holly LaFon
Articles (8902)  | Author's Website |

David Rolfe Comments on Facebook

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April 16, 2018 | About:

We have followed Facebook (NASDAQ:FB) for quite some time, first as a potential competitor to Alphabet (formerly Google) and more recently (the past few years) as an investment opportunity. Facebook has historically carried a rich multiple relative to what we are willing to tolerate for earnings growth. However, earnings growth has continued at a robust pace while the stock has not kept up. For example, from year-end 2015 through year-end 2018 (estimated), Facebook will have compounded revenue and earnings by over 200%, whereas the stock has appreciated by about 75%3. This has driven Facebook’s earnings multiple to contract to around 16-17X 2019 earnings (ex. balance sheet cash) – an all-time low for the stock, both absolute and relative to the S&P 500 Index and Russell 1000 Growth Index (n.b. P/E is at parity with the latter). We believe this is a classic valuation setup for our portfolio: as the Company continues to compound earnings at 20%+ for several years, a conservative, flat multiple should still result in excellent absolute returns – and better still at deserved multiple expansion.

Facebook exhibits vastly superior profitability metrics relative to its peers in the media and advertising industry. In addition, we believe Facebook’s value proposition is unique and defensible relative to peers, which should enable the Company to generate industry leading returns on invested assets for several years. This value proposition is focused on providing advertising customers with highly attractive, triple-digit returns on advertising spend (ROIs).

While many of Facebook’s peers offer a value proposition that entails better ROIs, it is often via an inflexible, expensive, or monolithic solution. In contrast, the Company’s low-cost value chain – especially its multibillion user social platforms, and an arsenal of ad measurement tools both acquired and internally developed over the past several years – provides advertisers multiple avenues to drive successful ROIs.

Facebook’s social platforms serve as very low-cost forms of user traffic and content. Many of Facebook’s competitors pay a substantial portion of their ad revenues in the form of traffic acquisition (sometimes referred to as “customer acquisition”) and/or content costs. For example, television advertising platforms are dominated by telecommunication and multiservice-offering conglomerates. The advertising businesses of these platforms are often carved out from subscriber economics, with the cost of content typically being the largest expense, by far, in running the ad platform. Even digital competitors such as Microsoft Bing, while not having to spend quite as much on content, spend substantial portions of revenue on traffic acquisition.

Facebook’s scale across its platforms – including Instagram and WhatsApp – continues to drive a “virtuous cycle” of user engagement and therefore low-cost content creation. Some recent monthly active user (MAU) stats include 2.1 billion users on Facebook as of December 2017, 1.5 billion users on WhatsApp as of January 2018, and Instagram MAUs nearing the billion-user mark as well. In addition, Facebook continues to report stable user engagement (as measured by DAU/MAU) at 66%.

Facebook’s recent actions of culling certain content is evidence of quality control and, if anything, signals that there is perhaps too much content. While there is the risk this could increase the cost of content – especially curation – we did not see much evidence of that on the recent conference call or earnings report. We will continue to monitor the risks and opportunities related to the Company’s advertising ROIs and low-cost content platforms, which play key roles in maintaining Facebook’s superior industry profitability.

As we mentioned earlier, we first began following Facebook as a competitor to portfolio holding, Alphabet. Facebook has significant business model overlap with the Google arm of Alphabet, with both companies hoovering-up share in ad spending globally, particularly in developed markets. The two companies combined are estimated to have accounted for over 60% of the digital advertising market in the U.S. in 2017; for example, with Google’s properties accounting for over 40% share and Facebook’s properties accounting for over 20%. To put the two companies’ dominance in perspective, no other competitor even cracks 5% of the U.S. digital ad market share.4 In the faster-growing mobile segment of the digital market, where Facebook derives the overwhelming majority (roughly 90%) of its revenues, the two companies are similarly dominant, with Facebook’s share (nearly 30%) much closer to Google’s (nearly 35%).

In a broad sense, our entire portfolio has some modest overlap with Facebook (and Google) as advertising partners. Advertisers’ ability to target customers in detail on both platforms makes the platforms attractive to both traditional large-scale advertisers (including consumer products and services companies such as Kraft Heinz, Visa, Apple, or Priceline/Booking) and to companies that might not have been able to target advertising effectively on traditional mass media, but who could cost-effectively target an ad to a specific group or to a specific user based upon search history (Google) or social media preferences (Facebook). We believe our entire portfolio either is, or will be, customers of one or both of these dominating digital media platforms.

Facebook found itself in news crosshairs during the quarter. First, news emerged pertaining to ads purchased by Russia and posted on Facebook’s platform during the 2016 U.S. presidential election with the intent to sway voter opinion. A couple weeks later, additional news surfaced regarding a data analytics firm and the harvesting of Facebook data for political gain. In all, information on tens of millions of Facebook users was leaked, bringing to question Facebook’s privacy policy and what the Company is doing to protect its user data. Steps to prevent this type of breach were put in place by the Company back in 2014, when Facebook made changes to the way developer apps could access users’ and “friends” data. However, the stock sold off (to our investment advantage) on concern that the Company was not performing appropriate due diligence on app developers’ use of data and their subsequent deleting of that data once they were no longer using it.

The Company vows to make further changes, which include conducting audits, improving its privacy policy, and banning third-party data services from its ad targeting platform. While we expect these actions to increase Company expenses, we do not believe there will be any significant impact to the Company's revenue growth as we believe there are few channels available that can match Facebook’s return on ad spend. We view the pull back in the stock as short-term headline risk, and we have used the opportunity to not only initiate our position in Facebook during the quarter, but also add to the position further at attractive valuation levels. We believe strong advertiser demand and healthy ROI, along with Facebook's ability to increase pricing on their ads, leaves the Company with plenty of room for growth in the years ahead.

From David Rolfe (Trades, Portfolio)'s Wedgewood Partners first quarter 2018 shareholder letter.

About the author:

Holly LaFon
I'm a financial journalist with a master of science in journalism from Medill at Northwestern University.

Visit Holly LaFon's Website

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