Facebook: "The Successor of the Mobile Internet"
(Facebook Q3 FY21 Earnings Review)
The tides have once again turned, and investors have swayed from “collecting Zuckbucks” to fearing the potential corrosion of the core business and expressing concerns over the size of the company’s investment in Facebook Reality Labs (the company’s AR/VR division).
From highs of ~$380 just months ago, Facebook’s stock now trades at closer to $312 at a 17.5x EV/EBIT multiple. The adage that price determines sentiment holds true, but it’s not all dumbfounded revelations. Why is Facebook’s share price being dampened?
A spate of bad press (what’s new?) from a whistleblower, Frances Haugen, as well as a consortium of journalists teaming up to coordinate a series of articles based on thousands of pages of leaked documents.
Zuck’s opening remarks in the call address the debate surrounding the company in some detail, citing that he believes this is a “coordinated effort to selectively use leaked documents to paint a false picture of our company”. He also acknowledges that Facebook is not blind to the challenges of balancing the competing forces of free speech and harmful content, whilst encouraging (yet again) greater regulation as he feels this is not something that big tech can manage on their own. The company are on track to invest $5B in safety and security in 2021, larger than any other tech company, but feel the assistance of regulators is needed.
“I also think that any honest account should be clear that these issues aren't primarily about social media. That means that no matter what Facebook does, we're never going to solve them on our own. For example, polarization started rising in the US before I was born. At the same time, independent research shows that many countries around the world have flat or declining polarization, despite similar social media use thereto in the US”. - Mark Zuckerberg, Facebook CEO, Q3 FY21
Elsewhere, investors may be having second thoughts about the big bet that Zuckerberg and Co appear to be making on the next transition for Facebook. We have already seen the team migrate from web to mobile successfully, aided by the acquisitions of Instagram and Whatsapp. Now, Mark has his sights set on the metaverse, which he believes “is going to be the successor of the mobile Internet”.
Facebook will (from Q4 onwards) break out their reporting segments across Family of Apps (FAO), which includes Facebook, Instagram, Messenger, WhatsApp and other services, as well as a new segment for Facebook Reality Labs (FRL), which includes augmented and virtual reality related hardware, software and content.
Download as PDF Below
For continuity, I must state that Facebook is a position I currently hold in my portfolio (weighted at ~13%).
Section 1: Performance - A quick run-through of Facebook’s Q3 performance.
Section 2: Youth and the Big Bet - Commentary surrounding two significant takeaways from the earnings call, Facebook’s revived positioning for youth, and their reinvestment plans for Facebook Reality Labs.
Section 3: Liquidity & Cashflow - A brief discussion of Facebook’s balance sheet as of the third quarter.
Section 4: Guidance - Commentary around Facebook’s fourth-quarter projections.
Section 5: Concluding Remarks - My final remarks, as well as some discussion on my primary takeaways, and the idea of thesis creep.
Section 1: Performance
As anticipated, there were some headwinds in Q3 from iOS14. Facebook’s revenues came in flat sequentially at $29B (+35%). Adoption of Apple iOS14 reached critical mass in Q3 (compared to modest adoption in Q2). Without that, management felt revenue would have sequentially increased. Users across all reporting segments advanced sequentially and YoY with Facebook suggesting 2.8B users now utilise at least one of their apps on a daily basis.
Facebook’s other revenues hit $743M (+195%) bolstered by strong Quest 2 sales. This marks the second strongest quarter after last year’s Q4 ($885M). Management guided for a YoY decline in “non-ad” revenue next quarter after lapping the Quest 2’s maiden holiday launch.
I have a sneaking suspicion that management may be sandbagging guidance here, but suppose other revenues reach $800M in the fourth quarter, that would put FB’s full-year sales at close to $2.7B. With disclosures set to change to FRL in Q4, we will have to wait and see how they decide to disclose this going forward.
The total number of ad impressions served across FB’s services increased 9% and the average price per ad increased 22% during Q3.
Advertising revenues ($28.3B) were down sequentially (from $28.6B in Q2) but were up 33% on the year. Facebook has been warning investors for quarters that these changes would dramatically impact the accuracy of their ad targeting, as well as measurement. Previously having specific and more granular information, the data that Facebook now collects on users is more aggregated in nature (explained here). Whilst not isolated to Facebook, this means that, for advertisers, the cost of driving the same outcome has increased in tandem with greater difficulty in measuring those outcomes.
Sheryl Sandburg seems to think that measurement difficulty can be addressed much faster, citing that she expects “more than half” of the underreporting to be solved by the end of the year. Targeting, however, is a multi-year effort. This will require a rebuild of FB’s targeting and optimisation systems to work with less, and more aggregated, data.
Pair this with the fact that e-commerce growth has begun to decelerate in most parts of the world. As the acceleration in e-commerce begins to taper, so too does the desire for generating demand from consumers, particularly when there are so many issues with building inventory amidst global supply chain constraints. The holiday season is upon us, however. A period in which the demand for advertising increases, as well as the costs.
This will be the first holiday season Facebook have to endure the iOS headwinds, but the company have guided for between $31.5B and $34B in revenues for Q4. This should bring Facebook’s annual revenue growth into the mid-30s, an acceleration from 2019 and 2020 where the top line grew at 27% and 22%, respectively.
Facebook generated $10.4B in income from operations in Q3 (+30%). Given the flat revenue base and the incremental hike in OpEx spend, margins are down 150bps YoY and 660bps sequentially.
David Wehner suggests that revenue growth will slow in 2022 from the 2021 rate and that margins will be lower in 2022. Not entirely surprising given the lift from commerce and ad spend during 2020 and the expected deceleration coming in FY22. On the margin front, the sizeable reinvestment into FRL is going to eat the operating margin for years to come.
Section 2: Youth and The Big Bet
Despite a lot of time given to FRL, Facebook’s priorities still centre around creators, commerce, and, obviously, building the next computing platform. Ultimately, all three of these focuses lend themself to the vision for the metaverse. But to avoid repeating myself, I wanted to dig deeper into two specific takeaways surrounding creators and youth, and FB’s aspiration to build the rails to the metaverse.
(1) Creators and Youth
Nothing entirely new on this front from my previous discussions (here and here). I have spoken before about Facebook’s intentions to attract more creators onto their platforms and the initiatives in which they intend to use to do so.
The bulk of the earnings call discussion in Q3 centred around Reels. Sheryl suggested that over 2B users now watch videos that are eligible for in-stream ads across Facebook and Instagram. Further, over 60% of FB’s video revenue now comes from mobile-first videos.
As Reels have proven to be the leading driver of engagement across Instagram, management expects to make “significant changes to Instagram and Facebook in the next year to further lean into video and make Reels a more central part of the experience”. With the release of various internal studies (I have linked a couple below this passage), it would appear that Facebook has feared the competition from TikTok and Snap for some time. It is no secret that Facebook’s base of young users (ages of 18 to 29) have deteriorated over the previous generation.
Zuck explains that their focus on ensuring the service is the “best for the most people” (ie, serving the aggregate over the youth) has come at the expense of ensuring the platforms are the best for young adults. During that period, TikTok and Snap have come in and eaten a considerable share. Zuck labelled TikTok as “one of the most effective competitors we have ever faced”.
Facebook is now re-tooling their teams to make serving young adults their north star, rather than optimising for “the larger number of older people”. Naturally, there will be tradeoffs here as older generations have greater spending power but with respect to the LT health of the business, bringing back churned youth cohorts is vital. This won’t be a quick fix, with Zuck talking in terms of years.
“This shift will take years, not months, to fully execute, and I think it's the right approach to building our community and company for the long term.” - Mark Zuckerberg, Facebook CEO, Q3 FY21
Links to Internal Research
I highly advise flicking through the two above internal studies. They paint some unique insight into Facebook’s study of the deterioration in youth on their platforms, as well as how TikTok shapes up compared to Reels.
(2) The Next Computing Platform
After announcing plans to hire 10,000 employees to work on the metaverse vision back in October, as well as prior commentary from management, investors have long known the reinvestment into FRL was going to be significant. For context, at the end of Q3, Facebook had 68,100 employees.
“This is a major area of investment for us and an important part of our strategy going forward.” - Mark Zuckerberg, Facebook CEO, Q3 FY21
Transparency on just how big a swing Facebook is taking at this project was provided in Q3. First, with the addition of FRL as a new reporting segment. Second, with the disclosure that this project will cost ~$10B by the end of this year with the figure expected to “grow even further for each of the next several years”.
The long-term vision for this sizeable reinvestment being; “we hope that by the end of the decade that we can help a billion people use the metaverse and support hundreds of billions of dollars of digital commerce”.
The biggest drivers of those costs in the order of size, according to VP of Finance Susan Li, are “headcount related costs followed by basically a lot of R&D, R&D OpEx, and then the cost of actually manufacturing all of the devices.”
With goals of reaching over one billion people and generating hundreds of billions of dollars in digital commerce through this project over the next decade, Facebook is looking to build out the apparent successor to the mobile internet on their own rails, and not having to rely upon competitors like Apple and Google.
This isn’t about creating VR devices, or fancy Ray-Bans. The vision of the metaverse incorporates multiple generations of VR and AR devices, the operating systems on which both of these products live on, digital commerce platforms, content studios, and the social platform from which all of this is linked together.
Right now, our minds are drawn to Facebook’s FOAs, the classic social networks that we know today. In the future, I don’t think it’s hard to imagine that Facebook develop some newer iteration of a social platform that centres around VR/AR. For those who have used the Oculus platform, you can see how this may take shape. The Oculus network is inherently social, but more so in a manner similar to games consoles.
Elsewhere the closed beta for Horizon Worlds, Facebook’s social network, might offer up a more succinct vision of where they may be heading. Horizons is less of a game, and more of a virtual simulator for friends to connect and have different virtual experiences from cooking to creating, to hanging out. Gaming is an aspect of this also, but Facebook’s commitment to funding creators to use and provide feedback on this and build virtual worlds is interesting.
Candidly, I just don’t know how big virtual social networks are going to be at this stage. With only a limited amount of evidence of proof of concept or product-market fit, paired with a product (headsets) that is still very early in the adoption curve, it certainly feels like a multi-year bet and one in which the outcome is not even remotely known.
The problem with that is, and I will touch on this more in my concluding remarks, is that the investor is now being taken along this ride either way. This FRL metaverse, over the last 24 months, has grown from a small side bet, or a call option, to a huge and concentrated side bet which is spearheading a multi-year transition for the entire business. I am certainly not ignorant to thesis creep here.
Over the next 1 to 3 years, Zuck suggests we will see Facebook laying the “foundational pieces” into place for this project, remarking that this is not an investment that will be profitable anytime in the near future. Immediately I think that we could see in excess of $40B allocated to this project over that time with no profits to show for it.
That’s the name of the game when you are attempting to build something nobody else is building. My fears are that, and Zuck himself acknowledges this, the metaverse will not be built by one company. It will be a multi-year, multi-company, effort and despite FB reinvesting more than anyone else, it doesn’t necessarily mean they are going to win.
Facebook is undertaking a commitment that will essentially see them lay the groundwork for multiple years with murky projected ROI under the assumption that the returns will be realised at the end of the decade.
“There's all the social platform work that we're doing with our Horizon effort that touches a bunch of different areas of what we're doing. But I think you'll see all of those pieces start to get built out and start to mature a bit over the next few years. And then if we do a good job on this, and I would say later in this decade, is when we would sort of expect this to be more of a real business story.”
Mull on the significance of that for a moment. Zuck believes the fruits of their work will only, potentially, be realised in the next 5 to 9 years.
I will quickly run through the balance sheet, and guidance, and come back to this for further discussion in section 5.
Section 3: Liquidity and Cash Flow
Facebook’s balance sheet remains pretty pristine with $58B in cash and securities sitting there, so not a great deal to dissect here.
More notable is Facebook’s acceleration in share repurchases, combined with an increase of the stock repurchase program to the tune of $50B. In total, that leaves FB’s authorisation at $58B in stock repurchases under the current terms.
For context, Q3’s buyback is ~2x the size of Twitter’s projected FY23 revenue base. Perhaps the ramp in share repurchases is an attempt to appease the existing shareholder base, who may be less comfortable with the size of the bet Zuck is making. Alternatively, it may have been that management saw this as an opportune time to repurchase shares at a relatively attractive valuation.
Despite share count sliding modestly from 2018 (~2.9B) to today (~2.78B), I can’t help but think a great deal of this will be to offset dilution from SBC. Particularly when I can see that FB is looking to accelerate hiring for their new FRL effort.
Whilst the headlines whirl around this company, the underlying fundamental strength of the business continues to grow. I mentioned in my opening remarks that the multiple compression for Facebook is real. Gauging whether sentiment will see a reversal in the implied multiple is a hard game, and not one I am banking on in the near term. More of the focus for me is targeted towards whether or not Facebook can continue to build under the hood over that period.
Granted, now that the company are embarking upon a multi-year effort to reinvest aggressively in FRL with uncertain outcomes, the strength of FB’s core business (FOA) is going to be even more important. At the end of the day, this is going to be their combustion engine which they fuel their vision of the metaverse with.
There are a lot of moving cogs to consider here, so let me run through guidance, and circle back in the concluding remarks.
Section 4: Guidance for Q4 and FY21
Facebook’s guidance included both Q4 and full-year figures, as well as the preliminary outlook for FY22.
Q4 Fiscal 2021 Guidance
Revenue: $31.5B to $34B, representing YoY growth of between 12% and 21%.
Non-Ad Revenue: Down YoY from the $885M reported in Q4 2020.
Tax Rate: In the high teens.
Reporting: Facebook reporting segments to be broken out into FOA and FRL.
Full Year Fiscal 2021 Guidance
Revenue: $115.7B to $118.2B, representing YoY growth of between 35% and 37%.
Total Expenses: Between $70B and $71B, narrowed from the prior outlook of $70B to $73B.
CapEx: To be ~$19B, narrowed from the prior guidance of $19B to $21B.
Full Year Fiscal 2022 Guidance
Revenue: Growth will decelerate from 2021 levels of ~35%.
Margins: To be lower than 2021.
Total Expenses: Between $91B and 97B, driven by investments in technical and product talent and infrastructure-related costs.
CapEx: Between $29B and $34B, driven by investments in data centres, servers, network infrastructure, and office facilities.
Tax Rate: Similar to 2021.
Note, the FY22 budget is not complete, so those figures are to highlight just how aggressive FB plan to be with their spending. The biggest takeaways here being that CapEx is expected to grow 70% YoY (at the midpoint) combined with a 30%+ increase in total expenditure.
From the commentary, it would appear that the ramp in OpEx is where FB will reinvest into FRL, whilst the increase in CapEx will be attributable towards improving the user experience for the core business.
OpEx/FRL: “we expect these investments to reduce our overall operating profit by approximately $10 billion, and I expect this investment to grow even further for each of the next several years”
CapEx/User: “outlook really reflects a significant increase in our planned investment in areas like AI and machine learning. And a lot of that will be dedicated to investing in areas where we can use machine learning to improve ranking and recommendations to power experiences across our products in areas like Feed and in emerging areas like Reels. We'll also be dedicating that to ads as we work to improve ads relevance and leveraging machine learning and AI to help balance out the loss of signal that we've experienced from some of the platform changes.”
Section 5: Concluding Remarks
The earnings call was littered with management explaining that they are undertaking a number of projects that will take multiple years, and in some cases decades.
A few examples:
Ad Measurement post-iOS14: “we think we can address more than half of that underreporting by the end of the year and make more progress in the years ahead.”
Ad Targeting post-iOS14: “In order for this to really work and benefit all businesses, it can require some cross-industry collaboration and more commerce tools, and those are going to be longer-term efforts.”
Commerce: “Building a full-fledged commerce platform is a multi-year journey.”
Youth as the North Star: “This shift will take years, not months, to fully execute, and I think it's the right approach to building our community and company for the long term.”
FRL Reinvestment: “I expect this investment to grow even further for each of the next several years.”
FRL Vision: “Our goal is to help the metaverse reach a billion people and hundreds of billions of dollars of digital commerce this decade.”
These are all audacious efforts, some of which may fail or not quite reach the desired outcomes. Recapturing youth (likely at the expense of the collective) and FRL strike me as the biggest doubts. Navigating the iOS issue will also be critical to the core ad business and commerce aspirations too, but I have more faith in management’s ability to navigate those waters.
The Big Bet
Facebook’s bet on the metaverse is bold, but not new. Below is a slide from Facebook’s keynote presentation at a 2016 F8 conference, where Zuck laid out the 10Y plan for the company.
There are some who feel the pivot is coming in wake of concerns of a corroding core business. There are others who simply see this as a high conviction bet. If your prior thesis on FB was focussed mostly on Zuck as a stellar steward of capital, then not much has changed. You are still putting your faith (and money) in his hands to execute on what he feels is the right path for the business to generate long-term shareholder return.
The decision to break out FRL labs shows confidence, it also shows a longing to separate the reinvestment in that side of the business, as it will be a drain on the bottom line for years to come.
But without a proof of concept or product-market fit, it feels less like “reinvesting” and more like throwing money at a concept that may or may not be realised. If Facebook does create the rails to the next computing platform, they will certainly be rewarded, if they don’t then tens of billions of shareholder dollars will potentially be squandered.
Thunderdome Capital put it very well.
“Let's say you were a VC and I came into your office and said: I want to build a VR platform and I am going to spend $10 billion a year to get it going with minimal evidence it was working. Would you fund that for me?”
You could argue that the long thesis has become even more of a bet on Mark Zuckerberg. But what if your original thesis was not so concentrated on Zuck?
Thesis Creep: When an investor purchases a stock based on a specific thesis, but after that thesis plays out or is proven to be incorrect, they continue to hold the stock based on some new mutation of that original thesis.
Put simply, if your original thesis did not include FB making a decade-long bet on the metaverse, or did not place a high emphasis on Zuck, then you must consider that the bet on Zuckerberg just got a whole lot bigger. This is no longer a small side bet, but rather a considerably concentrated one.
I personally find it hard to envision the “metaverse” replacing the internet as we know it today, but then that’s why I am not running a $900B+ company. The metaverse feels more like an additive feature, as opposed to one that consumes the “old” way of doing things. But then, most paradigm-shifting innovations often do.
We are already in the metaverse. I exist digitally through my Twitter account, I converse daily with the subscribers to Investment Talk in Discord. I Facetime my family, beaming directly into their living rooms.
But it is highly likely that I don’t possess the vision to be able to see 10 years ahead. Thus, the trust a shareholder places in Zuck is that he does.
Facebook is set to add an incremental ~$30B in revenue by the close of this year. Next year, whilst growth rates will decelerate, it’s likely we still see FB generate 20%+ more revenues by the close of FY22. Trading at ~22x earnings, it’s certainly discounted relative to its big-tech peers. Whilst the market plays voting machine with FB in the short term, it is my hope that continuous compounding of free cash flows will eventually lead to the business being weighed instead of voted for.
That said, I am not betting on multiple expansion here. There are just too many reasons to hate Facebook and fear further regulatory scrutiny, for positive sentiment to hold strong.
My position in FB currently sits at 13% of the portfolio at an average cost of $278 per share. The quarter, as a whole, was pleasing. The outlook for the future of the business, including the insights into potential OpEx and CapEx for FY22 and the general direction of the reinvestment flows, could warrant position alteration.
For me, however, I don’t work with fixed capital. Each month, new inflows are entered into the portfolio, allowing for some organic dilution. I would not say that this quarter has made me more bullish on the company. Rather, it has raised some eyebrows, made me consider thesis creep and, as a result, I have a more cautious outlook. Not necessarily bearish, I (correctly or incorrectly) have some faith in Zuck's ability to steer the ship. New information should always incite a new, and honest, perspective.
This Thursday at 10AM PST, Facebook will be hosting Facebook Connect. This should give shareholders a unique insight into Zuck’s vision for AR/VR, and I will be watching.
I am hoping we get some further discussion on Horizon Worlds here too.
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