FB has almost half the planet in aggregate on its platforms (Facebook, Instagram, and WhatsApp). Although FB has compounded negative goodwill with endless scandals relating to privacy and manipulation of elections, and Zuckerberg is probably one of the more disliked people on the planet, we think FB is trading at bargain levels given the quality of the business. Q1 2022 earnings has shaken investors’ confidence due to low growth, and fear over ATT and TikTok. Can FB overcome short-term problems and continue to leverage its platform? There are primarily three factors to address with FB: Apple privacy changes, the rise of TikTok, and the Metaverse.
For clarity's sake when FB is mentioned, it means Facebook, Instagram, and WhatsApp, however when Facebook Blue is mentioned, it is solely referring to the Facebook app.
Apple ATT (App Tracking Transparency)
Apple changes in iOS 14.5 (occurred in April 2021) have virtually eliminated the ability to track users across third-party apps and websites. Before these changes, each user had a unique identifier(called an IDFA-Identifier for Advertisers) and when the user went off-app and browsed the internet or other apps, they could still be tracked using these identifiers. Tracking users off-app helps understand user behavior and refine ad campaigns once that data is shared with advertisers. Now, Apple asks users in a semi-ominous pop-up (see below) whether the app can track their activity, and once the user declines to be tracked the app is not able to ask again….ever. Unsurprisingly, about 80% of users select No and as a result, tracking is severely hindered. This lack of tracking primarily affects two things: targeting and measurement ability.
Targeting ability is impaired as FB has less data that it can harness to serve personalized ads. Cookies via the Facebook pixel and other methods of tracking activity are greatly handicapped. FB can’t follow users off-app to see what they clicked on, what they saved in their cart etc. Attribution is likewise impaired as FB has a more difficult task of finding lookalike audiences to feed similar ads to. As most ad revenue is derived from a minority of customers, being able to target lookalike audiences is extremely profitable for advertisers. Advertising with IDFA is analogous to using a sniper rifle while post-ATT, targeting is more akin to using a grenade. In short, ads are less effective. How about the petabytes of data FB has amassed over the years from their 3B user base? It is not much help as the most effective advertisements are ones in which the user has recently developed an interest. Recency drives conversion. It is not too helpful when serving ads to someone that was interested years ago. The drawing below from mobiledevmemo depicts the difference between FBs tracking ability pre and post ATT
Measurement ability is impaired as FB cannot calculate the monetary return of these ads. For example, when a consumer clicks on an ad and goes off Instagram to shop, FB cannot determine what % of users bought anything and thus cannot provide metrics for advertisers on what their expected ROI should be. Shared data also allows advertisers to fine-tune their ad campaigns to make them more effective. Ad prices are auction-based. How the prices are derived are off the value advertisers are willing to pay multiplied by the potential effectiveness of the ads. With the latter variable lacking, the prices advertisers will pay will likely decrease.
So how is FB mitigating the impact of ATT?
Interestingly, this is not FB’s first rodeo with limited ad tracking. In 2016 Apple allowed users to opt-out of targeted advertising however users had to go into settings to enable this feature. About 30% of users turned this on. This newest iteration just makes it more convenient to disable tracking. Luckily for Facebook, millions of businesses and almost half the world use their platform. This change has affected advertisers (businesses) just as much as it has FB. In other words, incentives are aligned for both parties to figure out a solution quickly as there are no suitable alternatives to FB (more below). That solution is more integration. First-party data can be used for advertising, thus the more FB and businesses merge, the better both parties will do. FB has vertical integration already built with features such as Shops and WhatsApp to directly connect consumers with businesses. FB is aiming to be an all-in-one app, similar to WeChat in China where users rarely go off-app. Ironically, ATT changes may have helped in these pursuits as businesses are driven into the arms of FB.
Besides first-party data, there are still other workarounds. Apple limits browser tracking but not server tracking. With server tracking, businesses can maintain data privacy while still delivering personalized ads. FB via conversion APIs will be able to track the following: leads, form submissions, email subscriptions, purchases, length of time on website etc. Although FB will not be able to identify unique users, we believe over time it can refine contextualized advertising enough to become a decent proxy for IDFA.
Why will advertisers not go elsewhere?
The only big game in town for digital advertising is Google, Facebook, and Amazon. GOOG is exempt from the ATT changes(however YouTube is not) as it is a search browser. Both Amazon and Google excel as they serve ads to people based off their searches and thus provide a high ROI to advertisers. Although some advertising dollars will shift to search, the reason advertisers won’t flee FB is because it excels at funneling customers based on interests. Think of Facebook as window shopping for the entire world. Google and Amazon only know what you specifically searched for and gives you relevant ads. They are not able to identify other latent interests and use that to convert to new purchases. Stratechery had an illustration of this “funneling effect” below.
In addition, the global digital advertising industry is still growing and is not in a zero-sum environment. It is expected to grow at low double digits for the next decade from its current base of $450 Billion per year. It is astonishing that even with severe headwinds FB is guiding 3 - 11% qoq growth for Q1 2022. FB is not only dealing with ATT, but also staggering comps with the stimulus, COVID releasing its grip which means users are spending less on goods and more on services, along with monetizing at lower rates as engagement is drawn from FB’s highly lucrative Stories to its newer format Reels.
What is axiomatic is that advertisers are going to be where peoples’ attention is. FB currently has the eyeballs with almost 2B Daily Active Users. Although a short-term headwind, ATT changes have driven advertisers and FB even closer together as both parties are now incented to develop a closed-loop system to serve better ads with relevant return metrics. Instead of cookies and app tracking, advertisers will either be vertically integrated with FB or share data through back-end anonymized APIs. ATT changes also make it more difficult for new entrants to reach profitability. Advertisers will be less profitable for longer on these platforms as they will need to garner significant attention before advertisers go to their platform. It is analogous to a manufacturing firm needing to reach a much higher production threshold to reach economies of scale. We believe this increases the size of incumbents’ moats. Whoever has the most first-party data will control advertising market share. This brings us to the next topic.
TikTok’s meteoric rise in consumer adoption is unprecedented. It has been able to reach 1B users in half the time it took Instagram. The graph below shows the rapidity of its ascension. To many, TikTok has raised the specter of existential risk to FB. We believe these fears are overblown for a couple of reasons, however before diving in, we will examine TikTok and why it is so addicting.
As Zuckerberg aptly put it, “there are a finite number of different social mechanics to invent”. Social mechanics are analogous to soft drinks, there is mostly Coke, Pepsi, and a couple of others. Looking at the list below, it seems the base rate is approximately 1 new app every two to three years, although, with apps that are truly a global phenomenon, that number is likely 1 every 7 years or so. TikTok has undoubtedly tapped into something that has caused its virality, with better algorithmic fed videos and tighter feedback loops keeping users more engaged.
TikTok is an extremely engaging cultural remix app that relies on ML algorithms to dictate feed as opposed to algorithms that rely primarily on networks (like other social media platforms). This appeals to new users as getting a large following on older social media platforms is significantly harder than on newer platforms as the economics of social platforms follows an exponential distribution where 1% of users have 90% of the followers. Here is what Eugene Wei wrote on TikTok-
“The result is a feedback loop that is much more tightly wound than that of other social networks, both in the positive and negative direction. Theoretically, if the algorithm is accurate, the content in your feed should correlate most closely to the quality of the work and its alignment with your personal interests rather than the drawing from the work of accounts you follow. At a time when Bytedance is spending tens (hundreds?) of millions of marketing dollars in a bid to acquire users in international markets, the rapid ROI on new creators' work is a helpful quality in ensuring they stick around”
In short, TikTok allows for better discovery of new content whereas FB was founded primarily on networks and connecting with family, friends, peers, and celebrities. FB provides models whereas TikTok provides content. In thinking about which platform is harder to replicate, FB’s seems almost impossible to recreate whereas it is a more achievable pursuit for FB to create a channel dedicated to discovery as they can leverage their 2B DAU base. This is precisely what FB has done with its introduction of Reels in 2020. This segment has been growing faster than Stories (although this is sacrificing short-term profitability as attention is drawn from the more profitable Stories) and likely will continue to do better. FB is also leveraging its cash war chest to lure creators from TikTok which is a large advantage given that TikTok is much smaller than FB. TikTok generated revenue of about 5B in 2021 whereas FB generates about 120B. What is interesting is that when comparing business models, TikTok has more intersection with Youtube than FB. Both YT and TikTok revolve solely around interests without much reliance on an established network. The only difference between the YT and TikTok is YT is generally for longer-form videos, however, TikTok has been making inroads into this category. A killer app drawing engagement is never a good thing for FB but it is important to distinguish business models.
Growth in mobile usage is far from slowing down. Looking below shows that time spent on mobile has grown by almost 500% over the last decade! This growth enables more apps to enter the precious phone screen real estate without being involved in a zero-sum game with other established apps
Regardless, FB cannot take the threat of TikTok lightly. Zuckerberg is hyper-aware of these risks and is willing to pivot. A look at the “TikTok” before TikTok is illustrative. When Snapchat came on the scene, it was dubbed the Facebook killer with teens being addicted to it. Headlines like the one below were prevalent. FB went through several iterations to take on Snap. FB first came out with Poke, then Slingshot, and finally going with Stories which quickly surpassed Snapchat within 8 months. Granted there are significant differences between TikTok and Snap however the story is illustrative of FB’s competitive ability ex acquisitions. Interestingly enough, Snap is still doing well with about 100+ mm users in the USA, about as much as TikTok, and still managing to make the 2021 top ten most downloaded apps list.
Although we ascribe a very low likelihood of it happening, even in the worst-case scenario where TikTok locks in Gen Z and FB is unable to pry them away, current FB users are locked in. With the networks already established, users are likely not going anywhere in the foreseeable future. And as the users on FB are the ones with purchasing power, businesses also will likely not be going anywhere anytime soon. Facebook Blue, which most people think is a dead platform, still has the largest marketplace on the planet (Facebook Marketplace) and is the third most downloaded app in 2021. This encapsulates the resilience of large network effects. We think the current runway for the platform is a good decade if FB wanted to do nothing else but monetize. This is just a thought exercise to estimate downside risk, however, we believe that FB will be able to handicap TikTok whether it be through Reels or some other means. TikTok also has significant regulatory risk and has already been banned from India, Pakistan, Indonesia, and Bangladesh, and was almost banned from the USA. As tensions rise with China, political backlash could take the form of banning Chinese companies, with FB and YT being the primary winners.
FB’s killer app on steroids. The metaverse is a bet on the next computing platform. Augmented Reality and Virtual Reality are the next step in OS evolution after mobile. AR and VR will only continue to get better at an exponential rate and provide a significantly more immersive and intuitive experience than mobile or desktop can provide. The questions are when will demand hit an inflection point and reach widespread consumer adoption and will FB be the leader in that space?
To begin with, FB has a singular focus on AR and VR while mobile OS incumbents Apple and Google face the classic innovator dilemma. FB has a massive lead with Oculus unit sales reaching 8 mm in 2021, almost equalling Xbox sales. FB generated about 2B in 2021 from Oculus, about a 100% increase from 2020, and has been subsidizing costs to the tune of 10B dollars per year in order to get mass-market adoption. FB has been executing remarkably however it is still too early to tell how successful Oculus will be. There are still massive leaps to be made in both software and hardware before mass adoption can occur. The value of FB’s Reality Labs is an artistic exercise with the value being somewhere between -100B to 10T. As investors, we are betting on management’s ability to make the right decision to either continue to invest in Reality Labs or divest it. In this framing, this bet is likely to have a positive expected value.
We believe Zuckerberg is one of the more remarkable CEOs of our generation. Here are some of his accomplishments: being CEO for 18 years at one of the largest companies in the world with majority voting rights (and is only 37 yo), has made some of the best acquisitions of all time (which at the time everybody thought was ludicrous), was able to monetize FBs userbase when no one thought it was possible, led FB to transition to mobile when it was an existential risk, and fended off competitors such as SnapChat. This was done all while navigating a more restrictive regulatory landscape. For the crescendo, he is making unheard-of staggeringly large bets on the next computing platform. To put in perspective how much FB spends on Capex and R&D, it is about 6x more than what Tesla spends, a leading electric car manufacturer with a market cap 2x the size of FB.
In a normalized environment with a lack of stimulus coupled with IDFA headwinds and lower monetization in Reels, FB will likely generate about 100B in revenue in 2022. With incremental margins of about 40%, and revenues growing about 15% (growth of the digital advertising market, a conservative proxy given that FB has been growing at greater than 25% CAGR) per year, FB will be generating about 135B in revenue in 2024. Decoupling FB’s core business from Reality Labs is a bit murky, however, we know Oculus has been a 10B drag on profitability in 2021, and we believe the majority of the increase in Capex is due to VR and AR-related investments. After netting out maintenance Capex of 20B and adding back operating expenses of Reality Labs, we have FB generating about 45B in cash per year. After adding back cash, Core FB is trading at about 12x ’24 Cash Flow. We believe that a company of this caliber should be trading around a high teen earnings multiples, representing at least 50% upside from today's levels. For simplicity, we have netted out Reality Labs as a wash however we believe this will likely drive FB's valuation in the future.