Economies of Scale at the Cost of Public Opinion
Among the most divisive components of the S&P 500, Facebook (FB) is arguably Cheif in this unfortunate cohort. The stock has seen two consecutive years of first-half upside momentum followed by second half retracements. Although 2019 has not yet explored any negative return territory, this is largely because of just how deeply prices fell in the fourth quarter of the prior year. This backdrop has framed a period of improving relative valuation, with the catalyst being undesirable market sentiment and the adversity of political risk.
Facebook remains the leader in the online advertising space and comes with a diversified business model that offers untapped opportunities to drive future top-line growth. Most companies that make up the internet media peer group, operate a sales force mandated with the objective of successfully persuading prospects to allocate an experimental ad budget to their services. Facebook enjoys the advantage of having a budget allocation built-in to many internet proprietors and thus are paying a fraction of the cost their competitors incur for every dollar of sales. What is most impressive is the company’s ability to do this while maintaining a revenue growth rate above 20% y/y, and while trading substantially lower multiples than the majority of its peers.
This success has been the result of the company’s first-mover advantage, which means that much of its history has entailed the traversal of uncharted territories in a developing industry, with unforeseeable risks. It is not a surprise that this company has found itself in the midst of scandal as a result of the journey into the unknown, however, it is highly unfortunate that this same scandal has placed the firm squarely in the crosshairs of politicians situated on both sides of the aisle, and going as high as the executive office. Add a CEO with a public persona so negative that he has been compared to the Superman Antagonist “Lex Luthor” (and even inspired his portrayal in 2016’s ‘Batman v Superman’), and you have one of the biggest quagmires facing investors today- a strong fundamental thesis that is weighed by controversy and political risk.
Political Risk is the Biggest Drag on the Stock, and There is a Reason Why
“The “Wild West” days of the internet are over.”- Senator Mark Warner of Virginia on the state of big tech. Source: Bloomberg Television
American politics have historically been characterized by a 50/50 split between Democrats and Republicans. Today, this truth remains, but where traditionally average political sentiment has gravitated towards the center, the mean in each party has shifted significantly towards their respective poles. This has created an atmosphere where every decision faces a divided vote and gridlock proceeds. A notable exception to this, however, has been a negative sentiment on internet giants, most prominently Facebook. This has lead to rare bipartisan cooperation in subpoenas against the company, and even more allusive overlap between statements made by politicians as different as Elizabeth Warren and Ted Cruz.
Republicans view the company as a manipulator of public opinion and an agent of the left engaging in active thought-censorship. Internal whistleblowers have somewhat offered similar accounts of mandates at the firm, but there has yet to be conclusive evidence this is the case. Moreover, the Democratic party views the company as a beneficial stakeholder in the successful proliferation of propaganda by hostile foreign entities, which has been attributed as a factor in the 2016 upset defeat of Hillary Clinton.
What makes this dangerous is that adverse action against Facebook has become a political platform. This blurs the lines between logos, ethos, and pathos in their appeals to appease constituents, which creates a dangerous narrative. Before Facebook was simply an internet company led by a somewhat wooden Silicon Valley stereotype, but today it has become a proverbial “Boogey Man” many politicians are using to frame as an opponent of themselves and the American people. Defeating this enemy suddenly becomes advantageous to their political careers and darkens the storm cloud brewing above the company’s head.
A Divergence in Consensus on the Street
In the investment profession, there is an often misunderstood dynamic between the analysts on the “Sell-Side” and their counterparts in the “Buy-Side”. Intuitively, this sounds like a dynamic explaining bullish analysts and their relationship with bearish short-sellers, but this is not the case. The difference is in the purpose of the financial analysis that is being performed. Buy-side analysts are looking for investment ideas to be used in a managed portfolio of stocks that they buy and sell. An example of a buy-side entity is a hedge fund or a mutual fund that engages in active stock picking. The sell-side is characterized by analysts writing research reports for the solicitation of stocks that they do not have a professional interest in. The bank analysts you see discussing their rating changes and price targets on CNBC are the most prominent example of sell-side analysts the public will recognize.
I explain this dynamic because an understanding of it is critical to an effective explanation of the divergence in price targets from the real price movement in the stock over the most recent fiscal quarter. The value proposition of access to sell-side analysts is not found in their models or their price objectives. Buy-side analysts have their own, but what they do not often have is direct access to the c-suite or at minimum less frequency in their communications. Additionally, sell-side analysts are not burdened with the risk of skin-in-the-game in the game, and often only stand to lose by issuing “hot takes” on companies in their universe of coverage, and often rely more strictly on fundamentals. From this view, Facebook is a low-debt, solvent company, with high growth, large reserves of cash, positive free-cash-flow-to-firm, high revenue growth, and below-average valuation multiples.
Meanwhile, a buy-side analyst sees a company that has consistently traded at a discount, and that is burdened by a risk-class that is unpredictable, uncorrelated, and thus difficult and expensive to hedge. Buying Facebook offers upside potential, but the question then becomes if it’s enough at the respective level of risk? Do they really want to have to explain to their boss (the fund portfolio manager) why their top pick failed to deliver? Does the portfolio manager want to explain to clients why they allocated to a company with such well-documented controversy? The answer often becomes “no” and given how significant the impact of institutional dollars is to the stock market compared to retail, it is easy to draw conclusions about why the price has not corrected to its relative expected value.
Valuation & Estimates
The table above details an overview of some key projections of my valuation model on the company. I am expecting the company to maintain double-digit revenue growth over the next five fiscal years, likely waining off after 2023. Libra and similar yet-to-be-announced projects could be a catalyst for outperformance, but these are too theoretical for me to give weight in my assumptions. I will note that the exponential growth in cash is simply a result of the difficulty of predicting how future net income will be spent by the firm, so without an informed thesis on this, the assumption is that it will be retained. Thus, the further out my projection goes, it should be assumed that most of this capital will be deployed rather than stockpiled.
Source: Contributor Research
The table above details the multiples of the peer group of companies with which Facebook trades. The bottom two rows show the average and median values in each respective category. Given that several of these companies are not turning a positive net income result (or even are even posting positive EBITDA), and that many of those that are profitable have only become so recently, it is apparent that revenue is the most meaningful metric to share price. While sales price multiples are not always preferred, the company’s high rate of growth makes this metric a bit more palatable than it would be otherwise. Applying the mean EV/REV multiple provides a $222 implied trading price given 2020 estimates (see below).
Source: Contributor Research
This figure can is supported when using the following discounted cash flow model (assuming a 8.73% WACC discount rate).
Source: Contributor Research
It is worth note that price targets themselves are not entirely significant given that no one has a crystal ball allowing them to peg a specific price a year into the future. The importance is truly within the implied upside potential the valuation methodologies convey. Using the close of trading on October 4th, 2019, the stock is showing around 22% upside potential, so one could conclude the expected return to be somewhere in the neighborhood of +/- 5%.
Despite the Short-Term Risks I Like the Long-Term Prospects
US equity markets are at a point of inflection and there are ample catalysts that suggest a late-cycle continuation, as well as for an impending recession. Uncertainty is the only certainty and this is in part why we have seen a sudden positive change in favor of value vs momentum. Facebook at ~20% below implied valuation aligns with the characteristics of this investment thesis, but the trouble surrounds the regulatory concerns. Every investor needs to decide for themselves in they can handle a draw-down resulting from adverse regulatory action, and given that there are currently anti-trust investigations into the firm, this is a real possibility. I can only speak for myself that the prospect of a break-up resulting in a split between shares of Instagram, WhatsApp, Facebook, and any other assets is not something I would be concerned over long-term. There might be some accretive synergies that are casualties of such an occurrence, but I see no evidence of user migration or a change in trends of advertiser adoption. For the time being, the ads are working and, as a direct result, advertisers are continuing to increase their spend. Until I see evidence of a catalyst for change I am not concerned about growth. Additionally, while I do not see follow-through on the near horizon from legislators, I am young and have a sufficient risk tolerance to stomach an adverse decision. For this reason, I am bullish on the stock. I would recommend prospective longs look into the cost of hedging with protective puts vs the potential upside before making an investment here.
Disclosure: I am/we are long FB. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.