Facebook: Why it may be a BUY!!

I have decided to initiate a long position in Facebook. Facebook stock has fallen dramatically in price over the last few months. This precipitous fall can be largely attributed to an escalating scandal around Facebook’s alleged mismanagement of user data, concern about the effects of this ‘breach of trust’ on user engagement, and fear of a brewing regulatory backlash against Facebook’s business model. In this post, I will attempt to evaluate some of the significant risks in Facebook, and then explore why I think it is a buy. There are two questions to consider: (i) Is it available cheap? and (ii) is it a good quality business?

Good Price?

Data scandal

There are a few reasons why the scandal - and ensuing concerns - may be overblown. Whilst I am not delusional enough to believe that Facebook is not at fault, I suspect that the extent to which it has mismanaged data is being exaggerated: a headline about how Facebook is selling your personal information will obviously attract more attention than a headline which says that some of Facebook’s practices could potentially be considered to be unethical. Indeed, I think that this scandal will pass. There are two reasons for that. Firstly, the rate at which people moved past the VW emissions scandal suggests that people have a tendency to be forgiving if companies resolve ethical issues. Thus, the impact of the data scandal on user engagement may be less significant than it is perceived to be - provided Facebook resolves issues. Secondly, any regulation arising from the data scandal will only benefit Facebook. It is likely that regulation will legitimise and entrench the data economy. Rules will make it harder for start-ups to enter the space occupied by Facebook (that is the space of a social network, which generates cash by selling targeted advertising products). 

Despite my confidence that the current scandal will not necessarily weaken Facebook’s hand, there are two reasons to be more reserved when one is dismissing the impacts of the data scandal. Firstly, Facebook, which - unlike VW - relied upon the network effect to build its platform, may be unwound by the same forces. Secondly, Facebook may be subject to steep fines for its misuse of data. 

Changing user habits

Whilst the scandal is certainly not to be ignored, as a long-term investor, I am more concerned about Facebook’s ability to retain and monetise user engagement across its different platforms. There are ‘shorter-term’, and longer-term concerns in this regard. 

In the short-term, as people are shifting from posts to (1) personal messaging, (2) stories, and (3) video content, Facebook must rapidly alter its business model. Facebook has already begun to address these issues - Facebook has started placing advertisements in Instagram’s stories feature, and has also launched IGTV (Instagram TV) so users can share video content. The success of these two changes is difficult to assess, but I am inclined to believe that Facebook can deal with these two changes (2 & 3). The shift to personal messaging is more concerning. I struggle to understand how Facebook will be able to deliver targeted advertisements without making people feel that their privacy is being invaded. However, there are at least two positives in this regard as well. Firstly, Facebook has an established personal messaging offering in WhatsApp (they have the users). Secondly, the monetisation of WeChat in China - which I do not fully understand - suggests that Facebook should be able to find a creative solution to this issue as well (they should be able to monetise this existing user base). Overall, I think that Facebook should be able to create more value, as it begins to monetise Instagram, and potentially WhatsApp. They will have to be careful not to over-advertise though, as this may put-off users.

In the longer term, there are two concerns I have. Firstly, with generational changes, people tend to move from one social network to another. For example, people moved from Facebook to Instagram, and may make another shift as time goes on. Thus, generational changes may pose a risk to Facebook: children may not want to use the same social networking platforms as their parents. Secondly, there may be a technological shift - a step change - in the way people share information. However, this is (i) probably very far in the future, and (ii) something Facebook will be able to adopt and adapt to - if it is not leading this change.

Management concerns

The mismanagement of people’s data raises questions about the company’s value system. This may be partly responsible for the decline in share price. However, there is reason for hope. Facebook - by reducing the number of polarising, and provocative posts - is watering down users’ feeds. The reduced availability of ‘juicy’ content could negatively impact user engagement. This may be evidence of Zuckerberg and co. sacrificing the short-term for the long-term. Getting rid of such content may indeed enable the company to grow in a more ‘clean’ manner. Thus, this helps to restore my confidence in Facebook’s management.

Overall
From a valuation perspective, whilst I have not tried to use a D.C.F model, I am fairly confident that Facebook is cheap. A high-growth company with substantial earnings is trading at only 19x P/E.

Good Quality Business?

If I am going to make a long-term investment, I want to buy a good quality business at a good price. So far, I have considered the challenges facing Facebook, and explained why I think that they are less significant than people might think. These factors are very important, as they explain why my view on the company is different to that of the current consensus - the risk-factors considered and my evaluations of these factors explain why I think Facebook may be available at a good price. But, if I am going to make a long-term investment, I must now decide whether it is a fundamentally good business. 

There are two reasons why I think Facebook is a good quality business. Whilst neither is particularly insightful, I think they provide a rudimentary base for thinking about Facebook. Firstly, Facebook’s platforms serve a fundamental purpose. People - being the social creatures they are - need to have a means to communicate with each other from afar, and companies must advertise in order to promote their offerings. Secondly, with a growing world population, rising amounts of free time and increasing internet penetration, the potential market is continuously expanding. Thus, I think Facebook is a good quality business.

Conclusion

I think that there is a range of possible futures for Facebook. I also think that amidst the flurry of recent bad news, people have become overly negative on Facebook. Facebook is not a risk-free investment by any means, and there is a chance that I am being over optimistic. But, I think that despite being challenged, it is a good long term investment. Indeed, it is made more so by the fact that they are investing capital in other projects as well (eg: Oculus, e-commerce). 

Facebook will test my emotional resilience in the time to come. I hope I will live up to the challenge.