A Relook at Facebook (NASDAQ:FB)

I am probably late to the party when I decided to pen my thoughts on this matter. However, I still feel compelled to write about the recent Facebook (FB) saga. For some background, this is what happened.

After Facebook announced its Q2 2018 earnings on 25/7, the share price took a nosedive from its pedestal at $218 all the way down to close at $176 the next trading day. This represents a 1-day drop of approximately 20%, and is one of the greatest 1-day lost by the company. During that period, the 200-day MA is around $180, and so this drop fell right through the 200-EMA. (Yes, despite the title of the blog, I do use a bit of TA and in this case, the 200-day EMA is my gauge of strong price support,)

In the days that ensue, a flurry of articles, facts, opinions, and hype went viral on the internet regarding this event. Almost every finance-related website I visited, this seemed to be the No.1 topic du jour. Since it was the largest holding in my portfolio, this event prompted me to re-examine my investment to see if it is still sound.

Business - What Facebook Does

I believe most of us reading this has a FB account. The account can be active or otherwise, but regardless, we are registered with FB. Every time we access our account, we are tracked. FB knows the sites we visit, where we log in from, the applications that you have (or have not) authorised to access your data via FB, the sites that you have visited asking if you will like to login with a FB account rather than create a new account. In fact, it is likely FB may know more about your online activities better than your mum or spouse does. This site offers a comprehensive look at what FB knows about you.

FB does not invest in algorithms to collect data about individials and provide you with a free account so that they can do nothing with the data they collected. In fact, the information that we knowingly, or unknowingly provide FB allows FB to profile us pretty well - our likes and dislikes, our hobbies, our close friends and where we hang out, how many girlfriends we have had at any point in our lives etc...

Using this profile, FB then sends us TARGETED ads. This means that if the algorithms determine that we are interested in, for e.g., investing, ads on invesing courses, investing seminars, investing sites etc will appear more regularly in our feeds. For the more visual readers, here is an infographic from 2014:

Source: Business-Management-Degree.net

No FB does not sell your personal information to third parties for money. The Cambridge Analytica saga had made FB's handling of personal data suspect, but at least to CEO Mark Zuckerberg during the Senate hearing, FB does not sell data.

“What we allow is for advertisers to tell us who they want to reach, and then we do the placement. So, if an advertiser comes to us and says, ‘All right, I am a ski shop and I want to sell skis to women,’ then we might have some sense, because people shared skiing-related content, or said they were interested in that, they shared whether they’re a woman, and then we can show the ads to the right people without that data ever changing hands and going to the advertiser.”    

~ Mark Zuckerberg

In summary, the main source of revenue for FB is advertising. They have disrupted the traditional advertising industry because gone are the days where companies are made to pay insane sums of money for a limited number of days where their ads appear in traditional media - newspaper, radio, billboards. I agree that such forms of advertising may still have its place for certain categories of advertising campaigns.

The traditional means aim to reach as wide an audience as possible. A large proportion of people who encounter your ad in this sense may not even be your target audience or belong to the target demographic. On the other hand, FB provides a platform where they know their user inside out, outside in. When companies tell them the profile of the target audience to reach, no one else (maybe apart from Google) does it better than FB. I have recently suggested my wife to consider trying out advertising her business on FB, and honestly, for the service FB offers, the price is really reasonable.

One very last point on why FB is in my portfolio - it is founder-led, and I have a penchant for founder-led companies. Mark Zuckerberg is one of the 5 initial founders of FB. It gives me the confidence the founder will want to see the company succeed, and give his best to ensure the optimal outcome for the company.

Does FB has any moat(s)?

The term "moat" was first popularised by Warren Buffett. It refers to the characteristics of a business that allows it to maintain its competitive advantage over its competitors. Firms with wide ecomonic moats are able to generate an above-average return on investment while those without have to invest their capital for sub-par returns. I hope to write an article detailing the various types of economic moats in the near future. However, in this case, FB possesses a strong moat - its network effect.

Network effect refers to the phenomenon where the value of a platform (FB) or network increases with the increase in the number of users. In this case, the more people there are on FB, the more data the company collects, making it a better targeted advertising company. With Daily Active User (DAU) at around 1.5 billion and monthly users at around 2 billion, almost a third of the world's population is on FB. This speaks volume of the network effect the company enjoys. On this end, the main competition would be from Google, but even so, the business model for the advertising portion between these 2 companies are still slightly different. This website offers an overview of the differences.

Now have you ever wondered why your FB account is free?
Now for some numbers. I will do a quick survey of the financials to see if FB is worth the price that it has fallen to based on some back-of-envelope estimates. Yes I am a lazy person...

Quantitative Analysis

I prefer to start the analysis of the company from the quantative perspective mainly for 2 reasons

1. Numbers give me a sense of the extent of the various characteristics that I am looking at.
2. I am more comfortable with numbers.

Trend of Profits vs Operating Cashflow

The first question I ask is, does FB still generate increasing profits over the years? The chart is unambiguous. Take a look:

I got the data from Morningstar and generated the corresponding graph. Do note that FB was listed only in 2012. This is the kind of shape I wished all the companies in my portfolio had.

For some numerical perspective, this represents a growth of 58% per year over a period of 6 years! This rate is nothing to scoff at with any standards. Of course, people who are further in the investing game can point out that one should not fully rely on accounting earnings, since this number is partly subject to management's judgment which introduces a certain degree of subjectivity. This brings me to the next point in my framework.

Comparing the trend of operating profits to that of operating cashflow is important because as mentioned, accounting profits can be easily manipulated by management. Manipulating cashflow, on the other hand, is harder, though not impossible. Ideally, the trend of operating cashflow should mirror that of the operating profit. Any discrepancies should warrant further investigation. Let's take a look.

Data from Morningstar. Self-created chart.

Once again the trend is something investors love to see in their companies. There is a slight hiccup in 2012 which affected the OCF, Operating and Net Income, but the overall multi-year trend remains intact.

ROE

The Return on Equity (ROE) measures how well management allocates equity. Equity is the part of the company's asset that is made up of the sum of shareholders' investment, and retained earnings from previous years. Hence, we can interpret ROE as the amount of earnings the company generates per dollar of shareholders' equity.

In the latest financial year (2017), FB generates an ROE of approximately 24%! Once again, this is a healthy ROE to me. But looking at the ROE is not enough because ROE can be artificially inflated by taking on excessive debt. We need to know how FB fare on that front, and this brings us to the next point.

Debt-to-Equity Ratio

Lesser management may decide to take up excessive debt to prop their ROE number up. This may work well in a rising bull market when the crowd is getting euphoric, but we know why we shouldn't:

After all, you only find out who is swimming naked when the tide goes out. ~Warren Buffett

The Debt-to-Equity ratio can help to check if the ROE calculated in the previous section is fuled by excessive debt or not. I cannot even describe how pleased I am to write this - 

FB employs NO DEBT!!!! 

This means that the ROE what the business generates, not supported by some interest-sucking loan from somewhere.

Before we get too carried away with ourselves, let's see if there are risks inherent to the company and if possible, to give a sense of how serious they are.

Risks

I consider FB a tech company, no matter what sector it is classified under NASDAQ. A characteristic of tech companies is continual innovation. The dynamics of the technology sector abhors companies that fall short on this front. As such, FB has to keep innovating to maintain its lead in this market. Anything less and it risks losing its leadership position.

Secondly, the image of CEO Mark Zuckerberg is linked to FB like how Howard Schultz was once linked to Starbucks. To investors, Zuckerberg ⇔ FB. As mentioned above, being the founder of the company, it is likely that Zuck has the drive and the desire to see the company succeed more than a CEO that is employed to run the company. His "tender" age of 34 will see that he has a long runway ahead with FB should he choose to do so. However, there is no guarantee that he will not do a "Howard Schultz" one day when he thinks the company's business is on track and it is time for him to move on. If that happens, I will be watching who he names as his successor. I believe there will also be some short-term downside pressure on the share price in the few weeks after his eventual departure.

Third, from the reaction in the Senate during Zuck's hearing, it seems that the US is looking at imposing regulations or restrictions on FB in the light of the Cambridge Analytica scandal. Whether that was made for the Senate to be seen in a better political light or otherwise, regulation on FB is likely to be a bad thing for the business. It implies additional constraints on the management's decision-making process which will undoubtly put a dent in margins and/or profits. Europe has already started the ball rolling with the introduction of the revised GDPR (General Data Protection Regulation). The impact of this most-recent round of regulation is still unclear, but FB is now required to adhere to it or face fines of up to 4% of its annual revenue. The performance of the company will need to be closely watched over the next few quarters to determine any adverse effects on the business of the company.

Conclusion

The attempt at valuing a company is a subjective exercise at best. If one is only comfortable with numbers that are cast in stone, then the conclusion of this valuation exercise will not leave him feeling fulfilled.

Personally, I am confident with the business model of this company and I am comfortable with the inherent risks. FB has grown to be the biggest component of my portfolio via both stocks and options. Given the (not-so-recent) recent drop in share price, I further nibbled at this company, adding to my already-large position. 

For those of you who think that my analysis has helped you, please give me some encouragements in the comment section. If I had missed anything or projected any facts incorrectly, please let me know so that I can correct myself. If you have any insights to add to this analysis, do feel free to share in the comments too!