Image: Facebook’s free cash flow generation has been resilient in the face of prior iOS updates, and we think it will continue to grow rapidly in the future. Source: Facebook.
By Brian Nelson, CFA
We never like to see a 10-rated stock sell off, even if it’s up more than 30% so far this year and up over 140% since it registered a 10 on the Valuentum Buying Index in January 2019, but that’s what we’ve been closely following with Facebook (FB). The stock experienced similar selling pressure during the summer of 2018, and while we’re huge fans of this underpriced tech giant in the long run, we think shares may face more selling pressure in the near term. Nonetheless, we’re reiterating its 10-rating on the Valuentum Buying Index and our $515 fair value estimate. Shares closed Friday at ~$353 each.
Apple’s iOS Updates Mean Facebook Customers Will Spend More
Facebook is against the ropes right now, seemingly getting hit from every direction. Most of the “news,” however, is old “news.” For many months now, Facebook had been telling investors that it would experience some growth headwinds from Apple’s (AAPL) iOS updates, which now require apps to have an opt-in function, which essentially limits user information exchanged with Facebook for its targeted ads. The markets had been expecting a top-line growth impact from iOS updates earlier this year, but Facebook powered through with impressive first- and second-quarter results. The market shrugged the concerns off at the time.
However, unlike in previous updates, with the latest iOS update, released September 20, Facebook users seem to be finally experiencing some impact, per the company’s latest update:
We’ve heard from many of you that the impact on your advertising investment has been greater than you expected. The cost of achieving your business outcome may have increased and it’s also gotten harder to measure your campaigns on our platform. In some cases, this is due to underreporting on our part. Our estimate is that in aggregate we are underreporting iOS web conversions by approximately 15%; however there is a broad range for individual advertisers. We believe that real world conversions, like sales and app installs, are higher than what is being reported for many advertisers. We are committed to helping you better measure these outcomes and improve your performance.
We’re on this journey with you as our business also navigates and adapts to these changes. As we noted during our earnings call in July, we expected increased headwinds from platform changes, notably the recent iOS updates, to have a greater impact in the third quarter compared to the second quarter. We know many of you are experiencing this greater impact as we are.
We’re optimistic about our multi-year effort to develop new privacy-enhancing technologies that minimize the amount of personal information we process, while still allowing us to show personalized ads and measure their effectiveness. Those efforts will take time, but there are actions you can take right now to maximize performance in this new environment while still respecting people’s privacy.
The long and short of the Facebook performance update is that it seems like Facebook advertisers may be paying a bit more for a little less as a result of the latest iOS update. It seems highly doubtful that ongoing iOS updates will be a sustainable negative for Facebook’s top-line performance in the longer run, however. Quite simply, Facebook ads may now be a little less efficient for advertisers, but that may only mean that its advertisers will have to spend more to achieve the same goals, a view that seems to be what the latest Facebook performance update implies (“The cost of achieving your business outcome may have increased…”).
It appears that Facebook has also been conservative in its prior ad reporting due to the iOS updates (and perhaps because of other factors). By disclosing that its advertising success may even be better than reported (as in the block quotes above), however, we view it as an attempt to cushion the blow that advertisers are probably now going to have to spend more to get a desired result in a post-iOS update world. The headline wasn’t great, but we’re actually neutral on the development, as we’ve been factoring in slowing annual revenue growth at Facebook in coming years in our valuation model.
Facebook’s Policing Costs to Increase and Antitrust Scrutiny to Persist, as Expected
Facebook’s website has always been controversial, and that brings us to the second reason why investors may be selling shares. The political divide between those that want Americans to be vaccinated and anti-vaccine activists has never been bigger. Facebook, perhaps no more than the “Octagon” in an MMA match, however, is nonetheless the object that everyone is blaming for the fight, fairly or not. The blame doesn’t stop with COVID-19 vaccine information either.
Facebook has gotten a black eye from potential illegal activity being sourced on its platform to reports that its properties may be unhealthy for the teens that use them. The WSJ has jumped on the bandwagon, writing a series of articles titled ‘The Facebook Files.’ We think Facebook’s business practices have room for improvement, of course, but we’ve been factoring in material cost increases in the coming years that the company will allocate to better police its platform. This is neutral on our fair value estimate, as a result.
The list of Facebook criticisms is long and probably growing, but the third one that is driving some angst among shareholders is anti-trust considerations. Facebook made a number of savvy acquisitions in the past, and regulators are looking to clawback some of its prior decisions–again fairly or not. It’s difficult to handicap the probability that Facebook or any other big cap tech company will be “broken up” in the coming years, but we’re generally neutral on this development, too.
For starters, Facebook shareholders own the free cash flow streams of all of Facebook’s properties, and this won’t change in the event of a breakup. If anything, a breakup would force the market to re-value shares on a sum-of-the-parts basis, which would be a positive, and may serve as a long-term catalyst to send the company’s shares to our fair value estimate. Though we’d prefer the company stay as one, a breakup isn’t necessary bad.
Concluding Thoughts
Facebook has been here before.
Concerns over the pace of top-line growth, its brand image and business practices, and whether it operates as a monopoly are nothing new. However, we think Facebook will continue to be effective in serving advertisers (despite the ongoing iOS hiccups), spend in-line with expectations to combat controversial issues and improve business practices, and come through anti-trust issues relatively unscathed–either staying whole given the increased ad competition from the likes of Twitter (TWTR), Amazon (AMZN), Snap (SNAP) and TikTok, or be broken up, which would only serve as a catalyst for price-to-fair value estimate convergence.
From our perspective, Facebook retains its status as a moaty, net-cash-rich, free-cash-flow generating powerhouse with substantial secular growth prospects. In the event shares of Facebook were to substantially weaken further to the low $300s or high $200s, we would not be surprised to see the executive suite increase its buyback authorization. The near term will certainly be rocky as Facebook faces a whirlwind of negativity from almost every direction, but its business remains very attractive, and we expect the company to eventually navigate these troubled waters to new highs–once again.
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Image Source: Value Trap
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Brian Nelson owns shares in SPY, SCHG, QQQ, DIA, VOT, and IWM. Valuentum owns SPY, SCHG, QQQ, VOO, and DIA. Brian Nelson’s household owns shares in HON, DIS, HAS. Some of the other securities written about in this article may be included in Valuentum’s simulated newsletter portfolios. Contact Valuentum for more information about its editorial policies.