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The following relates to Facebook Inc and its subsidiaries. This article is not designed to recommend a buy/hold/sell position on the company.

By the numbers

The company currently trades at about 11 and 22 times its Trailing Twelve Months (TTM) sales and profits, respectively. From 2013 to 2017, Facebook revenue and earnings grew about 51% and 81% on average, per year, respectively. From the perspective of discounted cash flows, if the market price was static (or worse dropped) over the next three years and the company achieved a 50% CAGR, the 22x earnings multiple will be reduced to 6.5x. If the company achieved a 30% CAGR for the following 3 years after, the multiple reduces to 3x. However, that’s simply 6 years of cash flows discounted, and for a company that will be around indefinitely, the current price-to-earnings multiple is determined more than 90% by the earnings after the first 5 years. This is factored in to the price target (not included in this article). Additionally, the revenue per global user is about $5.97 per user currently (not including Instagram, Whatsapp, or Oculus VR). The current revenue heavily leans on Facebook’s controversial Pixel feature, though as you will see below, the revenue structure is likely to change significantly in the near term.

Capital Structure and Expenses:

The company’s capital structure has been very consistent since its IPO in 2012. Facebook hasn’t used bank money – only $2 billion of long term debt in the past 3 years (paid off almost immediately). Assets have increased about 48% on average every year for the past 5 years. The capital structure relies on the retention of internally generated profits. The only other deviation from the capital structure was a stock issuance for the Whatsapp acquisition (2014) – since then, the company has consistently bought back every year, including over $5 billion in Q2 2018.

With a TTM profit margin of nearly 40%, the company should not pay a dividend to shareholders. Facebook returns 25% per year to equity holders, and has increased free cash flow 51% on average each year over the past three years. The business model does not have any inventories (ex-Oculus), so cash generation is simpler and purer than many other businesses (including Amazon) – this is the reason accounts payable is an insignificant figure (<$400 M). SG&A at 18% of revenues in 2017, from about 23% in 2015. R&D at 19% of revenue, from 27% in 2015. These are the main drivers of current bottom line growth and will likely continue to be. Margins will like continue to improve as Facebook continues to automate processes. The decrease in labor costs maybe from programs being able to replace employees.

Regulation:

Many investors believe regulation will compress Facebook’s margins, saying that litigation on grounds of data practices and even antitrust will erode earnings growth. Such positions are hard to justify, since Facebook competes in many circles, most notably against Google, Twitter, and Amazon.com. Further, the company does not charge users any fees, so it does not have the ability to ‘fix prices’. Litigation would be protracted if it did occur, though simple fines are much more likely. The Justice Department likely will not step in here for high profile trials. As you will see below, Facebook Inc is taking large steps to enhancing Pixel and encrypting data points to secure user data.

Facebook and the future of shopping

In the near future, Facebook will be a leader in e-commerce globally. This will manifest through use of both Business to consumer (B2C) marketing and Rich Communication Services (RCS). Facebook consistently is making the buying experience easier, more secure, and less expensive (both monetarily and psychologically). We are in the early days of Facebook being a dominant business.

At this time, Facebook has a total of 1.47 Billion daily active users (DAU) using only Facebook (not Instagram, Whatsapp, or Oculus). Whatsapp has about 1.5 Billion daily active users, and Instagram has about 0.6 Billion DAU. On all of their platforms, Facebook Inc has about 2.5 Billion Monthly Active Users (MAU), and there is very little penetration in China at this time. Considering these numbers, about 40% of the world (ex-China) is on Facebook. For another reference point, Amazon has about 30 Million MAU (0.5% of global population). Facebook has created a social experience that does not cost anything and users receive tremendous value every single day from Facebook.com, Instagram, and Whatsapp. The users are generally able to make significant purchases, do most shopping online, and will shop at the market with the best prices/products. Thus, if Facebook can prove to its users that it can provide a better shopping experience than other online stores (Wal-Mart, Amazon, Etsy), it will be able to better connect businesses and consumers on the platforms. The better shopping experience will likely come from knowing the customer in depth, using prescriptive analytics to enhance the sales process for millions of goods and reducing the potential stresses of purchase decisions. Once achieved, Facebook will monetize by charging businesses a small markup on each customer interaction, though users will likely never pay a fee for the service explicitly.

Main Ecosystem

To the untrained eye, it would appear that Facebook acquired Instagram, Whatsapp, and Oculus for more users and possibly synergies. A commonly held belief is that Facebook made these acquisitions to harvest user data to sell to advertisers. Seems that very few people are unsure what Facebook has planned for these acquisitions currently, let alone in the future.

Whatsapp – how does it fit in? Whatsapp is the largest rival to traditional SMS texting that comes standard on mobile phones (ie Android SMS, Apple chat). Whatsapp currently supports Rich Communication Service (RCS, see generations summary below), which allows large files to be sent seamlessly without compromise. Whatsapp also uses end-to-end encryption over wi-fi so no one can see the message outside the sender and recipient (not the service provider or Facebook either). The end-to-end encryption will soon prove to be the largest competitive advantage for Facebook as an e-commerce company and also will give users confidence that Facebook Inc is a good steward of their data. Businesses selling to Facebook users need to ensure that the sales process is protected from malicious actors (ie hackers) because sensitive information will be sent over Whatsapp, including forms of payment from the user, and products from vendors (such as airline tickets). At this time, there are 1.5 Billion DAU on Whatsapp, and many of them business owners, making a strong case for B2C marketing. Whatsapp for business simply changes your Whatsapp account to a business account and now you can begin marketing with all of your original Whatsapp contacts. Your contacts can then share all of your business information with others very easily and in one place. From there, Whatsapp provides you free chatbots to communicate with clients. Facebook Inc’s Messenger App has very similar features to Whatsapp, though Messenger has only about 1 Billion MAU since spinning off just before the IPO.

Facebook – how does it fit in? Facebook is a leader in data aggregation, analytics, and prediction mostly on consumers, but increasingly on businesses. The longstanding idea has been to be able to prescribe what users want before they even know, based on data from its massive user population. This is prescriptive analytics, and it is the holy grail of advertising – with the potential to revolutionize the shopping experience. To be brief, prescriptive analytics in the 3^rd (and final) level of data analytics, allowing for conditional probabilities to determine each step in a given process. Thus, machines will put users in touch with businesses based on the users’ preferences, and in theory, the buying process should be very easy based on millions of iterations of the same transaction.

The two drivers of purchasing on Facebook: Facebook Market place and ads in the news feed. The market place (which launched October 2016) will allows consumers to search for products specifically and the feed allows vendors to push to consumers. In both cases, the consumer will click the advertisement and begin a Whatsapp chat (see link at the beginning of this article).

Instagram – how does it fit in? Very similar to Facebook above, while also using RCS very efficiently. Vendors show up with images and video advertisements in the feed and also in the ‘stories’ section. Users click on the vendor and can now communicate directly to the vendor. With Instagram TV (IGTV, launched July 2018), Instagram is attempting to add a YouTube mimic. YouTube currently has over 1.8 Billion MAU and has a large head start on IGTV, though YouTube is generally a destination for users, rather than a social square. Facebook Live is a very similar product: both of these ventures will be expensive in the short term as the company pays influencers to attract users away from YouTube. Interestingly, Instagram still has room to grow, since it is increasing market share every year from its rival Snapchat, which still has 188 Million DAU.

Oculus – how does it fit in? Hang out with your friends virtually. This brings a new dimension to ordinary conversation. The long term goal of the acquisition is most likely to have the experience of trying products before you buy them. Also, VR gives a stronger attraction to users getting on Facebook’s platform, since users will find it even more convenient to know what peers and influencers are doing. The VR market has not taken off– Oculus likely has years of sunk R&D and talent acquisitions costs ahead of it until costs scale down. 6g has been rumored to support peer-to-peer AR/VR.

Summary of network communication types (ie generations):

SMS (1g, 2g)– short messaging services, analog and digital. This service represented the entire mobile phone market from around 1980 until the early 21^st century, and still is dominant in developing countries. The 3^rd generation of mobile networks allows for much enhanced Multi-Media files to be transmitted user to user.

MMS (3g, 4g)– Multi-Media Services for the transmission of images and videos. This has been prevalent in developed economies for just over a decade, and was made possible by larger network infrastructure that led to expense scaling. While this service is an upgrade to SMS, there are still shortcomings, including file size limitations. Often, images and videos must be compressed, which is becoming more common with continuous mobile phone camera improvements. 4g allows for improved wi-fi connectivity.

RCS (wi-fi, 5g)– Rich Communication Services for easier transmission of very large files. This generation was first created in 11/2016 and is very limited currently. Many network providers do not support RCS for problems with expense scaling (AT&T and Vodafone do). At the end of 2018, beginning 2019, this service will become much more ubiquitous in developed nations, allowing for quicker, larger messaging capabilities. Thus, vendors will find it much easier to send “push” advertisements, products, receipts and consumers to “pull” large files from sites, vendors, and peers seamlessly. 5g may advance to make peer-to-peer AR/VR less expensive and attainable.

Current sales cycle (in general terms):

Suppose you are interested in buying a bed. You research online about beds.

The micro-decisions to make:

·        Where do you do the research and is it valid?

·        Price

·        Payment method

o   Cash

o   Credit

·        Sizes,

·        Interior design styles to match the rest of your home

·        What your friends have bought

·        What store to buy from

o   Online

o   Physical Location

§  Drive time

§  Sales pressure

·        Method, timing and cost of delivery

·        Complementary pieces (for each of these, repeat all above micro decisions)

o   Mattress

o   Sheet sets

o   Blankets

o   Bedside tables

o   Dressers

The current sales process (above) includes over 60 micro decisions for simply buying a bed. This raises a few very important points:

1.      Many consumers will avoid buying a bed and keep what they have, even if they are uncomfortable

2.      Mistakes can happen at any of the decisions.

3.      Psychological stress can arise from buyer’s remorse if mistakes are made. Also stressful if there was a missed opportunity (FOMO)

4.      Psychological stress can arise from avoiding the purchase and living uncomfortable

Machines can make the buying process easier by way of prescriptive analytics. Consumers will soon understand this is true because the true costs are the time these decisions take and also (most importantly) the stress of making all of these little decisions. The stress may come from inability to make decisions (paralysis by analysis) and/or living with poor buying decisions (buyer’s remorse and FOMO).

If you research beds online, Facebook (through its “Pixel” feature) will have popups for stores you can buy from almost immediately after you research . This technique is called ‘retargeting’ and is one of the largest competitive advantages of the Facebook platform. At this time, retargeting is very awkward and unwanted. Retail stores (and Amazon) get the majority of all traffic because it feels natural to pick something on your own.

The general idea of machine learning is to help us make all decisions easier. We are still at the beginning of machine learning – only a small fraction of buying decisions (both residential and commercial) around the world are handled by machines currently. However, as new generations find that all decisions can be made by machines, and that by this, the consumer has a more convenient, more efficient, and overall less expensive shopping experience, sales traffic will only be online. We are likely a long way off from this, though e-commerce growth numbers clearly show we are moving in such a direction.

Future of sales:

If you are considering buying a bed, you search the Facebook marketplace for vendors. When you find one you like, you can begin discussing the options through Whatsapp directly (as detailed in above segment). With its Pixel feature, Facebook Inc. will maintain advantages over competitors by providing the vendor with troves of information about you as the customer. There are hundreds of quantitative data points and several qualitative data points at the disposal of vendors and users right now, though the growth of these data points will rise logarithmically until a plateau stage (several years away). Vendors are strongly encouraged to make their offering as detailed as possible so that Facebook can create better, more personalized user audiences, and visa versa.

In the near term, the consumer will become more confident that his/her data is being properly secured (ie end-to-end encryption) and will enter the sales process increasingly from social media platforms/RCS providers where they visit each and every day. Prescriptive analytics will guide the consumer toward a fitting product; however, this sales process may not be prescriptive enough until the longer term. The coordination of quantitative and qualitative data points across millions of products will eventually lead to better fitting product recommendations.

E-Commerce example: Amazon vs. Facebook

Whichever company knows more about you will have an easier time getting your business. This includes your friendships, your family members, your socioeconomic status, your state of health, your demographics, your personality etc. Users go on Facebook to understand their world and friends better, which is a very strong value add that is showing increasing strength year over year.

Users go to Amazon for the sole purpose of shopping, which will likely be harder to maintain because users do not get anything out of the platform outside of purchases. This traffic-generation model may not be as sustainable as that of Facebook Inc. Amazon does, in fact, have many bolt-ons like Whole Foods, Twitch, Music, Alexa, etc. so that users are stickier. Currently, very few of Amazon’s potential sales centers make a durable profit margin over 3% (ie Whole Foods is still losing money). Based on many commentaries, users are indifferent to where they buy something, as long as they have the most convenient, least expensive shopping experience.

Facebook’s product has durability since the user’s peers and influencers (Instagram) are constantly posting things of interest to that user. Case in point: Amazon has 30 Million Monthly users, while Facebooks platforms have estimated over 2.5 Billion. To put that in perspective– monthly, for every 1 visitor to Amazon, there are over 85 visitors to Facebook platforms. Facebook currently has a 41% net profit margin (Amazon ~ 5%) with about $22 Billion in earnings (Amazon ~ $5.5). A big advantage for Facebook from a financial perspective is that it controls no inventories, preferring to act as a toll road for B2C transactions. Amazon, however, has distribution facilities, warehouses, and many low-level employees that have the potential to reduce long term profitability.

Amazon does not have a messaging application or social media platform yet. Facebook can meet the consumer where they are rather than having the consumer come into the Amazon store. Importantly, many vendors are not comfortable yet listing on Amazon, since Amazon owns the client, essentially, and can (not to say it would) cut the vendor out of the sale. Facebook allows vendors to simply have access to consumers and data to improve the sales cycle.

In summary, the purveyor that knows more about the consumer and can execute at the lowest applicable prices will win.

Disclosure:

We do not recommend buying, holding, or selling Any of the companies named, nor do we have price targets on them available for the general public.

I/we are long Facebook Inc. and have clients that are long Facebook Inc., Amazon.com, Twitter and Google