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Good morning. We don’t often go into detail about individual stocks, but the situation with Facebook is too interesting to pass up. We’d be interested in hearing your thoughts on it, too: [email protected] and [email protected]
A technical note. We are experimenting with a new graphics tool. Please bear with us as we do, and soon you will never have to look at another chart cut and pasted from Excel again.
Is Facebook cheap?
Note the title. I’m boycotting the name “Meta Platforms”, for two reasons. First, “platform” is a filler word used to conceal muddled thinking. Second, I am petty and dislike change.
That said, when Ethan and I were thinking about the FT stock picking contest, Facebook came up as a potential long. The stock crashed following an awful fourth-quarter earnings report, and it suddenly looked inexpensive relative to profits. Without doing a little more work, however, we were too nervous to pick it. Now we have done a little more work, and the stock price has co-operated by falling while we did it.
Start with a super-basic valuation comparison. Below are price/earnings ratios scaled to growth in revenue, rendering what is known as a “peg” ratio (I use revenue not earnings growth because revenue is harder to manipulate than earnings). I have compared Facebook to the other “Fangs” (more properly “Fmaangs”) plus, for further context, a creaking legacy tech company and the S&P 500:
At this absurdly high level of abstraction, Facebook indeed looks cheap, if consensus analyst estimates are roughly right. You are buying growth for much less than it would cost you at any other Fang — and indeed, cheaper than it would cost you at IBM or the S&P 500. But the reason for this, as we will see, is that Mr Market does not really believe that the company’s expected 14 per cent revenue growth rate will be realised this year, or prove to be representative of the long-term growth trajectory.
Before getting into the reasons for this, another two points about valuation in the abstract. Facebook’s P/E is cheap relative to peers and the market, but it is not fantastically cheap relative to its own history. It traded at a mid-teens P/E just a few years ago. I wonder if a lot of stocks might be headed back to their pre-pandemic valuation levels, and Facebook just got there first.
Second, Facebook does not trade that much cheaper than Google (yes, I’m boycotting “Alphabet” too). So why not just buy Google? It faces less competition than Facebook and does not have Facebook’s toxic brand problem. The best reason not to own Facebook might be owning Google instead.
On to slowing growth. The fall in the stock price can be explained by somewhat bad results in the fourth quarter, and very bad guidance for the current quarter.
One aspect of the bad results was active user growth that has ground to a halt. I think it wise to assume this will be a permanent state of affairs. I don’t know where you go from 2.8bn daily active users.
The other aspect of the bad results was higher expenses, mostly associated with investment in the metaverse. I don’t know if cash dumped into the metaverse (“an immersive, embodied internet that enables better digital social experiences”) will generate strong long-term returns, and neither do you. It is a highly speculative aspect of Facebook’s business, and should be valued accordingly. It has some option value, but the more pressing question for investors is how Facebook’s core advertising business will do in the coming years.
Which brings us to the guidance, which featured a nauseating projection of 3 to 11 per cent revenue growth for the first quarter. To contextualise this, if you put 7 per cent revenue growth — the midpoint of that range — in the valuation table above, Facebook suddenly looks more expensive than Microsoft.
Management put the slowdown down to the shift towards short-form video, which is harder to monetise than older social media formats, and to changes in Apple’s data tracking policies, which Facebook thinks will be a $10bn drag on revenue this year (revenue was $118bn last year). The company also noted that some advertisers were tightening their budgets.
These points have been widely discussed. A less noticed but equally dreary matter is that capital investment is set to go from $18bn last year to $29bn-$34bn this year. One of the great appeals of Facebook is that all of its earnings generally convert to free cash flow. This won’t be happening in 2022.
I think it is a reasonable assumption that Facebook, drawing on the data it extracts from its vast user base and the immense financial resources at its disposal, will solve the video advertising and Apple distribution problems. The company has a good record of solving these kinds of problems. I also think the massive investment in the metaverse will not go on for ever. In other words, my guess is that first-quarter guidance is not representative of the longer-term growth trajectory of the business, and that Facebook is, in fact, cheap.
Here is a possible kicker. Facebook may be sandbagging its guidance and overplaying the competitive effect of TikTok and Apple, in order to get the US competition authorities to back off. The goal would be to avoid (among other potential horrors) a forced reversal of the Instagram merger. This is the view of my friend Chris Rossbach, chief investment officer at J Stern & Co. He thinks Facebook is “fending off antitrust [enforcement] by talking up competition from TikTok and problems from Apple”.
If that is what Facebook is up to, it’s working. This is from a recent piece in The Economist:
The firm’s fourth-quarter results [suggest that] its position seems rather vulnerable and its profits somewhat less staggering. It comes across as a business with decelerating growth, a stale core product and a cost-control problem.
This should make regulators rethink their assumptions, The Economist says:
The narrative of the 2010s — of a series of natural monopolies with an almost effortless dominance over the economy and investment portfolios — no longer neatly reflects reality. Technology shifts and an investment surge are altering the products that tech firms sell and may lead to a different alignment of winners and losers.
Is Facebook this clever? Have they duped The Economist? If so, will the trick work on regulators, too? I have no idea.
Readers have thoughts about bitcoin
Tuesday’s letter featured a discussion about the diverging fates of meme stocks and crypto, in which we quoted the historian Niall Ferguson writing in Bloomberg. Here’s part of what we quoted:
It’s [bitcoin’s] scarcity that investors like, compared with — as the pandemic made clear — the potentially unlimited supply of fiat currencies. . . .
. . . I expect this crypto winter soon to pass. It will be followed by a spring in which bitcoin continues its steady advance toward being not just a volatile option on digital gold, but dependable digital gold itself.
We did not quote Ferguson to bring up the argument that bitcoin is valuable because it is scarce (which has been chewed up and spat out many times). We only meant to contrast crypto’s mainstream momentum and meme stocks’ lack of it. Ferguson is influential, and his endorsement is a sign of the times. But readers would not let the scarcity argument pass. Roger Tauss pointed out that:
The argument of bitcoin scarcity ignores the ease with which new cryptocurrencies are created. The relevant supply number is not the number of bitcoins but the total universe of cryptocurrencies.
Martijn Bron, head of cocoa trading at Cargill, thought that a comparison to commodities production is useful:
Scarcity is relevant if it is related to demand which is derived from an economic cycle. Meaning, if there is demand [for] a use case of an asset in an economic ecosystem [and] tight supply, then the price goes up to eventually increase supply and/or discourage demand . . .
My assessment is that bitcoin does not have that use case in an economic ecosystem, and its main purpose and attraction is speculation. And contrary to commodities, the demand for bitcoin goes up when the price goes up and vice versa, which is typical for speculative hypes.
Bitcoin needs investors more than investors need bitcoin.
The key point Bron and Tauss make is that scarcity in itself does not create value. The fact that only 21mn bitcoin will ever exist says nothing absent a use case. If the crypto bubble pops, at least we and our readers won’t have to repeat these arguments any more. (Ethan Wu)
One good read
Always read Joseph Wang, over at his Fed Guy blog. Here, he gives a novel (to us) account of how higher policy rates influence asset prices across the board. By imposing losses on bondholders — a “reverse wealth effect” — higher rates force portfolio rebalancing.
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