Facebook or Faceplant? Following weaker than expected earnings guidance on a recent investor conference call Facebook’s share price tanked 20%. We invested in Facebook earlier this year at the height of controversy around how it was using personal data. While the investment got off to a good start, the recent drop in share price had us asking that somewhat concerning question!
To be a successful investor you not only need to minimise the number of mistakes you make, but you also need to recognise mistakes quickly and act decisively. This is one of the most difficult aspects of investing – determining if an investment that is currently going against you is flawed, or is simply suffering a temporary setback.
We have done a lot of soul searching over the last week, to try and identify any flaws in our logic on our Facebook investment. While no investment is without its risks, I think this is just a temporary setback for a company with bright long-term prospects.
The $120 billion problem
On its recent results call, CFO Dave Wehner communicated that Facebook’s revenue growth is expected to slow, and that, combined with higher expense growth, the company will have declining profit margins over the next three years. While a slowdown in revenue growth was expected (no company Facebook’s size can grow revenue at 40% per annum for very long), the magnitude of expense growth caught the market off-guard and wiped $120 billion off Facebook’s market cap in one day. Facebook’s intention to hire more staff and increase spending on security, data protection and content moderation is driving expense growth. They are doubling the number of staff in these areas to more than 20,000 people. These investments are aimed at reducing the spread of fake news, eliminating election interference and protecting personal data.
The question for investors is if this investment will impact the long-term profitability of the business, or if it will strengthen and future-proof Facebook. .
To briefly put this news in context, on the same conference call Facebook announced that advertising revenues grew over 40%, global users increased 11%, and earnings jumped 31% on the prior year. That is stunning performance for a company of this size.
Occasionally management teams need to make difficult decisions that reduce the short-term earnings growth in order to strengthen the business and to grow more sustainably over the long term.
Facebook owns two of the world’s largest media assets (Facebook and Instagram) and the two largest messaging platforms in WhatsApp and Messenger. Across these platforms they reach over 2.5 billion users who use them to engage with friends and family, keep up with news and follow their interests. Advertisers are steadily increasing the proportion of advertising allocated to digital platforms, and therefore Facebook’s ability to maintain and grow engagement across its community is central to its ability to take a large share of these ad dollars.
In my view this recent step up in investment in security and content moderation, along with more transparency around data privacy, will increase trust and engagement by Facebook’s community. This will ensure the company’s longevity. Not only is this increased spend necessary, but by investing heavily in security and content moderation they are effectively raising the bar for any new entrants to the social media space – putting even further distance between Facebook and would-be competitors.
Ultimately these investments will help maximise the long-term value of Facebook. Some short-term pain, but for long-term gain.
Facebook is becoming more valuable by the day
Most people and businesses get a lot of value out of Facebook’s platforms – and they are gradually becoming more dependent on them.
I use WhatsApp groups to keep up with my kids’ rugby practices and game times, and with university friends now scattered across the globe. Facebook has become a convenient way to keep in touch with relatives and share photos. Instagram has effectively become my own curated magazine which is a cross somewhere between Runners World, National Geographic and Men’s Health (my wife’s Instagram is more like a cross between Daily Mail, NZ House & Garden and OHbaby!).
From our conversations with advertising executives and a range of companies, businesses that are embracing Facebook and Instagram are seeing great results. A furniture store near our office in Takapuna recently terminated its lease to sell its furniture online – mainly via Instagram. In doing so they saved considerable rent and staff cost. Social media can really help small businesses level the playing field against larger competitors. Small businesses (cafes, gyms, local retailers) no longer need to run expensive radio or newspaper adverts if they want to promote their businesses. For less than $50 they could target 5,000 potential customers that fit the right demographic profile from an ad on Instagram. This is becoming ever important in a world where we are spending an increasing amount of time on social media and mobile devices, and less time watching TV.
Facebook has already demonstrated that it is a very powerful advertising platform. Instagram is hugely popular and has just passed 1 billion user mark. This is still only half the number of users of Facebook, but it is rapidly catching up and is starting to show its promise as great place for businesses to advertise.
Needless to say, we think Facebook is a great business and believe they are taking the right steps to ensure Facebook and Instagram are well positioned to capitalise on its unprecedented global advertising reach.
While we are confident in Facebook’s long-term prospects, we cannot guarantee that the ride will not be bumpy from time-to-time. Volatility can be cost of higher long-term returns.