Facebook, Shame And Profits: The Long Thesis

Facebook is so ridiculously profitable that makes management blush under increased public scrutiny on security and privacy grounds.

Hence the self-inflicted punishment: massive investments in safety and security resulting in 15 percentage points margin compression over a number of years.

Facebook’s multi-billion dollar commitment to safety may not appease regulators, but will elevate Facebook’s barrier to entry even higher.

We claim that business tailwinds will outweigh the headwinds in the mid to long term.

We value the business based on very conservative assumptions and argue for a long position at $160/share.

There’s a lot going on at Facebook (FB) these days: Russia meddling, fake news, hate speech, Cambridge Analytica… Add to that management guidance for decelerating revenue growth, margin compression and rising capital expenditures, and you get a serious selloff.

Yet despite all the uncertainties, we see lots to like on Facebook at $160/share. In fact, if we had to summarize our take on the business in one paragraph, it would be this one:

Facebook is a ridiculously profitable business.

So ridiculously profitable, that under increased public scrutiny on security and privacy concerns, management is apologetic, almost ashamed of its profitability.

By ridiculous profitability, we are talking 50% operating margins and 45% ROIC for full year 2017. For context, operating margins at Google (GOOG) (GOOGL) and Apple (AAPL) are in the low to mid-20s %.

Now, this is not to deny that Facebook has been reaping the benefits of its stranglehold in social without bearing the full cost of its responsibilities. That is to say, that 50% operating margins and 45% ROIC are unsustainable.

But we have a hard time interpreting plans to build a permanent 20,000 safety workforce and expectations for a 15 percentage point hit to margins over a number of years, as anything but an exaggeration. A purposely overreaction to redeem past sins. “We’ve learnt our lesson, we’re willing to pay a hefty price, now let us preserve the social throne”.

Facebook CEO Mark Zuckerberg testifying on Capitol Hill, April 10, 2018, in Washington, DC. (Photo: JIM WATSON/AFP/Getty Images)

On profits and shame

Part of the 15% margin compression is associated to investments in growth (video content, virtual and augmented reality, etc.) rather than safety and security measures. Still, even a 10% hit to margins to improve safety would require annual expenses to increase by $4+ billion based on 2017 revenues.

What’s more: by the time the full margin compression is realized (2021 at the earliest, in our view), revenues are likely to exceed $110 billion, hence a 10% hit to margins related to safety initiatives would necessitate an annual budget of $11 billion. Again, for reference, that’s 110,000 employees searching for fake news, hate speech, violent content and the like, based on a cost per employee of $100k/year.

In reality, machine learning will do the heavy lifting, and Facebook will replace labor with automation where possible, but the fact remains that $11 billion is an insane amount of money to devote to safety enforcement every year. And even if a large human team is necessary initially, won’t those employees be working on their own demise by building the multi-language labeled datasets required to train the neural networks to detect unwanted content? How many years of data labeling until they are let go?