FB: All You Need is Like

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SEE LAST PAGE OF THIS REPORT Paul Sagawa / Artur Pylak

FOR IMPORTANT DISCLOSURES 203.901.1633 /.1634

psagawa@ / apylak@ssrllc.com

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@PaulSagawaSSR

April 11, 2016

FB: All You Need is Like

Our bull case for FB is straightforward. 1. Ad spending will shift toward digital more quickly and more completely than consensus expects, with TV, print and radio all likely to cede share. 2. The ongoing swing toward mobile platforms inherently drives the concentration of usage, and thus, ad sales. 3. FB, with reach to 1.6B global MAUs, unmatched mobile user engagement, compelling ad formats, and a trove of user targeting data, is likely to add to its share of the mobile ad pie, particularly if it commits more fully to the strategy of breaking the monolithic newsfeed into more focused apps, as it did with Messenger. In this context, we believe consensus forecasts for 34.4% annual sales growth and 34.9% eps growth through 2018 materially underestimate FB’s likely trajectory. With a Forward PEG ratio of 1.1x, we also see considerable room for future appreciation. Still, we do have longer term concerns, as FB’s steadfast focus on connecting and engaging an ever larger global community closes off significant opportunities (hosting, enterprise software, e-commerce, transport, media distribution, etc.) for which we believe FB could compete and where its chief rivals, GOOGL and AMZN, have already established meaningful leadership. Meanwhile, we are concerned that FB’s attention toward driving marginal MAU growth via messaging and pushing virtual reality as a broad based interface standard could prove disappointing.

  • Ad shift to digital will be more pronounced than expected. US digital ad spending will pass TV in 2016, accelerating share gains in the post-election/Olympics 2017 and beyond. The audience for traditional TV continues to shrink, even accounting for rampant time-shifting, which seriously degrades the effectiveness of advertising. An unusually vigorous campaign spending cycle and the rise of fantasy sports betting as a new category of advertiser have propped up TV ad demand, which will have the further benefit of the time zone friendly Rio Olympics. We expect sharp TV ad sales declines in 2017, along with further deterioration in both print and radio, with digital platforms the overwhelming beneficiaries.
  • All the digital growth will be mobile, and then some. In the US, mobile accounts for 65% of time spent on digital media, with total minutes up 78% in just two years, while desktop use has been static. Mobile ad spending is catching up, accounting for over 60% of US digital ads in 2015, up 64.9% YoY. Overseas, the opportunity may even bigger – mobile is 17.3% of the $195 total US measured media advertising market, but just 10.8% of the $375B spent in the rest of the world.
  • FB’s share of mobile ads will keep growing – The mobile app model exacerbates the natural on-line tendency toward market concentration. The typical smartphone user spends 90%+ of their time with their 6 favorite apps, with FB far and away the most used app worldwide. Just 27 apps can claim as many as 20M unique monthly US visitors (FB has 200M), vs. 93 sites on the mobile web. FB’s share of US mobile ad spending is already over 19%, second only to GOOGL (33%) and far ahead of #3 TWTR (4%), and it is growing its mobile sales at 82% YoY. FB’s mobile advertising strength is a product of its extraordinary reach (1.5B MAUs), strong engagement (46 min/day/MAU), valuable user data profiles, compelling ad formats and excellent targeting/analytic tools. With this growing demand, we believe that FB can continue increasing ad density across its services, particularly in mobile, with improving pricing.
  • Monetizing Messaging – WhatsApp and Messenger have been successful on penetration, but it is not clear that the strategy for monetizing the messaging apps – selling paid messages from organizations to users who have previously interacted with them – will be well accepted by either users or advertisers. In particular, WhatsApp, founded with a strict “no ads ever” policy and catering to low income market segments, faces considerable challenges in monetization. We think the answer for both messaging platforms may be in facilitating m-commerce, a la WeChat. In retrospect, we believe that paying 10% of FB for WhatsApp will prove to have been ill advised, and have some concern that the M&A process may lack appropriate discipline.
  • Is Oculus more than a gaming platform? – FB CEO Mark Zuckerberg has been enthusiastic in speculating broad future uses for virtual reality (VR) – distance learning, massive online events, even as the primary interface for desktop computing. We are concerned that latency limitations (>10ms can cause serious nausea, making cloud delivered apps impractical), the fully immersive nature, the high cost of content development and the lack of standards will limit VR to relatively narrow applications, such as high end gaming, that will prove disappointing to FB and its investors.
  • Upside opportunities need more attention – While we see significant upside to expectations in FB’s core business, we are concerned that it may be missing significant future opportunities. 1. Building the archipelago – Cleaving specialized apps (streaming media, news, scrapbooking, photo management, etc) from its cluttered and heavily filtered main app, as it did with Messenger, could increase engagement, reinvigorate social sharing and provide a more focused context for advertisers. 2. Getting m-commerce right – previous e-commerce initiatives have been disappointing, focused more on attracting ads than in adding value to consumers or merchants. If FB is going to play against AMZN or GOOGL, it needs to articulate a vision for drawing shoppers with a differentiated experience and facilitating transactions for retailers, although with former PayPal CEO David Marcus on board, this may be forthcoming. 3. Thinking outside the box – FB has the data center infrastructure and engineering chops to play in the emerging opportunities being explored by rivals like AMZN and GOOGL – e.g. enterprise IaaS hosting and SaaS analytics, streaming media, payments/fin tech, transportation, etc.
  • Get while the getting’s good – FB’s stick to the knitting strategy may prove a bit shortsighted in 5 years, but it plays well now, concentrating investment on driving mobile ad sales growth. We believe the core business will drive a further cycle of sales/earnings surprises and upward revisions throughout 2016. FB’s 18x ttm sales multiple may seem rich, but the 27.4x forward P/E makes for a modest 1.1x PEG ratio against conservative 5-year consensus earnings growth. We continue to hold FB as one of the 15 stocks in our large cap model portfolio.

Going Mobile

Not long ago, the knock on FB was that it would struggle to translate its desktop experience to its mobile app. So much for conventional wisdom. 90% of its 1.59B MAUs are mobile, including 823M that are only mobile. FB accounts for 13% of the time spent on US smartphones and has grabbed 19% of US mobile ad spending. 80% of its revenues are mobile, with mobile ad sales growing 82% in 2015. FB combines its extraordinary reach and user engagement with a world-class web-scale infrastructure, deep analytic expertise, and extensive user demographic and interest data, to deliver a unique platform for businesses looking to reach consumers on their smartphones and tablets. This mastery of mobile puts FB in an enviable position. The desktop ad market has plateaued, with all of the growth in digital coming from mobile, tracking a similar shift in user engagement. In the US, digital ad sales are projected to pass TV before year end, and mobile spending, now 17% of total US measured media sales, is on a trajectory to pass TV itself by 2019. Globally, there is even more upside, with digital mobile accounting for just over 10% of the $375B non-US media advertising spend.

So mobile advertising spending is growing rapidly and FB is taking an ever larger share of that spend. We believe that this can continue for the foreseeable future. Like many cloud-based businesses, mobile advertising is highly concentrated. GOOGL (33%) and FB (19%) together account for over half of US mobile ads, and we believe that the mobile weakness of traditional desktop ad players like YHOO and AOL (VZ), and the failure of newer platforms like P and YELP to gain traction, yields open terrain for FB to continue gaining. Meanwhile, substantial scale economies continue to give leverage on the bottom line, driving earnings growth faster than sales. What’s not to like?

Well, observers with a longer view might have some concerns. While there appears to be a few years of runway left, mobile advertising will eventually slow as it runs out of traditional media spending to cannibalize. Relative to its rivals, GOOGL and AMZN, FB seems to be doing less to prepare for that day. It has eschewed the opportunity to lever its data center expertise into the hot and potentially huge market for enterprise IaaS hosting. It dabbles in e-commerce – it offers “buy” buttons to allow advertisers to complete transactions directly on the FB platform, but has not invested to add value through logistical or brand marketing support. It sees a lot of video shared via its timelines and has pushed its autoroll video ads, but has built no organized platform for discovering and enjoying streaming media. Forget more far afield opportunities like on-demand transportation or FinTech -FB hasn’t been interested so far.

Meanwhile, FB has made a big leap into messaging, buying WhatsApp and cleaving off Messenger, albeit without a clear strategy for monetizing them. An idea to charge businesses for using the platforms to communicate with their customers may or may not pan out. The Oculus VR system has gotten a lot of hype as a next gen platform, but we are skeptical that it can be more than a niche product, given the nausea, isolation, content development cost and standards issues in front of it.

In balance, we believe the mobile ad momentum will drive FB to beat expectations for the next 2-3 years, with substantial upside to valuation given the modest 1.1x PEG ratio. Our concerns, should they remain unaddressed, would only become an issue as the mobile gravy train slows. We continue to hold FB as one of 15 large cap stocks in our model portfolio.

No Strings on Me

Nine years after the debut of the iPhone, and the onset of the Cloud-Mobile era, Facebook one of a handful of obvious and dominant winners. While investor concerns for how the company might make the jump from desktop to smartphone briefly weighed on the stock post its 2012 IPO, the last three years should be seen as nothing less than a triumph. The stock is up 350% in that time, while Facebook has grown to see more than 90% of its 1.59B monthly active users accessing from mobile devices (Exhibit 1). It now captures nearly 1 in 5 dollars spent on mobile advertising.

Exh 1: Global Facebook Mobile MAUs and DAUs, 4Q13-4Q15

This transition was critical. Americans now spend nearly 2/3rds of their digital time on mobile platforms, with total mobile minutes up 25% YoY in 2015 (Exhibit 2). These mobile minutes are passed on mobile apps, with mobile web browsers accounting for just 13% of time spent. However, app usage is far, far more concentrated than either the desktop or mobile web, with just 27 apps able to reach a minimum of 20M unique users on a monthly basis, compared with 93 different web sites reached via mobile browser. For the typical smartphone user, the most used app accounts for about half of the total time spent, with their top 6 apps accounting for more than 90% of minutes.

Exh 2: US Time Spent per Day on Major Media, US Q4

Exh 3: Facebook App Rank Among Smartphone Users, 18+ June 2015

Overwhelmingly, the top app is now Facebook. 48% of US smartphone owners list Facebook as their top app and 89% rank it in the top 5 (Exhibit 3). Given the company’s extraordinary global reach and engagement statistics – 1.6B MAUs, 1.1B daily average users (DAUs), 40 minutes of average daily use per MAU equaling over a billion total hours or more than 15% of the worldwide total time spent – its worldwide positioning largely echoes its US strength. It is this domination of engagement that has driven Facebook’s 52.1% average annual sales growth over the past three years.

We believe Facebook’s momentum will continue for three simple reasons: 1. Digital advertising is poised to take significant spending away from TV and other traditional media. 2. All of the digital growth will come from mobile, the structure of which inherently concentrates value to a small number of winners. 3. Facebook is positioned to add to its already strong #2 share of mobile.

Digital Eats a TV Dinner

The digital ad market, having already rolled over newspapers and yellow pages, may be finally ready to siphon spending from television. We have written extensively of deteriorating metrics for linear TV. (http://ssrllc.com/publication/video-media-the-cord-cutting-myth-gets-real/) Despite misleading metrics from Nielsen, there is clear evidence that the overall audience for traditional television – including the increasing viewing on a time-shifted basis – has been shrinking for several years. Moreover, the quality of that audience for advertisers has been eroded by that time-shifting via DVR and by of 2nd screen distractions. If anything, these trends are getting worse (Exhibits 4-7).

Exh 4: Reasons for Time Shifted Viewing

Exh 5: Traditional TV Viewing Among 18-24 Year Olds, 1Q11-3Q15

Exh 6: Average Network Prime Time Households and CPMs, 1980-2014

Exh 7: Time Spent in Media versus Advertising Spend in the US, 2014

Against this backdrop, TV ad spending has remained relatively strong, rising slowly as a percentage of total advertising as networks packed more minutes of ads into each hour of programming and conservative agencies and buyers proceeded cautiously with digital (Exhibit 8). However, weak demand during the 2015 Upfronts and the rising tide of digital spending suggested an inflection point for big advertisers that has been obscured by an unexpected deluge of Presidential primary spending. Combined with the upcoming US time-zone friendly Rio Olympics (NBC reports $1 B in pre-sold ads), this short term revenue windfall for linear TV has given media bulls an adrenaline rush. Most ad industry forecasts still expect modest growth in US linear TV ad sales, with radio and print revenues remaining fairly stable. We see this as wishful thinking.

Reality will take its bite in 2017. Without an election, Olympics, or surprise spending by fantasy sports betting sites, declining ratings will finally mean weak linear TV ad sales (Exhibit 9-10). Falling circulation will also take its toll on magazine ads. Eventually, the slow turnover of the automobile installed base will snap traditional radio’s hold on commuters, as smartphone interfaces become the norm. This should open a LOT of additional runway for digital advertising.

Meanwhile, digital advertising seems to have hit its stride with the big advertisers and agencies that drive measured media spending. US digital spending grew 15.4% in 2015, on a trajectory to finally pass TV spending sometime this year. Globally, digital spending was up over 17% last year and is expected to pass TV before the end of 2017. A recent study by Mondo showed 80% of companies surveyed were planning to increase their spending on digital advertising, often at the expense of TV. Unilever, the world’s 2nd largest advertiser, raised its global digital spending from 20% of budget in 2014 to 24% in 2015, with digital approaching 50% of its budget in technologically advanced countries like the US.

With all of this as a backdrop, it is surprising that most industry forecasts still expect 5-year growth from linear TV ad spending. We believe that this is a bias toward TV, from years when previous gloomy forecasts failed to materialize. Still, we are reminded of the sharp downturn in newspaper ad sales that began in 2006 after a few years of similar revenue resiliency in the face of declining readership.

Exh 8: Broadcast Net Commercial Clutter and Average Cost of 30 Second Spot

Exh 9: US Mobile, Desktop, and TV Advertising Forecast, 2014-20

Exh 10: US Media Advertising Share, 2014-20

Goin’ Mobile

All of the growth in digital advertising, and then some, is coming from mobile platforms. In the US, mobile ads account for just over 60% of digital spending and 17% of total spending. The category is expected to grow 19.5% per year over the next 5 years. Globally, the shift is a bit further behind – outside of the US mobile ads are a bit more than 10% of total measured media spending – but are also growing at a 29% annual pace (Exhibit 11). This tracks to the shift in online usage that we referenced previously – ad buyers are following their target consumers onto their smartphones.

This has huge implications for the digital ad market. Unlike desktop computers, where a browser presents a fairly neutral window to the internet and through which users easily open new tabs to visit a variety of websites, the very large majority of activity on mobile platforms happens via specialized apps. Switching and sharing between apps is cumbersome and the home pages, where the most popular apps live, are crowded. Including basic utility apps – like search, calendar, email, camera, etc. – the average smartphone user opens just 26 apps per month. Of these, 91% of the time is spent with the top 6 apps, with the favorite app grabbing nearly half of the minutes (Exhibit 12).

As a result, usage on mobile devices is much more concentrated than on the desktop or during the 13% of the time that smartphone owners are using their browsers. 93 different sites on the mobile web have as many as 20 million monthly unique visitors vs. just 27 different apps (Exhibit 13-14). Of these, just a few pull in the big numbers, with Facebook and Google leaps and bounds ahead of all of the others.

It is no surprise then, that Google and Facebook dominate mobile advertising, with Google holding 33% of US spending and Facebook more than 19%. Here, we must note that engagement statistics like time spent do not completely correlate to the value that an app may have for advertisers (Exhibit 15-17). For example, a user may spend just seconds executing a Google search that steers them immediately to an advertiser’s website – this obviously creates more value to advertisers than another user who is engaged in a lengthy web chat session with friends. As such, Google’s ad revenue per minute of engagement is absurdly high relative to Facebook, which comes in even below Twitter on that metric. Still, Facebook’s utter dominance of both reach and time spent on mobile devices positions it to continue to increase its share of mobile advertising, even as mobile grows as a percentage of digital and digital grows as a percentage of the total.

Exh 11: Global Mobile, Desktop, and TV Advertising Forecast, 2015-18

Exh 12: Share of Time Spent on Apps by Rank

Exh 13: Number of Web/App Properties Reaching Unique User Milestones

Exh 14: Share of Time Spent on Mobile: App versus Browser

Exh 15: Mobile Advertising Share, 2014-17

Exh 16: Ad Dollars per Time Spent on Property, US users Q4 2015

Exh 17: Facebook Mobile Revenue, 3Q12-4Q15

The Kids Are Alright

There have been occasional news stories reporting Facebook’s falling status amongst young consumers, but the data suggests otherwise. According to ComScore, the average 18-34 year-old Facebook user spends nearly 26 hours a month on the service, with Facebook owned Instagram second amongst social apps at 7 hours (Exhibit 18). The much hyped Snapchat user spends less than 6 hours. At this point, the sheer ubiquity of Facebook, its massive volume of sharing activity, and the extraordinary technical challenge of hosting all of it makes it very, very unlikely that another platform will replace it for its core functions. Remember, Facebook is still growing its user base and engagement at a reasonable pace, despite its size.

Facebook is also introducing new capabilities to maintain that momentum. Facebook Live is an example of this. Built on a breakneck schedule by a crack team of 150 engineers, Live enables any Facebook user to launch a live video broadcast to audiences ranging from a small closed group to as many people as the user can attract. Viewers of these broadcasts can comment in real time, or even join in if allowed by the originator. While Live is perhaps derivative of Twitter’s Periscope, or Snapchat’s video messaging, Facebook’s massive reach makes it an important launch.

Of course, we have argued that the breadth of functions integrated into the core Facebook news feed leaves it a cumbersome vehicle. The feeds have long been algorithmically filtered, meaning only a fraction of the activity generated by each user’s friend list and follows actually makes it to the screen, frustrating to those using their Facebook pages as a commercial tool and to users that might miss content that they might deem more important than does the algorithm. Even with the filtering, the news feed is still a bit of a cacophony, with different activities calling for attention, drowning out the social context that has always been Facebook’s reason for being. Articles to read, videos to watch, personal comments requiring response, photos to tag, games to play, etc. – all interspersed with advertisements, often featuring auto-roll video – can be overwhelming.

Exh 18: Average Monthly Hours Spent on Social Networking Mobile Apps

Facebook struck gold by keeping Instagram separate, and not long ago, it broke out Messenger as a separate, and wildly successful, app (Exhibit 19). At the time, CEO Zuckerberg suggested that Facebook would follow the Messenger move by separating other functions into their own apps. We see Live as well suited to be spun out to a separate app once it gains momentum. Similarly, Facebook’s attempts to build a viable YouTube alternative might be better off not encumbered by the news feed as the primary discovery mechanism. Facebook might better challenge Twitter in news distribution, Google and Apple in photo archiving and Pinterest in scrapbooking if the functionality were cleanly separated from the busy and filtered feed. At the same time, with recent data suggesting that users are increasingly hesitant to post personal updates to Facebook, de-cluttering the news feed would help mightily in re-establishing the sense of intimacy that had been at the core of the original Facebook experience.

Exh 19: Number of Monthly Active Users by Property

Money for Nothing

18 months ago, Facebook traded 10% of the company to the owners of WhatsApp, a zero revenue messaging startup with 400M global users enjoying free messaging as an alternative to the wildly overpriced text messaging service provided by wireless carriers. Since then, Facebook has driven WhatsApp to the billion user threshold, while eliminating the $1 annual fee that had been the original plan for monetization (Exhibit 20). Given assurances given users (and the founder upon acquisition) that WhatsApp would never 3rd party advertising and the fluidity with which users can shift messaging platforms, Facebook’s options are fairly limited.

Thus far, Facebook has put forth a plan to encourage smartphone owners to use the service to communicate with businesses, thus opting in to receiving messages back from those same businesses, who will pay for the privilege of responding. The same strategy is further along with the Messenger app spun out from Facebook without the promise of an ad free future. Those WhatsApp users that do not overlap with Messenger likely skew heavily toward developing markets where the value of executing customer service via the app is likely low and where the users are not accustomed to using online messaging in this way. We are skeptical that this approach is likely to generate the revenues needed to validate that 10% of the company price tag.

Exh 20: Global WhatsApp MAUs, 1Q13-1Q16

Ultimately, we see Tencent’s WeChat as a better model for WhatsApp monetization. Combining messaging with mobile payments and a portal to a huge library of services allows WeChat to be a commerce platform. Chinese customers use the service to pay bills, make appointments, order services with messaging as the primary interface mechanism acting as a middleman between consumers and businesses. While this role is no longer available in most developed markets, WhatsApp’s popularity in developing economies could allow Facebook to step in a broader role in coordinating commerce. Such a move would likely require Facebook to renege on its “no advertising” pledge and there are many wanna-be WeChats eyeing the same move, but Facebook’s enormous resources and WhatsApp’s billion plus reach gives it real advantage if it can move quickly.

The Sleeping M-Commerce Giant

To date, Facebook has only dabbled in e-commerce. An attempt in 2009 to launch company store pages on the platform failed miserably and was withdrawn. The jury is still out on the 2014 introduction of “Buy” buttons to enable purchases directly from commercial posts, with the response by merchants fairly underwhelming. However, former PayPal CEO David Marcus is now at the helm of Facebook’s messaging efforts, making a strategy shift toward a more muscular approach to m-commerce appear natural. We believe that the company may be working on a tokenized payments product, with peer-to-peer transfers via Messenger and WhatsApp an obvious context. Still, Facebook’s play in m-commerce could, and should, be much more ambitious than that.

With 1.6B users, all of whom are asked to log in with their bona fide identity, it would be a reasonable step to establish secure authentication for financial transactions a la PayPal, and leverage the token facility provided by Visa and MasterCard to offer a universal payments utility along the lines of Amazon or Google. With this single-log on mechanism and its treasure trove of personal data on its massive user base, Facebook could offer an interesting proposition to merchants looking to reach their customers online. For example, users that link to a retailer’s loyalty program could receive targeted product recommendations, e-coupons and other special promotions tied to their interests and online activities, with one-touch transactions enabled within the app.

Of course, Facebook would face the same shortsighted data sharing objections from merchants that have slowed Google’s e-commerce ambitions, but ultimately merchants must face up to their inability to reach their customers online and interact with them. The concentration of usage on mobile platforms will be an insurmountable obstacle for most retailers laboring under the fantasy that their modest loyalty app will hit the home screens of more than a small handful of their customers or that even these users would allow them to spam them with commercial notifications. Facebook, which gobbles up roughly 15% of all time spent online from mobile devices, CAN reach these customers and engage them (Exhibit 21). Add in payments, and this should be very valuable.

Moreover, a bold move toward commerce would extend Facebook’s addressable market from the $575B global advertising industry to the $8T retail industry. While we believe that the shift to digital and mobile will drive strong growth over the 3-5-year timeframe, eventually that change will play out. M-commerce is a natural extension, but one that might not be available if Facebook waits much longer.

Exh 21: Facebook Share of Total Digital Time by Platform, 4Q15

Reality – Virtual and Otherwise

As the many thousands who have experienced it can attest, the Oculus Rift VR system is very, very cool. With the display strapped to your head and headphones on, Oculus fools your brain into believing that you are actually somewhere else, a step far beyond previous immersive interfaces. In the demo chair it is easy to imagine how the technology could utterly transform the online experience – gaming, video entertainment, virtual conferences, etc. – with a sense of “being there” that has not previously been achieved.

While it is easy to imagine VR becoming the next ubiquitous interface technology, we see towering, and perhaps, insurmountable obstacles blocking that future. The first is human biology. Our senses are intrinsically coordinated – if our vision doesn’t jibe with our sense of motion and gravity (proprioception), we get seasick. This proved a major problem for early VR solutions, as a lag of more than 10ms between a turn of the head and a change in the field of view caused nausea in a majority of testers. The team at Oculus solved that problem with precise engineering which reduced the latency of its system below that 10ms threshold – for content served from a computer across the room. Meeting that latency target for content served from internet runs against serious limits, not the least of which is the speed of light, which dictates that electrons can make a round trip of no more than 930 miles in 10ms. Add in the inherent latency of each optical/electronic transition, of each router or switch, and of the CPUs at either end, and the distance threshold is cut by at least a magnitude. “Live” events will have to be buffered locally, requiring the full 360 degrees of potential viewing to be streamed, a huge bandwidth requirement at any level of fidelity. Users would not be able to interact with others at the “live” event under the 10ms threshold, eliminating multiplayer online games.

Even if the nausea problem can be circumvented, we believe VR is far too immersive to be useful for most applications or for most people. As we have noted, more than 60% of online usage is now from mobile platforms and growing – a powerful trend toward “anytime, anywhere” access that runs entirely counter to an interface mechanism that completely engulfs the user’s vision and hearing and must be tethered to a computer across the room (Exhibit 22). Within the home, we expect a significant backlash against a technology that so completely separates the user from the rest of the household – it is hard enough to get the attention of a teenager playing regular video games. In this sense, we see augmented reality, which interpolates computer generated 3D images into the field of view, as a much more practical general purpose interface.

We expect VR will be popular amongst gamers, even if they cannot play live across the internet. Still, there will be obstacles within that niche market that will delay its adoption. First, the standards for VR content are unsettled, with multiple competing systems vying for attention from both gamers and developers, none with the critical mass needed to build real momentum. Second, developing for VR will be expensive, with a cost per hour of content more than a magnitude higher than for games designed for traditional screens. All things being equal VR games will have much less playable content or will be much more expensive. Finally, compelling VR gaming systems, like Oculus, are expensive, and require expensive PCs to run the software, before we even consider the cost and availability of high quality games. Given all of this, it may be unrealistic to expect virtual reality to take off before the end of the decade.

Exh 22: Share of Time Spent Mobile vs. Desktop, 2013-15

Would You Capture It? Or Just Let It Slip?

Facebook’s mission “to give people the power to share and to make the world more open and connected” has served it well, as focusing on relentlessly building those interpersonal networks has given it the data and platform to become the advertising behemoth that it is. Still, that focus on communication has led it to ignore huge future opportunities being pursued by its rivals that are well within its skill set.

For example, Facebook has the data center infrastructure and computer science talent to be a real competitor for the red hot IaaS cloud hosting business now dominated by Amazon and to a lesser extent, Microsoft. By remaining doggedly focused, Facebook has ignored an opportunity that could have easily become a $10B or more annual revenue stream for it by decade end, in an addressable market that could grow to as much as a trillion dollars in the longer run.

As we noted above, Facebook has only dabbled in e-commerce, another potential trillion-dollar plus addressable market (Exhibit 23). Facebook’s archrival, Google, has taken the lead in self-driving vehicle software with an eye on disrupting the multi-trillion-dollar global transportation industry. Facebook, one of the few companies with the AI chops to compete, has shown no interest. Google and Amazon have both stepped investment in original content for their streaming video services – Facebook is content to serve video as a component of its core news feed, but as yet, offers no real platform for creators to effectively distribute and monetize their programming. Facebook’s engineers have built world class tools for “big data” analysis – it has no interest in selling those tools to enterprises, even if Google has begun to sell some of their tools. Perhaps it is time for Facebook to show some foresight and prepare for the day that its mobile advertising momentum slows.

Exh 23: Facebook Payments and Other Revenue, 3Q12-4Q15

What’s It Worth?

The reacceleration of Facebook’s revenues over the past two quarters took many observers by surprise, prompting ad market forecaster e-Marketer to sharply raise its projection of overall digital ad sales in 2016. We believe that this recent trend is the manifestation of the pro-digital, pro-mobile, and pro-Facebook forces in the market, and we expect it to continue to play out over the course of the next few years. With 4Q15 sales growth of nearly 52%, including an 82% increase in mobile ads, we see 2016 projections for 42.6% annual growth as quite conservative (Exhibit 24-27). We also see considerable leverage to the bottom line at these growth rates, making forecasts for EPS to grow at a slower pace than sales incongruous. Bottom line – we expect Facebook to easily beat consensus all year long absent major upward revisions.

In a scenario where Facebook can grow its sales and earnings at a nearly 50% YoY pace in 2016, and carry strong momentum into 2017, the current 18x multiple of trailing sales is far less lurid. The 25.7x forward P/E, reflecting consensus earnings estimates that we believe are materially low, suggests a PEG ratio of less than one. Our valuation framework, which assesses the value of the next 5 years of cash flows projected by consensus vs. the implied terminal value suggests that the current market capitalization may be seriously undervaluing Facebook’s long term strength.

While we have some concern with Facebook’s propensity for value destroying acquisitions (see the WhatsApp discussion above), we believe the risks are far outweighed by the potential rewards. We continue to hold Facebook as part of our large cap long model portfolio.

Exh 24: Facebook Consensus Summary, April 2016

Exhibit 25: SSR’s ST/LT Quadrant Valuation Framework

Exh 26: ST/LT Quadrant Valuation Framework – FB and the LONG Model Portfolio

Exh 27: SSR Facebook Model

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