Terry Smith on Meta (Facebook) (META): P/E of 14

[MaynardPaton]

Interesting snippet from FundSmith’s annual shareholder video about Meta (the renamed Facebook) from 43m15s:

FUNDSMITH Annual Shareholders' Meeting March 2022

Co-managers Terry Smith (TS) and Julian Robins (JR) are bullish on META. TS intriguingly says:

“We own the stock, that [digital advertising] business on a P/E of about 14. Obviously the share price performance has been poor recently, very poor, but it certainly says that we own that digital adverting business pretty cheaply I would suggest at the moment.”

TS highlights META’s advertising brought in revenue of $115b last year that achieved an operating margin of 49%(!). Checking the financials, the margin is indeed $115b/$57b = 49%:

Share price when the video was recorded during March was c$200 (about the same as now) and supported a c$550b market cap. TS’s 14x P/E suggests digital-advertising earnings of $39b, which seems very plausible given the $57b operating profit from digital advertising through META’s ‘family of apps’ (Facebook, Instagram etc).

So quite an average P/E for a fantastic-margin division, but the downside is META’s expenditure on ‘reality labs’, which includes the augmented reality ‘metaverse’.

JR is upbeat about the metaverse:

“If we meet back here in 5 or particularly 10 years time, I think we will probably look back in amusement we thought the metaverse was something weird because I think we will all be living it in then”.

I must admit I did not think JR and presumably TS were the type of investors that liked to invest in such tech:

Apparently, it's the next big thing. What is the metaverse?

Last year the ‘reality labs’ produced revenue of $2.2b and incurred losses of $10b. Subsequent Q1 figures showed revenue of $0.7m and losses running at $3.3b, so perhaps $2.8b and $12b annualised respectively.

Questions are I guess: i) how much will META spend on ‘reality labs’ until the division breaks even, and; ii) if ‘reality labs’ profits are eventually forthcoming, will the economics be anything like those of the digital-adverting division?

TS’s P/E of 14 effectively values ‘reality labs’ at a net present value of zero (i.e. all the upfront metaverse investment will eventually be recouped, but excess profits will then not occur). Group net cash and investments at the last count were $44b, so META has plenty of resources to fund ‘reality labs’ for now.

META could always scrap ‘reality labs’, too, which would make the valuation guesswork much easier. Active users of META’s platforms are growing at a mid-single digit pace at present and I am not sure underlying advert income can persistently outpace user growth by some distance over time.

This cursory look suggests META shares do indeed look “pretty cheap” – assuming the ‘reality labs’ one day come good. But is META and its metaverse investment the type of company and situation that have served TS/JR well do date? It certainly does not seem to be in the same bracket as, say, FundSmith favourites L’Oreal and Estee Lauder.

Maynard

[MrBlobby]

Hi Maynard,

JR seems to be buying META for the future, as he sees it.

TS seems to be buying META for it’s high, and increasing, barriers to entry (ref African internet cable and user numbers).

They both seemed to like the stock, but for different reasons.

I think the Metaverse gives META optionality in the future?

i.e. If the Metaverse works, the sky is the limit for the stock. If not, well, FB have dented their margins for a few years but not lost their dominant market position.

As for style drift, I don’t personally think so. L’Oreal and Estee Lauder are just a different sector - He only invests in a few. I appreciate what you are saying, though:

MrBlobby

[JohnKingham]

My issue with Facebook is that I always thought it had no durable competitive advantage. I mean, obviously it does have massive network effects and switching costs, so those who are in the network and have their peers in the network are locked in for life. But what about the next generation?

My son is 12 (a “zoomer” is what they call themselves, the gen-z version of boomer) and none of his friends are on Facebook. They all chat through Discord or Roblox or Minecraft or WhatsApp (yes that’s Facebook but there are no meaningful barriers to exit) or something else.

Of course, younger types do like Instagram and that’s why Facebook bought it, but buying up the competition only works until the government says you’re being anti-competitive.

As for the Metaverse (a terrible name that has unfortunately replaced the existing much better name “cyberspace”), it might work, but it’s more of a hardware business than software, and as the gaming consoles have shown for decades, hardware is a hard market to dominate, with the console market being carved up between the PlayStation, XBOX and various Nintendo devices for decades.

My guess is that Facebook will go into a long multi-decade decline, a bit like linear TV, with an ever-aging demographic. Instagram has younger users and therefore longer legs, but is still at risk from new competitors like Tic Toc or whatever comes next.

If my son’s friends are anything to go by, online habits are set early in life and as far as zoomers are concerned, Facebook is full of boring old people (and the next generation may say that about Instagram).

[MaynardPaton]

Hi John,

@JohnKingham

My issue with Facebook is that I always thought it had no durable competitive advantage. I mean, obviously it does have massive network effects and switching costs, so those who are in the network and have their peers in the network are locked in for life. But what about the next generation?

I recognise Fundsmith has a much better investing record than me, but I do wonder if the fund is becoming caught out by its ‘late-cycle’ tech investments and some of its companies losing ground to more agile competition.

Sage for instance:

Terry Smith dumps Sage after flagging underperformance in December

In the report, Smith said: “Sage’s share price remains in the doldrums as we wait to see whether the new management team can make the product fit for purpose in the age of the cloud and subscription software and compete effectively with those who can.”

My accountant friend tells me Xero software is now the product of choice for small-business accounting.

Paypal perhaps could be another Fundsmith candidate for losing ground. My understanding is that any half-decent web developer these days chooses Stripe for payment processing.

And Facebook might well be another Fundsmith investment losing ground in light of the alternative networks you mention.

The brilliant stockcircle.com puts Fundsmith’s tech purchases into perspective:

Here’s META (Facebook):

Fundsmith started buying at $170, bought more at $340 and the price is now $199.

This is Paypal:

Fundsmith sold at $300 locking in big gains, but bought more at $200. Now $79.

And investments in Alphabet (Google) and Amazon look badly timed at present:

Maynard

[MrBlobby]

Hi

I cant see anything late stage in FB or PAYP’s or GOOGL’s annual accounts as yet. (AMZN is a strange thing and in the too hard pile for me!)

The stated policy of Fundsmith is they dont overpay on the basis of perceived value vs market price. I dont see a contradiction in the purchases against the recent market sell-off.

They also have a policy to not hold cash and remain 100% invested so I personally can’t mark them down on putting the money to work, because this is in line with their stated policy.

From your comments, you think they may have a blind spot in their competitve analysis of the future? Maybe this is why they tend to invest in 100 yr old companies outside of the tech arena? Time will tell.

Perhaps we should look at these purchases in 10 years time before disapproving them after 6 mths? Not saying you are wrong, just that its too early for me to have an opinion?

MrBlobby