Everyone on Wall Street is Wrong About Facebook
A company on the verge of cyclical decline takes a bet that's doomed to fail
Disclaimer: I do not hold any position in Meta Platforms, long or short. This piece is my thoughts alone and is not investment advice
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Note: I will be calling Meta Platforms “Facebook” in my writing for simplicity. When using this term I’m referencing the whole family of apps, not just the Facebook app unless stated otherwise.
Acronyms: DAU = Daily Active User | MAU = Monthly Active User | ARPU = Average Revenue Per User
Facebook geographic segments: US & Canada, Europe, Asia-Pacific, and Rest of World
Facebook, (yes, they’re “called” Meta now, but nobody uses that, even their investor relations page still says “Facebook Investor Relations”), is one of the most powerful companies on the planet. With over 1.9 billion daily active users and over $100 billion in annual revenue, Facebook is certainly a long way from the college dorm room that it started in. But beneath the surface, things are not as glamorous. They’ve been losing ground to new competitors, got blown out by existing competitors in vital future markets, and have been knocked off their feet by large companies trying to break into their space. On the outside, this is ignored. They’re growing quickly so there can’t be a problem, right? That’s the thoughts of Wall Street where only two out of over sixty analysts covering the company give it a sell or underweight rating.
Take Mizuho Securities for example, which says, “All-in on next gen of social; Core FB business attractively valued”
But this is what all those people are missing. Facebook is not an attractively valued business. Facebook is a value trap that lost battles on fronts it could not afford to lose and is using the metaverse as an all-or-nothing gamble to reengage young users and avoid cyclical decline. But their gamble is doomed to fail before it has even begun.
Breakdown in Efficiency
Over the past two years, the pandemic caused dramatic changes in the business environment. Advertisers were forced to shift their spending to digital methods, and this caused supernatural growth in ad prices. This resulted in an unprecedented revenue and ARPU boost for online advertisers, Facebook included. But these short-term trends merely work to temporarily hide the long-term issues facing the company. Efficiency in generating ad sales has become a highlighted issue for Facebook. The changes brought with Apple’s iOS 14 update negatively impacted both measurement and targeting for ads, making Facebook’s data less valuable to advertisers. While measurement is something that can be addressed, the company acknowledged in their third-quarter conference call that targeting is a more pressing issue.
Targeting is a longer-term challenge. Our direct response products are built on user-level conversion, and as a result of the iOS changes, we don't see the same level of conversion data coming through
This disadvantage has not only wiped-out Facebook’s market share in ad placements on Apple’s app store since its rollout and damaged revenue growth but had an immediate impact on the company’s margins. I’m focusing on their COGS component because of what it represents to the company, delivery, and distribution of their products. In just the first quarter after the iOS 14 update, Facebook’s COGS as a % of sales worsened from 18.6% to 19.9%. But drilling down reveals a more serious impact. If you remove depreciation and amortization from the equation, COGS as a % of sales went from 11.7% to 13%. That’s an over 11 percent decline in the efficiency of Facebook to place ads because of this change. That’s bad enough on its own but zooming out shows a significantly worse picture.
While the immediate punch to efficiency is substantial, Facebook’s margins in placing ads have been on the decline for several years. At 12.2% for the last four quarters, Facebook’s COGS margin excluding depreciation and amortization is at its worst level since the start of 2013. Since reaching its best point in 2015 and 2016, Facebook’s COGS margin in this area deteriorated from 5.1% of sales to its current 12.2% rolling twelve-month value. That’s an over 100% negative change in Facebook’s COGS margins. The reason it doesn’t stick out more is that depreciation relative to sales has declined, obscuring worsening efficiency in the COGS component of the business. And like other concerns that people may have with the business, like young user engagement, Facebook will give as little information as possible on purpose. Take these two quotes for example. One is from the 10-Q the company released a few months ago, and the other is from the 10-K the company filed in February of 2017.
The increases were mostly due to an increase in cost of consumer hardware products sold and an increase in operational expenses related to our data centers and technical infrastructure, partially offset by a decrease in the depreciation growth rate primarily due to increases in the useful lives of servers and other equipment. To a lesser extent, costs associated with partner arrangements, including traffic acquisition and payment processing costs also increased.
The majority of the increase was due to an increase in operational expenses related to our data centers and technical infrastructure and, to a lesser extent, higher costs associated with ads payment processing and various partnership agreements.
The same problem has been here with them for years, flying by with barely any attention given to it by anyone on the outside. And to clear the air on the consumer hardware point, non-ad sales make up 2.5% of Facebook’s total revenue. Its impact is minimal in comparison to the broader damage to efficiency in managing data and placing ads that have caused almost all the worsening COGS margin. Since 2015, Facebook has faced diminishing marginal returns from having to manage more data as well as higher payments to third-party partners that attract advertisers, a trend that does not look like it is reversing any time soon.
While margins are suffering in other areas, with SG&A as a % of sales excluding R&D recording its worst Q3 since 2015 and its worst Quarter-over-Quarter change in over half a decade, this relates to headcount acceleration from the gamble Facebook is beginning to engage in rather than something that was already festering under the hood. Efficiency wasn’t hiding alone though, other problems have also been lurking.
Declining User Growth & Engagement
The next major issue for Facebook is its inability to grow in key markets or expand engagement, which in turn influences the efficiency issues I discussed. I’ll be blunt: Facebook’s user growth and engagement growth outside of the Asia-Pacific region is bad. Rest of World, which is Latin America, Africa, and the Middle East is growing daily active users at under 1% sequentially and likely grew under 5% in all of 2021. The bigger issue is in Europe, and especially the US & Canada. User growth in these two regions over the past year has been abysmal. DAUs have not grown in Europe through the first three quarters of 2021 and are up under 1% since Q1 of 2020. The US & Canada, the highest ARPU market by far, has fewer DAUs today than it did in Q1 of 2020 and has consistently missed analyst forecasts that have called for DAU growth to materialize.
On top of user growth, engagement is also showing itself to be a growing problem. The Facebook Files shed a lot of this info, but even in company filings, engagement is running into headwinds. the DAU/MAU %, which tracks daily active users as a percent of monthly active users, was historically growing at a good clip, showing increasing engagement among users, and growing their ability to be monetized. But this metric has run into a wall over the past couple of years. In its higher growth markets of Asia-Pacific and Rest of World, growth in this metric has slowed to a crawl, with DAU/MAU% changing by 1% in the past two years and remaining far below that of other markets. More concerning is what is going on in Europe and the US & Canada. the metric is declining. Both are now at levels not seen since 2014 and have either been stagnated or fallen since 2018.
Declining engagement and no user growth in its highest ARPU markets are of particular concern for Facebook. This is because at its current maturity Facebook cannot grow users fast enough in lower ARPU markets to compensate for losses in high ARPU ones. For context, the ARPU of a user in the US & Canada is 12 times higher than the ARPU of an Asia-Pacific user and 16.66x higher than that of a Rest of World user. This means that if Facebook loses a user in the US, it needs to add a minimum of a dozen users in its two growth regions to offset it. Such a pace is no longer attainable by the company with ARPU growth in Asia-Pacific being 17.16% Year-over-Year as of the third quarter being far below the over 32% ARPU growth in the US & Canada.
But if this is the case, how is Facebook growing revenue in these regions? The answer to this is large increases in ad price growth that I mentioned earlier, as well as increasing the number of ads served on their platforms. But both have their limits. Despite the current omicron surge, the extreme growth rate in digital ad prices that has been observed in the past two years is not sustainable in the long run in a normalized environment, whether Covid-19 is endemic or not. Meanwhile, ads served is a careful balance. With declining engagement, the company must be wary of growing the number of ads served to users to an amount that would further discourage engagement, meaning there is a limit to how far this lever can be pulled.
Together the set of problems I’ve already written about gives me serious concern about the long-term growth rate that Facebook can reasonably obtain. But these alone would not have Facebook facing a substantial risk of cyclical decline. It’s their capitulation among young users that cements this fact.
The Lost Battle For Young Users
Ask yourself this: do you know anyone below the age of 20 that regularly uses the Facebook app? Your answer will likely be no or almost nobody, and that’s a stark change from a decade ago. Now ask yourself: How often do you see young people on Instagram? You’ll probably say most have it, but don’t use it as much compared to a few years ago. It’s a trend that has been increasingly obvious even before the Facebook Files were published. Facebook has lost the battle for young users, and it’s nothing but bad news for the company’s future.
One of the main drivers of Facebook’s failure in this is its complete capitulation to competitors in rising social media formats and its failure to attract content creators.
Video production and sharing: lost to YouTube years ago. There’s a reason Mr. Beast puts all his focus on YouTube despite having some of the highest watch times ever recorded for videos uploaded to Facebook.
Live streaming: completely lost to Twitch and YouTube to the point where Facebook Gaming distorts data to obscure poor engagement by viewers. Engagement in chats is far lower than that of competing platforms, resulting in a FB Gaming streamer with over 5,000 viewers being likely to have a less active chat than a Twitch streamer with 500 viewers.
Group communication: Discord obliterates Facebook Groups. Messenger and WhatsApp cannot properly compete as their design is for smaller groups despite high user counts in non-US markets.
Short-form video: utterly lost to Tik Tok. Reels is a substantial investment for the company that is not up to par. Despite reaching over 90%+ penetration of its target demographic already (ages 10-29), TikTok’s 8.1% 2022 US user growth indicates its 30+ US audience by about 20% in 2022, another bad sign for Facebook.
Close-friend communication: Snapchat is much more authentic and is growing its lead in preference for young users.
The reality is simple. Facebook has only ever competed by acquiring and is incapable of organically competing against new media formats. Because Facebook can no longer acquire large competitors due to the risk of regulatory action, it has failed to properly deploy countermeasures against these new media formats that competitors have brought forth.
From the media formats above, there are some common traits in their impacts on Facebook. One is that Facebook is unable to fight off encroaching competitors effectively and it shows with their declining engagement and stagnant DAUs in their two highest revenue markets, particularly among young users as we’ve seen from the Facebook Files. Facebook has been deliberately dodgy about giving specific information on this demographic and this quote from a Bloomberg article covering the files explains why.
An internal chart included in Haugen’s filing with the SEC shows that Facebook’s teenage and young adult user bases in the U.S. have shrunk since 2012
The other standout trait is that their apps are used by content creators only as top-funnels to draw users to other platforms where they can be more effectively monetized, shutting them out of a major growth market. Twitter is notoriously horrible at point two yet arguably has Facebook beat with how they’ve been able to integrate newsletters into their offerings. Creators are very sticky to their platforms, meaning they aim to choose a place that gives them the right environment and tools to succeed rather than just a massive amount of users. Despite having a massive userbase, Facebook has virtually excluded itself from the content creation supercycle by missing this point.
Not to mention, another vital piece of the puzzle is getting new people to start creating content. New creators begin making content at the bottom-funnel of where the people that inspired them to operate. With Facebook’s apps serving no purpose in this field, they’ve dealt themselves a critical blow as organic content by new creators will not be made on their platforms at the rate of peers, putting them at a further disadvantage for young user retention in the coming years.
Another major factor in this failure for Facebook is sentiment. When initially facing declining engagement, The Facebook Files revealed that the company changed its algorithms to promote more negative content to turn things around. And it worked like a steroid. Steroids, however, have long-term consequences, and these consequences have started showing themselves. People, young ones especially, have become less engaged with Facebook products over time in part because of the unhealthy and negative nature of the content promoted to them. For Instagram, young users are avoiding it more due to the sentiment that content on the platform is not realistic, wary of the psychological impacts.
“Thirty-two percent of teen girls said that when they felt bad about their bodies, Instagram made them feel worse,” the researchers said in a March 2020 slide presentation posted to Facebook’s internal message board, reviewed by The Wall Street Journal. “Comparisons on Instagram can change how young women view and describe themselves” (WSJ).
We all know people that have deleted Instagram off their phones because of this phenomenon. With young users disinterested in the Facebook app itself, the company’s strategy relies on cycling them from Instagram to the more monetizable Facebook app over time. Something this sentiment materially damages. All this rolls together into a simple fact: Facebook has lost the battle for young users, and it has forced them to take a final gamble.
The Metaverse Gamble
With all the issues I’ve mentioned, Facebook is in a prime position to enter a cyclical decline. Once they reach maturity in the Asia-Pacific and Rest of World markets, their failure to add and retain young users will likely create a systemic long-run decline. As young users become adult spenders without being involved in the Facebook ecosystem, Facebook itself will find its data increasingly less useful to advertisers, slowly burning out as a result. So, what does a company that knows it’s losing do to try? It makes a gamble to attempt to change the momentum. That’s exactly what Facebook is doing with the metaverse. It’s a gamble to get engagement and retention from young users that we know they’ve been using so that they can reset their competitive footing and come out ahead. The problem is that this gamble is already set up to fail.
Other than the fact that the speculative nature of the bet reduces cash flows available to shareholders and raises the risk profile of the company, there are key issues that signal that Facebook put it all on red while the roll is going to land on black. Take the cost-prohibitive nature for example. While this is something that they can engineer down, the current minimum cost of an Oculus is $300. However, Oculus games like Lone Echo or Stormland, require PCs. The fact that PCs are tied into VR and metaverse content substantially raises the cost profile of accessing it, and until Facebook can make their own M1 chip it’s something they will struggle to combat.
Another likely issue in development is timeline and cost. Throughout the virtual and gaming spaces, delays in releases and increases in projected costs have been a constant over the past few years. From GTA VI to Overwatch 2 to Minecraft, everything isn’t happening on time or at initial costs. There isn’t any reason to believe that Reality Labs will be any different, especially with the concept of what they’re trying to make being something that isn’t even fully known at this point. And whenever a delay or increase in projected costs occurs, it only makes the gamble even riskier.
But the real reason that Facebook’s gamble in the metaverse will fail relates to their failure in attracting young people to their products. More specifically content creators and developers, both of which have an age profile skewed to the younger side. As I already wrote, Facebook’s apps are not places where content creators set up shop, and that won’t change. This fact alone creates a significant disadvantage as a lack of organic creation of content will hamper the ability of Facebook’s metaverse to be adopted by the vital young age groups. In a culture that is set to be increasingly dominated by influencers, the inability of Facebook to generate major creators on their platform that can influence younger people is a pressing issue. Combined with decaying engagement and use of Facebook apps among young people, there are valid concerns about whether there can even be initial traction to expand the project beyond the current enthusiast audience.
Other than content creators, Facebook is appearing to face substantial issues in obtaining developers for their metaverse. Any successful metaverse requires an army of independent developers creating experiences and worlds for people to engage with. But with developers skewed to the young side, it seems that Facebook is struggling to convince them to build out Oculus games compared to alternatives. This is particularly blatant when looking at Facebook’s acquisition history. Since the start of 2020, 69% of the M&A deals reported on FactSet were acquihires to gain developers for either VR games or tech to be used in their metaverse project. Compare this to Roblox, which has had almost all its M&A activity centered around enhancing the existing experience it provides.
This may be because the incentive structure to develop is not aligned in a way that attracts independent developers (those not on payroll). Take Roblox as a comparison again. Despite the dubious nature of their payouts and use of kids, the incentive structure Roblox has built for individual developers has given them a distinct advantage. The result? Roblox has 9.5 million independent developers, exponentially more than Facebook does in this space. To Roblox’s over 40 million games, the Quest 2 has around 200. Combined with their excellence in getting young users on the platform and the stickiness of people once engaged, there is a strong argument that Roblox is in a much better position than Facebook in the race to whatever the metaverse may become. While Facebook has the lion’s share of the VR market today through Oculus, there seems to be an issue facing the company when it comes to organically attracting independent developers to work on their open-source systems when compared to peers.
Betting It All On Zero
In no particular order, there are the afflictions Facebook is facing right now:
Worsening efficiency in getting ads placed
Diminishing marginal returns in additional data collection
Lower quality data and market share due to iOS 14
Lack of DAU growth in high ARPU markets
Insufficient DAU growth in “emerging” markets
Unsustainability of ad price growth
Barrier in the growth of ads served
Declining engagement in high ARPU markets
Failure to effectively combat new media formats
Inability to make Facebook apps a bottom-funnel for content creators
Shrinking userbase and declining engagement among young people
Improbability of achieving Reality Labs goals without higher costs and time
Poor competitive position compared to peers in attracting developers
Put all these problems together and Facebook’s future is essentially them betting everything on zero in roulette and hoping it somehow works. The metaverse successfully becoming cost-efficient and recapturing engagement with young people is the zero on the roulette table. Every other number means failure. With fading engagement in its most important markets, unsustainable ad price growth and continually declining user growth rates, it appears unlikely to me that Facebook can a street forecast 16.15% revenue CAGR from now to 2025. With Reality Labs likely set to face delays and higher than expected costs like most in the development space have faced as of late, it’s likely that Facebook’s margins decline at a rate higher than analysts currently forecast. And with Facebook’s losses to competitors mounting across the board and complete failure to turn around the trend of young users rejecting them, Facebook decided to take a gamble to right the ship. The metaverse is the all-or-nothing bet. But Facebook’s failure to retain young users, attract content creators, and make themselves aligned with the interests of developers has made it so their metaverse gamble is set up to fail before it has even started. While everyone on Wall Street sees a company set to capitalize on a new space, I see something different. A value trap that is facing a long and slow decline.