Facebook’s one day drop on July 27th was impressive. It marked the largest ever loss of equity value for a U.S. listed company. However, to achieve such a feat requires a large market cap before such a day, quite an impressive feat on its own. This feat was only accomplished because Facebook is a different kind of company
Facebook’s valuation is tied to its business model. It’s business model is, however, unlike that of most companies with the exception of a few internet giants. Ben Thompson has written in the past about a new business model he calls, “Aggregators.” Although not his first article on the subject, I believe this is the best one detailing the various characteristics of such a business, Defining Aggregators.
Additionally, he points out that Facebook and Google have all three types of “Aggregator” characteristics, which he terms, Super-Aggregator. The defining characteristic of a Super-Aggregator (Facebook and Google are the purest examples of this definition) are:
Super-Aggregators operate multi-sided markets with at least three sides — users, suppliers, and advertisers — and have zero marginal costs on all of them. The only two examples are Facebook and Google, which in addition to attracting users and suppliers for free, also have self-serve advertising models that generate revenue without corresponding variable costs (other social networks like Twitter and Snapchat rely to a much greater degree on sales-force driven ad sales). For more about Super-Aggregators see this article.
Thompson is arguing that, while it does cost money to run Facebook and Google, the marginal user, supplier or revenue require zero marginal costs specifically attributed to any of these groups. Furthermore, there is theoretically no limit (beyond human population and internet accessibility) on the additional numbers of users being added to these networks.
The key underlying assumption to Thompson’s thesis is that if the users, customers, suppliers are all in the same room, there are no additional costs to adding more people to this room. However, I believe his thesis is incomplete. Further, I believe where his thesis is incomplete can show us whether Facebook is doing the right things for the long-term health of the business.
An analogy might be appropriate. Facebook has built the largest stadium ever. Its capacity is limitless and everyone is welcome to come, for free. Current attendance is over 2 billion. There was a cost to build the stadium, but now that it is built and the people are there, Thompson is basically arguing that further growth is costless. And in some ways, the bare bones costs to maintain the stadium is very inexpensive, which is why Facebook is so profitable (currently greater than 40% operating margins).
Where I believe Thompson is wrong, however, is that there is a significant and potentially growing cost to ensure the quality of the stadium is high and the people in attendance stay there (and stay as active participants). Facebook could, in the short run, choose to defer the cost of bathroom, seating, or other upgrades in the stadium and show a much high profit. However, if Facebook’s goal is the long-term health of the stadium and its related high attendance levels, those increased costs are vital.
And The Point of the Story:
Facebook, in my view, is doing exactly what you want it to do. It’s long-term health is much more vital than a short-term 40% operating margin target that Wall Street is focused on (the future operating margin cited in the conference call was probably the main reason for the drop in share price the following day). The long-term value of maintaining the people in the stadium is going to come through decreased near term profits, which may manifest themselves through various avenues (more security: higher costs; better user experience: lower ad inventory and therefore lower revenue growth). Those are just two specific ways for lower operating margins, but, in my view, Mark Zuckerberg is very focused on making Facebook (and its related properties) the best stadium in the world, where people want to come and actively participate in the communities. Whether Facebook earns 44% or 35% operating margins in 2019 should not be the focus on investors, but instead whether Facebook is successful at making its properties the destination for their users’ online activity. This area of focus is hard to quantify and therefore something most investors ignore. It may sound trite, but not everything that can be measured matters and in this case, some things that are difficult to measure matter the most.
Matt Brice is the portfolio manager at The Sova Group and can be reached at firstname.lastname@example.org.