A Tale of Two Earnings
Note this post was written Friday (4th Feb), Asia Time.
I’m typically awake by around 5 to 530am Singapore time, usually having slept through US market hours. Given the recent volatility, I’m quite glad for this habit, as it allows me to avoid the day-to-day emotional stress of seeing your holdings fall 5-10% and then recover. However, this strategy to avoid the daily madness failed this last Thursday as I woke to see that Facebook[1] and Spotify (both portfolio holdings) had fallen 20%+ upon release of their earnings. I let out an agonizing sigh to express my frustration toward Zuck and Ek for having ruined my morning (and let’s be honest, the rest of the day). I assumed the worst and scanned the earnings releases. Something seemed off though, as the market reaction would assume both earnings were equally bad. It wasn’t until I got into the office a few hours later and with a clear head that I realized that this was A Tale of Two (different) Earnings.
Facebook:
I started first with the Facebook earnings, and I won’t sugar-coat it, it was a fumble. And not just a quick fumble, where you dust yourself off and go on about your day, but one where you fall, slide, slip into a ditch, and have to wear dirty clothes into the office. Revenue – missed, earnings – missed, DAUs – declined, revenue guidance – sad, mentions of “avatars” during the earnings call – far too numerous. The company blamed the results on Apple, TikTok, inflation, covid, the flying spaghetti monster, and Bigfoot. Now, certainly companies are going to have a bad quarter from time to time, but this was a frustrating one for long-term shareholders. We understand that Apple’s changes have made Facebook’s service to advertisers much more difficult, however, what’s been disappointing is that management has stated that they had a handle on it.
“When it comes to the iOS 14 changes, for example, and their impact on our business, I think the reality is that I'm confident that we're gonna be able to manage through that situation. And we'll be in a good position. I think it's possible that we may even be in a stronger position.” – Zuckerberg, March 2021
Granted, it might be that it’s just too early, and we’ll see both targeting and measurement improve over the next several quarters. But this is not an isolated incident. You must also remember that Facebook’s focus on short-form video (Reels) will lead to lower monetization for the time being as they try to compete with TikTok, and that they have placed a $10bn a year bet on the metaverse. In a market environment like this, shareholders were quick to lose their patience, and sent the stock falling 26%.
While I do think the magnitude was an overreaction, the fall itself was not. It’s as if management is flying a plane through a storm (very jittery markets), while fixing the engine (targeting), trying a new fuel source (Reels), and at the same time building a hyperdrive to take the plane into outer space (metaverse).
Now bulls (yes, I’m still a begrudging bull) will point to the fact that the stock is trading incredibly cheaply, and that Mr. Market is crazy to offer such prices. That may be true, as even a simple DCF of its TTM free-cash flows ($38 billion) growing at just 5% a year, would come up with a present value higher than what the company is currently valued at. However, we have to look at this result two ways; one is that the market is stupid (which could be the case), or two that there is a serious problem with the terminal value of Facebook. Given all the issues the company must work through (not to mention generally bad PR and an antitrust case), visibility on future cashflows is very weak. Further, as mentioned in our previous post about the subject, the company is trying to change its DNA so much that a bet on the stock has essentially become a bet on management. This, in my opinion, increases the range of potential outcomes, which inherently does lower any valuation you would previously apply to the company.
Source: The Science of Hitting
Now there are a few safety nets that the company can pull, and that bulls can rely on. For one, Facebook has a lot of levers to pull. Management have about $30bn left in their buybacks (btw I saw some bad takes about how the company was stupid to have bought back before this price drop, as if they can predict stock prices). The company is trading at the same valuation as Target, a physical retailer, with single digit operating margins and growth). Facebook has an 80-90% penetration with internet users in ex-China emerging markets which are churning out ~1MM new internet users a day. It's not going to be an easy ride for Facebook holders, and position sizes will likely be cut, but Facebook has come back from 20% daily declines in the past. I just wish management would talk less about the metaverse and go back to talking about lower-hanging fruit like monetizing WhatsApp, Facebook shops, and enterprise use cases. Because until they do or until they make huge strides in the metaverse, Facebook will remain the Fredo of the FAANG family.
Spotify:
Spotify’s stock had a similar post-earnings drop as Facebook’s. However, we thought earnings were quite good. Total users came in at the top of the guidance range, as did premium subscribers. Total revenue was above guidance, gross margin was above expectations, and operating loss was near break even compared to the -Euro 152MM projected at the high side. So, seeing all this, colour me surprised that the stock had such a visceral reaction to earnings. Before we get into where we think the market gets this wrong, it's important to remember that like Facebook, Spotify is in the midst of an evolution. It’s gone from a pure-play music streamer to an all-encompassing audio platform that now has two significant and growing revenue streams (advertising came in at 15% of total revenues this quarter). The difference between Facebook and Spotify, is that we can see the fruits of Spotify’s labour showing up in earnings now.
The ad-supported business did nearly Euro 400MM in revenues this quarter and has done over Euro 1.2billion for the year, growing at 62% compared to 2021.
Overall revenue growth rates are accelerating from 16.5% yoy in 2020 to 22.69% this year.
While gross margins remain low at 26.8% they continue to improve, allowing for any increment to drop straight to the bottom line. This led to Spotify for the first time to end a year with positive operating income (and even higher EBT). (Granted social cost fluctuations make this a bit hard to compare but adding those back would show operating income of nearly $180MM this year vs flat last year)
Now looking at this you might wonder why the drastic drop in stock market, and I think this centre around a few things:
Q12021 Guidance: Spotify guided to 418 million users at the end of Q1 (estimates for 422 million), which would be the slowest Q1 yoy growth rate since going public. However, a few observations make me think that the market is overreacting to this. For one, Spotify has stopped giving a range for its guidance, and just providing one number, implying they are probably sandbagging here a bit. Second the net additions (of 12 million users) is the highest over the last 3 years (barring 2020 which saw a covid bump). Lastly, management stated that “With that being said, we do not anticipate any material changes in the trajectory for net growth in MAUs and subs in 2022 when compared to the net growth we experienced in 2021” which means that growth rates should stay the same as 2021.
Issues with Joe Rogan: Most of you would be familiar with the controversy regarding Spotify’s most famous podcaster and covid misinformation which has led to a #cancelspotify movement. This can understandably make the market jittery. However, for one, I’ve never seen any of these #cancel movements make a long-term impact. Second the popularity of Joe Rogan’s podcast is skyrocketing, with it being #1 in 90 countries. Third, management doesn’t seem to be to be worried “And usually, when we've had controversies in the past, those are measured in months and not days. But I feel good about where we are in relation to that. And obviously, top line trends still look very healthy.” I will say here there is a risk if a more relevant artist (sorry Joni Mitchell and Neil Young fans) decides to pull their music but considering Spotify’s updates to its policies and Rogan’s apology, we do think this issue should abate soon.
Leverage of Labels: There has been a narrative that labels have more power over Spotify than Spotify has over them. While there is merit to this argument, people forget that Spotify is the labels’ biggest distributor and revenue source. This year the company saw an improvement in gross margins due to royalty adjustments and increasing benefits from its two-sided marketplace. As Ek said “I think the -- perhaps #1 misconception I see people making is that they think everything is an outcome based on negotiations with the industry”
Given the strength of the earnings and the call, we really think Spotify’s results couldn’t be any more different to those of Facebook. To anyone interested in Spotify, you should read the latest earnings transcript and compare it to the Facebook one, and you’ll see a very different confidence level in management, tangibility of stories, and clarity in outlook. There is some irony in comparing a company with some of the best margins in the world with one that’s breaking even, but investing is about the future, and right now, the former future looks far brighter than the latter. So, to compare the two earnings as equivalent (as the market seems to have done) seems to be a huge mistake in my humble opinion. While both companies are in the midst of an evolution, one certainly has a clearer path.
Alas, despite what I might think, the market is not healthy. The violent movements we are seeing are perhaps the withdrawal symptoms of a market starved of liquidity (thanks Jerome). Short-term movements are not making a whole lot of sense, and I think this tweet summed it up best.
It’s going to be a rough ride in tech-land, so hang on folks. I do believe over the next few years, the next generation of tech leaders will prove their worth. That said, in the interim, I’m very glad for our significant holdings of “boring/old-world” stocks to help ride out the current sickness in the market.
[1] Yes yes, I know its now called “Meta” but I still refer to “Mumbai” as “Bombay” – old habits die hard.