[FLASHBACK] Danger Ahead for Facebook and Google?

Editor's Note: Below is a brief excerpt from an institutional research note written by Demography analyst Neil Howe published on February 6, 2018. To read this entire research note email sales@hedgeye.com.

Our Take: Investors are pricing in years of steep revenue gains that may not occur. They expect that these firms’ market share expansion will accelerate even while their profit margins never revert to mean. They make the historically dubious assumption that total ad revenue will grow faster than the economy. Some are even waiting for the Internet giants to conquer whole new continents and invent whole new technologies—while taking little heed of worsening social and political headwinds, recently summarized by The Economist as the perception that these companies are “BAADD”: big, anti-competitive, addictive, and anti-democracy. The bulls, we believe, will likely be disappointed.

WHY INVESTORS REMAIN BULLISH

Yes, Google and Facebook rule the U.S. digital ad space—which in fact is worth a massive $71 billion as of 2016 by eMarketer’s count. The two companies together earned $42 billion in net revenue from their U.S. advertising operations in 2016, or 59% of the industry total, according to eMarketer. (For comparison, the next-largest slice of the pie went to Microsoft, at just 5%.) What’s more, the two firms accounted for somewhere between 83% (Pivotal Research Group) and 99% (Internet Advertising Bureau) of the entire growth in U.S. Internet ad revenue in 2016. Rest-of-world growth is similarly impressive.

WHAT INVESTORS EXPECT

Investors have clearly priced in the expectation that these companies’ sales are poised to skyrocket over the coming years. (Let that sink in: When you buy Facebook, you’re paying $15 for every one dollar in current sales!)

So let’s take a closer look at exactly what they expect. A Bloomberg roundup of consensus estimates indicates that Google’s revenue is projected to grow to $173 billion by 2021. Considering that Google earned 89% of its revenue from advertising in 2016, this projection implies that the company will generate $152 billion in ad revenue in 2021.

Let’s run through the same logic for Facebook. The company is projected to earn $96 billion in total advertising revenue by 2021. Considering that Facebook earned 97% of its total revenue from advertising in 2016, this projection translatea into $93 billion in ad revenue in 2021.

Are these projections feasible? It’s hard to imagine so. They imply that Google’s sales will grow at a CAGR of 14% from 2016 to 2021, while Facebook’s sales will grow at a CAGR of 28%. By comparison, the latest Congressional Budget Office projection shows U.S. GDP growing at just 3.6% nominally over the same period. Do you really trust Facebook to grow more than seven times faster than the U.S. economy for the foreseeable future?

WHY THE BULLS ARE WRONG

Let’s assume, as we’ve conceded in the earlier sections, that Google and Facebook do grow per their recent trend as a share of digital advertising, and that digital advertising does likewise as a share of total advertising.

As it turns out, this still doesn’t allow us to get to a scenario in which Google and Facebook earn enough from ads to justify their current price, because we’ve constrained ad spending as a share of GDP. In 2021, if ad spending grows on pace with GDP, it will reach $234 billion, or 1.04% of nominal GDP as forecasted by the CBO.

How much would ad spending have to rise as a share of GDP to get these projections to work? For Google and Facebook to generate $99 billion in U.S. ad dollars in 2021 thanks solely to a rise in total ad spending, the ad universe would have to grow to $462 billion—or 2.05% of GDP. That’s double 2016’s share.

History shows that this level of ad spending is without historical precedent. Over the past century, ad spending has averaged just 1.3% of GDP, with little variation. One could say, in fact, that ad spending and GDP are inextricably bound: This ratio has never strayed so much as half a percentage point in either direction—even with such jolts as the rise of radio, the Great Depression, World War II, the emergence of television, and most recently the dawn of the Internet Age.

BOTTOM LINE

There is no question that both Google and Facebook are large, innovative, highly profitable firms at the forefront of an information revolution that is transforming how people learn and communicate. There is also no question that both will experience a rapid rise in revenue and earnings into the foreseeable years to come.

Since both firms are very highly valued, however, one must assess whether the rise will be rapid enough to justify their current prices. We conclude that revenue and earnings are unlikely to rise at a rate that will meet the market consensus lying behind these prices.

Our core argument starts from the premise that both companies are basically in the ad sales business; and that U.S. ad spending as a share of GDP demonstrates remarkable stability over time. We do allow that both companies’ share of total digital ad revenue will grow and that digital ads as a share of total ad revenue will grow. Still, plausible values for such growth are unlikely to get the firms’ revenue numbers close to consensus by 2021 (our chosen out-year).

Finally, for balance, we offer an array of bearish scenarios of our own—each pointing to developments that could make the outcome significantly worse than we project. These include compressing profit margins; shrinking ad spending as a share of GDP; a worsening “tech-lash”; and rising political threats both at home and abroad. While it’s hard to say that any one of these is likely, we would argue that one or more of them are at least plausible.

At the very least, these scenarios make Google and Facebook a riskier play than many investors assume. It may be some time before investors are proven wrong. These companies are big enough to get by on reputation alone for the time being. Yet even before a general downturn hits, the market will certainly be on the lookout for the first signs that revenue and earnings performance may not be quite up to the consensus billing.

A word of advice to any investors choosing to bet on these ad-dependent Internet giants: Proceed with caution.