Facebook Inc. (NASDAQ: FB) owns the world's largest social network. The company's network effect and deep pockets create a competitive advantage over large tech peers and innovative upstarts alike. Wide operating margins and returns above cost of capital provide quantitative proof of this advantage. However, the dynamic nature of Facebook's industry casts doubt on the long-term sustainability of its economic moat.
Warren Buffett helped develop and popularize the concept of an economic moat, defined as a sustainable competitive advantage that allows a company to generate an economic profit for the foreseeable future. Without a moat, margins will eventually erode until they become equal to return on invested capital (ROIC). Moats can be established by economies of scale, network effects, intellectual property, brand identity or legal exclusivity. Buffett's strategy revolves around identifying companies with sustainable moats that generate cash flow, estimating the present value of future cash flows and purchasing stock when the price dips below the present value of those cash flows.
Facebook's Qualitative Moat Analysis
Economies of scale are an important part of Facebook's competitive advantage, but not in the same manner as low-cost manufacturing firms or utilities companies. Technology's tendency to evolve rapidly means that technology companies exist in a dynamic environment. To remain competitive, tech firms must update their existing offerings and roll out new products or services. This is accomplished through spending on internal research and development (R&D) or by acquiring smaller innovators, and large companies can generally afford to spend more on R&D and acquisitions. While higher spending does not guarantee staying power, it increases the likelihood of success.
Facebook's most obvious source of moat is the network effect. The company's flagship social network had 1.65 million monthly active users, as of March 2016, with 1.51 billion mobile monthly active users. Facebook also owns two of the most popular mobile applications: Instagram and WhatsApp. With social media, a network generally becomes more valuable as its user base grows. Smaller communities generally have less to share, consume and discuss. Facebook has created an interest-neutral multimedia platform that allows users to engage friends, family, acquaintances, total strangers and businesses in a variety of ways. Large networks are also more valuable to advertisers, Facebook's primary source of revenue. Large networks provide more data and access to a large group of potential customers. The relative failure of Google Plus demonstrates the power of Facebook's network effect.
Brand identity provides some benefit to Facebook, as it is immediately distinguishable from any upstart social network. However, this benefit is largely captured in the network effect, and the history of online services shows how quickly well-known brands like AOL or MySpace can move into and out of public favor. Intellectual property can help on the margins by improving data collection capacity, but this is a minor contributor to moat. Facebook owes no advantage to regulatory restrictions.
The existence of Facebook's moat based on these factors is difficult to deny, but the sustainability of that advantage is up for debate. The company's rapid rise to prominence shows that conditions can change quickly, and consumers of web-based services can be fickle. Additionally, existing tech giants like Microsoft Corp. (NASDAQ: MSFT) and Alphabet Inc. (NASDAQ: GOOGL) will likely overlap with Facebook as these companies diversify or refocus in the future.
Quantitative Moat Indicators
High, sustainable margins are the ultimate indicator of an economic moat. Facebook's operating margin has been volatile over time, ranging from 10.6% in 2012 to 52.3% in 2010. From 2013 to 2015, the company's operating margin was in the 35 to 40% range. The company's spending on administrative infrastructure and R&D has risen over time. Over the 12 months that ended in March 2016, Facebook's ROIC was 11%, well below the 19% levels realized prior to its initial public offering, but in-line with post-IPO figures. ROIC of 11% exceeds Facebook's cost of capital, which is roughly 6.7%, depending on calculation methodology. This five percentage point gap is not exceptionally wide, but Facebook is still in a strong growth phase where profits are not always prioritized.