Facebook Inc. (FB) owns the world's largest social network. Deep pockets and the company's network effect combine to create a competitive advantage over tech peers and innovative upstarts alike. Wide operating margins along with returns above the 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.

Economic Moats

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, profit margins eventually erode until they become equal to the return on invested capital (ROIC).

Key Takeaways

  • Facebook is the world's largest social media network.
  • Wide operating margins and consistent returns above the cost of capital are evidence of the company's competitive advantage.
  • Facebook benefits from having an economic moat in the form of economies of scale.
  • The dynamic industry in which Facebook operates casts some doubt on the sustainability of its economic moat.
  • Yet, despite some controversy, Facebook continues to grow and attract record numbers of users.

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. The tendency for technology to evolve rapidly means that tech 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 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 has more than 2 billion users. Facebook also owns two of the most popular mobile applications in Instagram and WhatsApp, which the company said it plans to merge with its own messaging service in 2020.

A social media network generally becomes more valuable as the 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 social media networks are also more valuable to advertisers, Facebook's primary source of revenue. One reason is that bigger networks can provide more data and access to a larger group of potential customers. The failure of Google Plus, which was shut down after user information was exposed, demonstrates the power of Facebook's sustainability thanks to the 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.

1.6 Billion

The number of people (in 2019) that log in to Facebook daily, according to Facebook.

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. (MSFT) and Alphabet Inc. (GOOGL) will likely overlap with Facebook as these companies diversify or refocus in the future.

Lastly, there has been no shortage of controversy surrounding Facebook and issues related to user privacy. In 2018, the company was accused of allowing a UK-based data-mining company to leverage user information—including from some users that had not specifically allowed access to their data—to help political campaigns capture votes. The Cambridge Analytica scandal led to a movement among some users to delete their accounts.

According to a 2018 Pew Research survey of 4,594 people, 44% of users between the ages of 18 and 29 deleted the Facebook app in the wake of the scandal. Nevertheless, the negative press seemed to have relatively little impact on user trends. Facebook reported a 1.6% increase in users, to 2.45 billion, in the third quarter of 2019.

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. It peaked near 50% in 2018 before falling back towards 35%.

Over 12 months ended in 2018, 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 5% point gap is not exceptionally wide, but Facebook is still in a strong growth phase where profits are not always prioritized.