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Morningstar | Regulatory Risks for Alphabet and Facebook Are Priced in; FVEs Unchanged

On June 1, The Wall Street Journal reported that the Department of Justice could be starting an antitrust investigation of Alphabet's Google. In addition, it appears that the Federal Trade Commission, or FTC, will do the same regarding Facebook. In our view, while Google may have been accused of some anticompetitive behavior, including some bias in search results, in the past (it reached a settlement with the FTC in 2013), we think the firm has attained its dominant positions mainly through creating and leveraging the network effect moat source that most of its offerings have, which create significant benefits for consumers, rather than through anticompetitive behavior. The same can be said of Facebook and its various assets including Facebook News Feed, Instagram, and WhatsApp. For this reason, we think the competitive advantages of both firms and their ability to generate excess return on invested capital remain sustainable.

While it is not clear when the investigations will begin and whether any legal action will be taken, we believe it is far too early to begin handicapping the potential impact on either firm. In addition, it’s important to remember that Google has faced relatively modest fines (with respect to the firm’s total annual revenue and market capitalization) after a decade of investigation in Europe. We believe regulatory risk is now more than priced into Alphabet stock, as it has declined nearly 6% since the article was published and is now trading in 4-star territory. We are maintaining our $1,300 fair value estimate on Alphabet and recommend buying this wide-moat and high uncertainty name. While the share price of Facebook has declined 5% during the same time, the stock remains in 3-star territory and we recommend a wider margin of safety before considering the shares.

In our view, the mere market-dominant positions that Alphabet and Facebook have do not warrant anticompetitive allegations that possibly could be brought forth by the Department of Justice or Federal Trade Commission, or FTC. We think the two firms have attained their market leading positions through offering better and more highly recognized products, creating network effects that have pushed usage and user counts higher. For Google, this is happening on many fronts, including search, Android, Google Play, and Google Maps. For Facebook, the network effect moat source remains present in its News Feed while strengthening in Instagram.

We think U.S. Department of Justice’s approach against Google likely will be different than that of the European Commission, or EC, in its July 2018 decision. We believe that unlike Europe, precedents in the U.S. indicate that if quality of service provided for consumers is not impacted while a firm gains market share, then legal action based on anti-competitive allegations is less likely to either be taken or to be ruled in favor of in the U.S. We note that the 2013 settlement between Google and the FTC is an example of such a precedent. For this reason, there is a possibility that Google may choose to settle with the Department of Justice rather than fight a protracted battle.

In addition, we think if the Department of Justice were to argue for a decision similar to the EC’s July 2018 ruling, U.S. consumers may be the unintended victims as smartphone prices are likely to increase. In Europe, Google was pushed to unbundle its apps from its Android operating system, which has forced the firm to charge smartphone makers such as Samsung licensing fees for apps such as Google Play, Search, Gmail, Google Maps, and YouTube. We think that extra cost is likely passed onto consumers. While switching costs of various apps for consumers vary, we believe the network effects of most of those apps will remain, especially given Google’s improvement of its machine learning technology which continues to enhance search results. As a result, we expect demand for the apps to continue to grow, forcing OEMs to place them on their devices as default, and pass the additional costs onto consumers. Consumers are likely to pay a bit more to have Google Play (which is the second largest app distributor), Search, Google Maps, and YouTube. Further, a judge deciding such a case may consider political factors that may have driven the initiation of this probe by the Department of Justice, and such consideration may help Google a bit.

Regarding Google's dominance (and that of Facebook) in online advertising, we think the mere emergence of Amazon as a competitor in this space, may weaken Department of Justice's argument that Google is guilty of anticompetitive behavior. We have been pointing out the up-and-coming Amazon as a major player in online advertising for some time. Further, as we learned recently, the firm's Google Maps is now facing increasing competition from Apple. The same can be said of Google's other assets, including YouTube, which while it remains the market leader, it faces competition from other options (such as Hulu, Twitter, and Snap) for digital video ad dollars, which strengthens the argument that there is not sufficient evidence of anticompetitive behavior.

In our view, Facebook is facing something slightly different. We think news of the FTC possibly looking at Facebook regarding antitrust issues may impact the FTC's decision on the data privacy settlement, which according to Facebook may require a payment between $3 billion and $5 billion by the firm. While possibly not intentional, the FTC’s move on antitrust issues may lessen any say that Facebook might have had regarding a finalized data privacy settlement amount. However, we do not expect the firm to be forced to pay significantly above the $3 billion-$5 billion range.

We have not made any adjustments to our top or bottom-line estimates of Alphabet or Facebook. We expect revenue growth deceleration and slight margin compression for both firms through 2023. Our $1,300 fair value estimate for Alphabet is 14.2 times and 12.2 times EBITDA for this year and 2020, respectively. For Facebook, those EV/EBITDA multiples are 13.5 and 11.5.