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Lynch: The Bigger Threat to Facebook

Given Facebook's strong network effect and high switching costs, its direct rivals are a smaller concern than something completely different that might divert users' attention away from social networks, say Morgan Stanley manager Dennis Lynch. Plus: Why Lynch lowered his Apple stake.

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Janet Yang: I'm Janet Yang with Morningstar. Today we are at the Morningstar Investment Conference with Dennis Lynch from Morgan Stanley. Dennis, thanks for joining us.

Dennis Lynch: Thanks for having me.

Yang: At our panel we were talking about companies and their competitive advantages. One company I think that comes up a lot in investor's minds is Facebook. Can you talk about why Facebook is not the next Myspace or the next Friendster. Why does Facebook have staying power?

Lynch: I think first and foremost Facebook has a very powerful network effect and a very large user base. I think at this point with over 1 billion users at that scale I think, it's hard for me to imagine that it's going to get disrupted in the same way that Myspace did early on. People forget when you think about Google, there were plenty other search engines that were effective early on in history of the Internet. But Google, once it got that commanding lead and that market share really, it never looked back and stayed a dominant company.

I think that Facebook's gotten to that point, given the size of its user base. There are also very high switching costs. The people using Facebook are constantly contributing content to it, sharing their photos, things that are going on in their lives. The idea of switching entirely to another social network as a substitute or direct substitute for Facebook, we're not concerned about that specifically. If you think about what can happen with Facebook in the future and what could go wrong on the risk side of things, certainly other forms of entertainment things that capture people's minds and attention I think would be more what we are worried about. Maybe it's not specifically a social network but something, that leads to people spending less time there. But at least so far the data points have been very strong for the company, despite the fact they've introduced some more advertising to the newsfeeds and have benefited financially from that. And the stock price is starting to reflect those things.

Engagement or the amount of time people are spending on the company's site is still actually rising. And so all the metrics look really good there. We think that there's enough of a first-mover advantage and network effect in place that they won't be disrupted. But we acknowledge that just like anything there are other alternatives that could develop especially in the days we live in which tend to be high in terms of innovation, and the speed at which companies go from small to big is significant. We certainly have to keep an eye out for alternative forms of entertainment and time spent. But for now I think the idea that Facebook is going to be like Myspace and suddenly no longer be the kind of core social network is not a concern.

I think there are some concerns that have been overemphasized, things like the younger demographic. There's a lot of recent research that shows that they might not spend all their time on Facebook, but certainly it's one of their core social networks. So generally we're comfortable with its competitive position, knowing that the future has some uncertainty, and we have to keep an eye on alternative forms of entertainment.


Yang: What are your thoughts of Mark Zuckerberg as a capital allocator?

Lynch: First of all, we think the whole management team, Mark Zuckerberg and Sheryl Sandberg specifically, are really impressive, and we have a lot of confidence that they can make the right decisions and guide the company going forward. And I think so far if you saw what happened post the IPO initially and some of the transitions they made effectively into the mobile arena, they have really done a great job on a fundamental basis, despite some of the crazy perceptions around the company that sort of occurred post the IPO initially.

We have a lot of faith in them generally. And I think we certainly will see how Zuckerberg does as a capital allocator. The company is still early in its lifecycle, and they are making some of those kinds of decisions of course. But I think we're more focused, probably for the next three to five years on Facebook's opportunity in the advertising world and those fundamentals. Not that we don't care about their capital-allocation decisions; of course we do. But given that it's still early in its lifecycle, we're more interested in sort of the core fundamentals.

Yang: Apple is another company that comes up a lot. It was a big part of your portfolio for a while, but you've been selling it down. Has Apple lost its edge?

Lynch: I think when people talk about valuation, they often hone in on things like P/E and free cash flow metrics, which are a very reasonable, conventional way of thinking things and certainly appropriate in many cases. I think another thing people forget about those are market cap or size of the company. And I think in the case of Apple, certainly it had an amazing run as a company and created a ton of shareholder value. We were fortunate to benefit from that along the way.

Certainly Apple I think on those conventional metrics I mentioned still looks very attractive relative to the market averages. But given the size of the company on a market-cap basis, it becomes more and more challenging for it to double over time, and then some. Certain other things can happen on a regulatory front when companies get really big. Not that we are necessarily predicting or anticipating that, but these are challenges of very big companies and Apple being, of course, one of the top few biggest companies currently in the world. So valuation is a little bit of a concern on a market-cap basis, not necessarily on a conventional multiple basis, but it's something I think worth considering.

In addition to that, they are sort of fighting a war that they once did against Microsoft, and it doesn’t mean it will play out the same way because it’s a little bit more complicated, I think. But the idea that the competition via Android is sort of an open-source type of competition, where in those kinds of scenarios often innovation occurs faster than in a closed system like the one Apple basically is providing through iOS and by controlling all the parts of that.

I think there's a little risk there, as well, that innovation might not happen as quickly as it does with the rest of the cell-phone makers and absent things like that occurring on the Android platform. It doesn’t mean it will happen. There are steps Apple can take to maybe offset that potential. And in fact at the most recent developer conference they had, they took some pretty interesting new steps toward being more open to outside development, being less in control, and really emphasizing the cloud a little bit more as part of their solution as opposed to just focusing historically on the power of the handset itself.

It will be interesting to see how those things play out, but those are some of the concerns, I think, out there why maybe it appears cheap on a conventional multiple basis. But in the context of it being such a big company already, we think there are a lot of positives here. They really dominate the high-end part of the market where most of the monetization occurs on an app basis, and that sort of top 1% is certainly less economically sensitive. So there is a lot to like in the balance sheet and cash flow, et cetera.

But in the context of that larger market cap and how big can it ultimately be and knowing there are some challenges to being more of a closed system versus an open system type of a strategic approach, those are reasons why we own less today than we once did. About 2.5% of our large cap fund is allocated to Apple; once it was much larger, as you mentioned. But we own it because we still like it. We just don't like it relative to the other opportunities we own today to the degree we used to because of that size and complexity I mentioned.

Yang: Dennis, thank you for joining us today.

Lynch: Thank you.

Janet Yang Rohr, CFA does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.