Two weeks ago, Barron’s released an in-depth analysis on Facebook[1]. It covered its main lines of business as well as made the case for FB being undervalued. We agree with most of their points, but we have noticed that the analyst community fails to cover in-depth one of FB’s jewels, its VR/AR business Oculus. In addition, we want to make a case for Mark Zuckerberg being one of the best capital allocators in the world.

 

Facebook has acquired many companies over the years, the biggest standouts being Instagram (U$1 billion) and Whatsapp (U$19 billion), which are worth multiple times their original purchase price. In both cases, FB invested billions and their business model improved drastically from when they were acquired. We would like to add a third acquisition to the list, that of Oculus in 2014 (U$2.3 billion).

Virtual reality created a lot of buzz in 2016 when headsets from Oculus, HTC, PlayStation, etc. started hitting the market. Since then, reception was muted and VR “failed” to generate the anticipated mainstream adoption. So why now? A month ago, the ever-so-secretive FB disclosed that 1 in 5 employees at FB were working on AR/VR initiatives[2], and that was enough to pick our attention. Below we address the main concerns around VR: lack of content and PC barrier.

 

Content

Since VR is a new technology the user base is small. In other words, developers aren’t incentivized to make enough applications to sustain the ecosystem, thus creating a chicken and egg problem. In 2018, Zuckerberg explained that 10 million users would be the critical milestone for the company to reach a sustainable environment for VR developers[3].

“Developers, developers, developers, yeah, people got it, we’re only going to exist if we can get application support behind our platform. There was no question the thing that established the PC was the set of work that developers did on top of the platform.” – Steve Ballmer, former CEO of MicroSoft[4].

 

On October 2020, FB released its new Oculus VR headset, the Quest 2, and since then, it already has sold more units than all of their other headsets combined, ~2 million units estimated. The biggest selling points is price at U$299, much cheaper than competitors, and cheaper than Quest 1 (released in 2019) while performing at least 50% better than its predecessor. We believe that the value proposition coupled with staying at home drove unprecedented adoption. Currently, VR apps and games are pricier than their 2D counterparts; we believe that the number of new units sold this year will propel development much faster going forward.

 

Last year, Valve (owner of Steam, the largest PC gaming marketplace) released the third installment of their critically acclaimed franchise Half-Life Alyx (HL) directly to VR. It is important to understand this development from the gaming community perspective. The original Half-Life was released in 1998 and similar to its successor (HL 2 in 2004) received one of the best reviews of all time. HL was the trampoline which helped Valve launch its marketplace. Steam takes a 30% cut and in 2017 (financials are not public) they generated U$4.7 billion, excluding DLCs (in-game content) and apps. Fans waited 16 years for the next Half-Life installment which came exclusively for VR, a strong vote of confidence.

 

Personal Computer

Originally, all VR devices required a PC to operate, the headset is merely a “monitor”. However, Quest 2 can be used as a standalone device where you can watch videos, play games and interact in VR chat rooms, one of the most popular activities, without needing a PC.

You can also connect the Quest 2 to a PC to run more powerful games (like Half-Life Alyx), which you can buy on Steam or Oculus marketplace (more on this below).  In addition, there are currently VR-lookalikes to popular titles like Counter-Strike (Pavlov VR) and Fortnite (Population 1). Ubisoft announced last year that they are bringing the Assassin’s Creed and Splinter Cell franchises to Oculus exclusively.

 

We don’t believe that purchasing a PC is a high barrier to adoption. In 2020, gaming PC shipments came in at 55 million[5] and we believe that the pandemic accelerated gaming PC adoption, further lowering the barrier. A gaming PC whose parameters meet the minimum requirement for a AAA[6] game like Half-Life Alyx will cost ~$1,000 (less than a new iPhone).

In fact, the biggest barrier would be the cable you attach to your headset when you are playing, which hinders movements. However, developers have already cracked this and you can play VR games while your headset is connected wirelessly to your PC. While not an official feature of the Quest 2, it shows that it’s stable and has a high chance of being a feature on the next model, which should come in 2022. FB is already working not only on Quest 3 but also Quest 4.

 

Oculus Marketplace

There are questions as to how Oculus will generate profit. We don’t believe profitability is in unit sales, since the goal is mass adoption. We believe that profitability will be in the marketplace (similar to the App store) and data, FB’s bread and butter. I like to think of the headset as a monopoly on vision, you can’t consume VR content passively like TV. There is currently a race between Steam and Oculus for VR marketplace share, but we have confidence that Oculus might gain the upper hand. 52% of VR headsets registered on Steam are Oculus, which is a good proxy for VR headsets market share (excluding console VR headsets); market share grew tremendously with Quest 2[7].

 

Conclusion

Currently FB is under-earning as R&D expense has almost doubled from $10 billion in 2018 to $18 billion in 2020. We believe that Oculus is taking a big part of that pie. In terms of valuation, there are no pure play comparable companies, but we believe that on a standalone basis, Oculus could be valued at least ~$40 billion. Unity Software (NYSE: U) and Roblox (NYSE: RBLX) which are two of the most unique assets in the gaming industry trade for 36x and 42x TTM sales. Oculus is estimated to generate ~$2 billion a year in sales. We believe that Oculus is a free optionality within FB and further proof of management’s stellar capital allocation.