Last week, Facebook (FB) reported results for the fourth quarter of fiscal 2019. Revenues in the period increased 25% to $21.1 billion, while the total for the year was at $70.7 billion (+27%). As shown below, Facebook’s annual revenues have more than doubled over the past three years.
Despite a number of press reports that have suggested otherwise, daily and monthly active users both continue to grow (each up high-single digits in the fourth quarter). There are now more than 2.2 billion people who use one of the company’s services (Facebook, Instagram, Messenger or WhatsApp) on a daily basis - an increase of 11% over the past year. To put those numbers in context, consider that an additional 60 million people joined that group in the fourth quarter - the equivalent of adding the entire population of a country like Italy to the platform(s) in ninety days.
With help from increased user growth and engagement, the company reported a 31% increase in ad impressions, offset by a 5% decline in the average price per ad. The decline in ad pricing reflects ongoing mix shift towards Stories and users in developing markets, both of which monetize at lower rates than the current base. That said, the continued growth in average revenue per user is broad based, with every geography reporting upwards of 15% increases in the fourth quarter.
As I’ve noted in the past, a big part of the story is outsized expense growth. Operating costs increased by roughly 35% in 2019 (adjusted for the $5.0 billion in legal expenses from the FTC settlement), with the outsized growth relative to revenues resulting in a few hundred basis points of margin contraction. As a result, non-GAAP diluted earnings per share (EPS) growth for the year was in the single digits. (And depending what you think about the current pace of spending on capital expenditures, that figure may be overstated as well.) Clearly this is not the kind of result that investors are hoping for.
Guidance doesn’t alleviate any of those concerns. Management expects $54 billion to $59 billion in expenses in 2020, implying an increase of 30% - 40% for the year. Based on realistic revenue growth expectations, that suggests operating margins will contract by a few hundred basis points in 2020 as well. This is materially impacting the company’s ability to grow earnings. By my math, the company will ultimately generate $6 billion to $7 billion in operating income growth from 2018 to 2020 on roughly $30 billion in incremental revenues (incremental margins in the low-20's).
In addition to business headwinds, the company’s capital allocation decisions continue to baffle me. At year end, Facebook was sitting on more than $50 billion in net cash. In addition, they will probably generate $90 - $100 billion in free cash flow over the next five years. Despite this, they spent just $4.2 billion on repurchases throughout 2019 – about 30% of what they spent in 2018.
What will the company do will all this excess capital? I’m still skeptical that any large acquisitions are in the cards; the regulatory risk is too high, especially after the Instagram deal. That leaves dividends or repurchases, but management has not shown any real interest in either route as of late. That suggests tens of billions of dollars will simply sit stranded on the balance sheet. In my opinion, investors who are valuing those dollars as akin to cash in their pocket are overstating its value.
Conclusion
At the end of 2018, I said the following about Facebook:
“I expect the company to continue spending aggressively on these priorities. Everything management has said and done over the past few quarters leads me to believe this is not temporary (as Zuckerberg said on the fourth quarter call, “I believe that these investments are the right thing to do and will make our community and business stronger over the long term”).
For investors, it matters whether run rate operating margins at Facebook will be closer to 35% (what the company guided to on the second quarter 2018 call) or closer to 50% (the actual result for fiscal 2017) has a big impact on the stock price. Considering that the investment ramp will likely coincide with a continued reduction in revenue growth, I’m of the opinion that we’re more likely to be end up at 35% EBIT margins than 50% EBIT margins, even 3 - 5 years out.”
A year later, management has done what they can to live up to those expectations.
As it relates to valuing the business, I assume that revenues will roughly double over the next five years (a compounded annual growth rate of 15%). In addition, I assume that operating margins ultimately settle around 40% (comparable to 2019). Finally, I assume that 40% of free cash flow is ultimately allocated to repurchases (alternaively, you can just assume that the net cash balance continues to increase over the next five years). With those assumptions and a 10% discount rate, along with a terminal trailing price-to-earnings multiple of 16 to 20 times, I end up with a fair value estimate of $195 to $240 per share.
That’s a long way of saying that if you think Facebook can maintain profit margins near current levels and deliver a few years of mid-teens revenue growth (compared to +27% in 2019), the stock is reasonably valued in the low-$200's per share. On the other hand, if you think incremental margins over time should be higher than current levels (as I do) and / or that investments in areas like AR / VR or commerce and payments will ultimately lead to sizable opportunities for the company, then the stock is undervalued. For these reasons, I continue to own shares of Facebook.
Disclosure: Long FB
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