On Thursday, Facebook Inc. (FB, Financial) reported financial results for the third quarter of fiscal 2020. For the period, revenue increased 22% to $21.5 billion, a meaningfully acceleration from the 10% growth reported in the second quarter. Ad impressions increased by 35% due to user growth and higher engagement with Facebook's offerings, with the average price per ad falling 9% (mix shift to Stories and geographies that monetize at much lower rates than markets like the United States).
Following a tough second quarter, Facebook has returned to over 20% revenue growth, with guidance indicating a further acceleration in the fourth quarter. As shown below, Facebook is on track to generate roughly $85 billion in revenue this year – a nearly five-fold increase from five years ago.
Facebook daily active users were up 12% in the quarter to 1.82 billion, with worldwide average revenue per user up 9% year over year (with U.S. and Canada ARPU up 15%). As a reminder, Facebook DAU only measurers users on Facebook and Messenger and does not include the company's other major properties (Instagram and WhatsApp). As noted on the call, there are now more than 2.5 billion people around the world using Facebook, Instagram, WhatsApp or Messenger every day on average, a mid-teens increase from the year-ago period.
A big part of the story continues to be outsized expense growth, with the company investing aggressively in safety and security, as well as future growth opportunities. For the year, management has guided for $53 billion to $54 billion in operating expenses, which implies that operating margins will decline by roughly 300 basis points in 2020. In addition, management has provided initial guidance for 2021, with the numbers implying another 300 basis points of margin compression next year as well (assuming 2021 revenue increases by roughly 25%). As shown below, the company's operating margins in 2021 are likely to be around 34% - with margins down by roughly 1,600 basis points from the peak in 2017.
As I alluded to above, I don't think this is a bad sign. First, ensuring the safety and security of the platforms was a necessity. And secondly, I think it's clear that the company continues to make sizable investments in areas like commerce and augmented reality (AR) / virtual reality (VR) that may potentially generate meaningful value for shareholders over the long run. For supporting evidence, consider that headcount in the quarter was up 32% YoY ("significant investments in hiring across a wide range of new products"). In addition, Facebook is on pace to spend more than $18 billion on research and development in 2020 – nearly twice as much as what it invested in 2018.
That said, while I support the company's outsized investments, regardless of what impact it has on the income statement in the short term, I continue to be perplexed by management's capital allocation decisions. In addition to the fact that Facebook is on pace to generate roughly $20 billion a year in free cash flow, the company continues to hold more than $55 billion in net cash on its balance sheet ($19 per share). My argument has been, and continues to be, that the company is highly unlikely to engage in any inorganic growth opportunities (acquisitions) that are anywhere close to its core business given continued regulatory pressures in the U.S. and Europe on big tech companies.
Even when it can complete smaller deals, like the $5.8 billion investment in Jio Platforms earlier this year, it simply isn't big enough to move the needle (note that the cash balance at the end of the third quarter was higher than it was at the start of the year). For these reasons, I think management should seriously consider returning at least $30 billion in cash directly to shareholders in the near future (and given the fact that the company has shown an unwillingness to aggressively repurchase shares when the stock comes under pressure, my preference would be a special dividend).
Unfortunately, it's apparent management does not agree with me. Here's what Chief Financial Officer David Wehner said when he was asked about the company's capital allocation plans on the call:
"On capital allocation, our focus is investing in growth and continuing to make sure that we make investments to drive the long-term growth of the business. That includes investing in our core product as well as investing in some of our longer-term initiatives like Facebook Reality Labs. This past quarter, we made an important strategic investment in Jio Platforms. So that was a significant outlay of capital. We continue to have an active share repurchase program authorized by the Board and we'll certainly factor in any changes in the tax landscape, but I wouldn't expect that to necessarily lead to a shift in our fundamental approach."
This answer is disheartening. A look at the financials clearly shows that investments for the long-term growth of the business – both organic and inorganic – are in no way restricted by the company's financial position. Simply put, they can invest many billions a year on both of these fronts and still have leftover cash at their disposal. Personally, I've come to accept the fact that tens of billions of dollars in excess cash will likely be stranded on the company's balance sheet for many, many years.
Conclusion
Facebook's rebound in the third quarter speaks to the value of its platform to both users and advertisers. The more than 10 million active advertisers across the company's services (up roughly 40% over the past year) depend on access to end users and Facebook's advertising tools. Personally, I think the company's moat has strengthened over the past year as both users and advertisers have become more dependent on the company's offerings.
As I look out over the next five years, and assuming there is no meaningful improvement in the company's profit margins or capital allocation, I believe the business can earn $15 to $20 per share. At today's price of $263 per share, that implies a multiple of 13 times to 18 times earnings. Given the optionality that I think is imbedded in this business, I continue to believe that shares are reasonably priced. For that reason, I continue to own shares in the company.
Disclosure: Long Facebook.
Read more here:
- Comcast: A Record Quarter for Cable​
- Microsoft: A Strong Start to Fiscal 2021
- Investment Note - October 2020
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