Facebook (FB) has four key products: its eponymous social network, Instagram, Messenger and WhatsApp. The company generates substantially all of its revenues from selling ads, with ~90% of ad revenue from users on mobile devices. Those advertisers are primarily on Facebook (six million advertisers on a monthly basis) and Instagram (two million advertisers on a monthly basis).
What really got me interested in Facebook was this quote from investor Pat Dorsey during a recent appearence on the "Invest Like the Best" podcast (bold added):
“We went to a bunch of digital ad conferences and asked advertisers [about advertising on Facebook] … It’s rare that you do primary research and the work comes back 95% positive, and that’s kind of what we found. The representative quote was, ‘If God invented an advertising platform, it would be called Facebook.’ Digital advertising offers the holy grail that has been sought for decades – measurement of return.”
Over the past decade, the digital ad market exploded. That has been particularly true over the past five years with mobile. From 2011 to 2016, PriceWaterhouseCoopers estimates that U.S. digital ad market more than doubled, to roughly $75 billion (the global market is closer to $200 billion). Over that same period, the mobile ad market went from a few billion dollars to nearly $40 billion. As eyeballs and attention moved to mobile devices, ad dollars followed.
In recent years, Facebook has consistently accounted for a growing share of the digital ad market. If advertisers are giving Facebook a larger percentage of their ad spend, it must be because the company offers a more attractive return on investment (ROI). As one analyst told Wired, “They are so far ahead of other platforms in their tools and their specificity that they’re still the best option.”
We can find additional support for this conclusion by breaking down Facebook’s average revenue per user (ARPU). In 2016, ARPU was driven by a significant increase in the number of ads delivered across the platforms (up 50%), with a relatively small contribution from the price per ad (up 5%). We saw a much different dynamic in 2017: When the number of ads delivered grew at a slower pace (up 15%), there was significant competition among advertisers to reach consumers. Demand outpaced the growth in impressions; as a result, the price per ad increased by nearly 30% in 2017.
Increases in APRU have been a huge tailwind for Facebook. Over the past five years, the company’s APRU in the U.S. and Canada has more than sextupled to $107 per user (those figures annualize the fourth quarter results). We’ve seen a similar trend across the globe, with the worldwide annual ARPU quadrupling over the same period (from $6 per user to $25 per user).
In addition to a significant increase in APRU, Facebook has continued to add users. In the past three years, the company added half a billion daily active users (DAUs) across Facebook and Messenger. This growth has continued, with daily active users reaching 1.45 billion in the first quarter of 2018 (up 13% from the year ago period). Instagram and WhatsApp, which are not included in Facebook’s DAU calculations, have more than 500 million and 1 billion DAUs, respectively.
The contribution of APRU and incremental users has led to significant top line growth. From 2011 to 2017, revenues increased more than 10x, from $3.7 billion to $40 billion. Despite significant growth in operating expenses (including long-term investments like research & development), revenues have grown at a faster pace. As a result, operating margins have expanded over time, reaching 50% in fiscal 2017. The incremental profitability on that next dollar of ad revenues is very high.
Life is good when you have huge revenue growth and operating leverage. Over the past two years, Facebook’s EPS has nearly quadrupled (from $1.4 per share in 2015 to $5.4 per share in 2017).
Conclusion
Facebook’s Q1 results show that the model hasn’t changed. Revenues increased 49%, with EBIT margins expanding 500 basis points (and lapping 400 basis points of margin expansion in Q1 2017). Diluted EPS increased by more than 60% to $1.69 per share.
Obviously revenues won’t increase 50% per annum in perpetuity. Let’s assume the growth rate tapers off pretty quickly, with Facebook reporting 40% revenue growth in 2018. From there, I’m assuming 15% annualized growth from 2019 to 2022, which reflects a slowdown in the growth rate of the online advertising market and less benefit to Facebook from taking market share. If you think those assumptions are fair, Facebook will report nearly $100 billion in revenues in 2022.
The other thing we need to consider is the margin profile. Management is expecting a significant increase in expenses in 2018 that should drive operating margins lower (by my math, to the low 40s). As I’ll explain in a second, I think that will be temporary. My model assumes that Facebook reports slight operating leverage from 2019 to 2022 (100 basis points per year), with EBIT margins reaching 47% in 2022. Note that this is still below Facebook’s operating margins in 2017.
It’s worth thinking about that margin assumption, because it’s important to the output. If Facebook reports 47% EBIT margins by 2022 (and also meets the revenue growth numbers discussed above), that assumes they will add more than $30 billion in recurring annual expenses over the next five years (from 2017 to 2022). With gross margins of 85%, that means two-thirds of the increase (more than $20 billion) will come from operating expenses. That’s a lot of money. For example, even if you double the company’s headcount (add another 25,000 people) and pay the new hires $250,000 per year, that only covers about about 25% ($6 billion). If revenues double over the next five years, it’s difficult for me to see how the company could spend its way to ~40% EBIT margins.
Here’s how Bill Nygren (Trades, Portfolio) of the Oakmark Funds put it in a note to clients:
“We believe that Facebook’s normalized operating margin is substantially higher than what it reports, as the company continues to invest heavily in a variety of growth initiatives.”
I agree with that conclusion.
The only other assumption I make that is worth noting is a small return (2.0% annually) on the company’s cash. By my math, Facebook will have more than $100 billion of net cash by 2022, assuming no large acquisitions or significant increases in capital returns to shareholders (I don’t think regulators would approve the Instagram or WhatsApp deals today).
Based on those numbers, I think Facebook can earn $14 - $15 per share in 2022. If the business is worth 20x - 25x trailing earnings, that’s a stock price of $250 to $350 per share (that does not back out the net cash since I've already given them "credit" for it in the interest income assumption). If the stock reaches thoselevels, investors will earn 8% - 15% annualized returns over the next few years.
Disclosure: None.
