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The Science of Hitting
The Science of Hitting
Articles (488) 

Thinking About Facebook

Some thoughts on Facebook's future

July 31, 2018 | About:

Facebook (FB) recently reported second quarter results for fiscal 2018, and the numbers were impressive. Revenues increased 42% (up 38% in constant currency), with daily active users (DAUs) and average revenue per user (ARPU) up 11% and 26%, respectively. The increases in ARPU were broad based, with the company’s most important region (U.S. and Canada) reporting 34% growth. For the quarter, average ad prices and ad impressions increased by 17% and 21%, respectively.

Outsized expense growth resulted in some margin compression, but operating income still increased by 33% over the prior-year period (with EBIT margins falling to 44%). Diluted earnings per share were up 32% in the quarter (to $1.74) and have increased 45% over the first six months of 2018.

Companies a fraction of Facebook’s size would love to report these growth figures. The fact that FB is doing this off a revenue base of more than $40 billion makes it that much more impressive.

The problems for Facebook came on the conference call – specifically when CFO Dave Wehner started discussing forward guidance. Here’s the first notable comment he made:

“Our total revenue growth rate decelerated approximately seven percentage points in Q2 compared to Q1. Our total revenue growth rates will continue to decelerate in the second half of 2018, and we expect our revenue growth rates to decline by high-single digit percentages from prior quarters sequentially in both Q3 and Q4.”

For a company that has consistently reported 40%+ revenue growth, that’s a disappointment (albeit an inevitable one as the company kept growing). As I noted earlier, revenues increased 42% in the second quarter. Assuming high-single digits means eight points, that implies 34% revenue growth in Q3 and 26% revenue growth in Q4. With those assumptions, revenues will increase by ~36% in 2018 to $55.4 billion. Again, it’s hard to view significant growth on a $40 billion base as a disaster.

Despite the slowdown in sales growth, management still expects expenses to increase 50-60% in 2018. At the midpoint (and using the revenue number from above), that implies around $23.6 billion in operating income in 2018 (EBIT margins of about 43%).

Here’s the second notable comment that CFO Dave Wehner made on the call:

“Looking beyond 2018, we anticipate that total expense growth will exceed revenue growth in 2019. Over the next several years, we would anticipate that our operating margins will trend towards the mid-30s [the expectation is that it would take more than two years to get there].”

This is the number that really surprised me. That’s 1,500 basis points lower than Facebook’s EBIT margins in 2017. In addition, it’s a change in the trend (Facebook’s margins have been expanding over the past couple of years). Prior to this earnings call, my assumption was that Facebook would be able to sustain 40% or higher EBIT margins, and maybe move back towards the high bar it set in 2017 as it digested the incremental cost of safety and security “investments.” Based on what management had to say, that now seems like an erroneous assumption.

Here’s why I struggle with the EBIT margin guidance. If you assume Facebook can increase revenues by around 15% per annum over the next couple of years (2019 to 2022), it will reach about $97 billion in annual revenues. I chose that number because it roughly approximates the pace of online advertising revenue growth over the past five years in the U.S. (there are numerous reasons why I think Facebook will grow faster than the overall market, but I'll err on the side of caution). For what it’s worth, that estimate is well below what I’ve seen from multiple Wall Street analysts.

If you accept that assumption, 35% EBIT margins on $97 billion in sales would equal $34 billion in operating income. Inversely, that implies more than $60 billion in expenses (COGS + OpEx). This suggests that Facebook’s run rate expenses will more than triple from 2017 to 2022. Over that same period, these assumptions would result in cumulative revenue growth of around 140%.

Let me give you one example to show just how much money we’re talking about here (over $40 billion in annual expenses). It’s assumed that Facebook will need to hire many people for its safety and security efforts. If it adds an additional 20,000 employees and pays them $200,000 each (not a bad salary!), that would cost them $4 billion a year. For some context, Facebook announced back in October that it planned on hiring an additional 10,000 safety and security personnel by the end of 2018. I’ve tried to give them plenty of room, and this still only covers roughly 10% of the incremental costs we need to account for to push operating margins to the mid-30s.

Here’s my point: I have a tough time understanding how Facebook can possibly need to spend this much money. It seems to me that this is largely a choice, not a necessity.

Facebook has specifically noted certain areas (like AI, Oculus and others) where the investments being made today are not necessary to support current operations. In those situations, I think GAAP accounting understates normalized profitability (no matching between expenses and revenues). The hard part is trying to intelligently break up this incremental spend between maintenance and growth. At this point, it probably cannot be done (at least not by anybody outside the company).

Said differently, if you’re going to invest in Facebook, you better hope that Zuckerberg and the management team will make intelligent capital decisions with the prodigious cash flow that is being generated by the business. It’s worth noting that the company’s financial strength also gives it the leeway to make strategic decisions that it believes are healthy for the business over the long run (for example, driving traffic from the news feed to Stories). Those kinds of decisions may reduce short-term revenue or earnings growth, but that’s a price worth paying if it widens the moat.

For what it’s worth, I don’t think Facebook is particularly expensive at current levels. If we assume that roughly 35% of net income will be used for share repurchases over the next few years, they can reduce the share count by about 1% per annum (I include a sizable buffer to account for the impact of stock-based compensation). In addition, assuming no other large cash outflows (further M&A is unlikely to pass regulatory muster), Facebook should have more than $100 billion in net cash by 2022. I assume nominal interest income (about 2% per year) on that cash pile, which brings operating income to $36 billion in 2022 (35% margins on $97 billion in revenues).

From there, with a mid-teens tax rate (which management has guided to for 2018), we’re left with ~$30 billion in net income on 2.8 billion shares. That implies EPS in 2022 of nearly $11 per share. Depending on the discount rate and terminal multiple used, I end up with a “zone of reasonableness” at $140 - $180 per share (as always, these are rough estimates). Long story short, I think the market is pricing in something like 35% margins and mid-teens revenue growth over the next few years.

Depending what you think of the above assumptions, Facebook could be a reasonable investment at current levels (I don’t own it at this point, but that might change). That’s especially true if you think run rate operating margins will be well above 35% or revenue growth will exceed 15% per annum. If either of those things happen, I think you will do quite well with Facebook from current levels.

Disclosure: none.

About the author:

The Science of Hitting
I'm a value investor with a long-term focus. As it relates to portfolio construction, my goal is to make a small number of meaningful decisions a year. In the words of Charlie Munger, my preferred approach to investing is "patience followed by pretty aggressive conduct." I run a concentrated portfolio, with a handful of equities accounting for the majority of its value. In the eyes of a businessman, I believe this is sufficient diversification.

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Comments

naresh23
Naresh23 - 2 weeks ago    Report SPAM

Good write up!

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