Facebook (FB, Financial) recently reported fourth-quarter results for fiscal 2018. Revenues in the quarter increased 30% to $16.9 billion, which was quite a bit better than the high single-digit sequential decline management guided for. For the year, revenues increased by 37% to $55.8 billion.
Despite media reports suggesting the contrary, daily active users (DAU's) and monthly active users (MAU's) on Facebook continue to growth, with both metrics up 9% year-over-year (MAU and DAU trends in the U.S. and Canada remained consistent with recent quarters). As noted on the call, 2.7 billion people now use Facebook, Instagram, WhatsApp or Messenger each month and more than 2 billion people use at least one of those services every day. In addition to user growth, the company reported a 19% increase in average revenue per user (ARPU), primarily driven by an increase in ad impressions on Instagram (Stories now has more than 500 million DAU's, up 25% since June 2018).
As I noted in a July article about Facebook, the story changed when the company guided for a significant increase in operating expenses that would result in material margin compression (from Facebook's second-quarter conference call: “Over the next several years, we would anticipate our margins will trend towards the mid-30s”). That played out in the quarter, with operating margins coming in at 46% - down 1,100 basis points from the year ago period. As a result, operating income only increased by 6% in the quarter.
For the year, operating income increased 23%, with EBIT margins declining by 500 basis points to 45%. Adjusted earnings per share (EPS) increased at a comparable rate, coming in for the year at $7.6 per share.
I question whether that EPS figure is actually representative of Facebook’s earnings power. I say that because of the material step up in capital expenditures we’ve seen in the past few years. In 2018, CapEx more than doubled to $13.9 billion. And it looks like this will continue: For 2019, management guided to $18 billion to $20 billion in CapEx, implying nearly 40% growth (by comparison, revenues will probably increase at about half that rate). At the midpoint of guidance, 2019 CapEx will be 4.4x larger than depreciation & amortization expense for 2018. If you assume run rate depreciation & amortization will be roughly $5 billion higher than what Facebook reported in 2018 (which doesn’t seem crazy to me), operating income for 2018 would’ve been 20% lower. This isn’t immaterial. Put another way, Facebook’s free cash flow conversion rate was only 70% in 2018 ($15.4 billion in free cash flow on $22.1 billion in net income). That is well below the average of the previous five years. Based on guidance, I do not expect FCF conversion to improve anytime soon.
With that said, Facebook’s astounding financial success puts it in a position where it can afford to foot this investment ramp. In addition, there may even be business opportunities that arise from this investment over time (from its fourth-quarter conference call: “Across all of our platforms and formats, we're investing in AI to make ads more relevant and effective. In Q4, we developed new AI ranking models to help people see ads they're more likely to be interested in … Looking ahead, we see more opportunities to use AI to keep people safe on Facebook and help businesses grow”).
But what has become increasingly clear to me is that this investment is a necessity (at least in management’s eyes). What has also become clear is they're covering a lot of ground. Consider what CEO Mark Zuckerberg said in his opening remarks on the call (bold added for emphasis):
“For the past couple of years, most of our focus and energy has gone into addressing some of the biggest social issues around the future of the Internet, including election integrity, content governance, safety and security, data privacy and digital well-being. And these are all complex issues but we've made real progress. In many of these areas, we believe we built the most advanced systems in the world and, in many cases, more advanced than any other company or government. And in other areas, we have clear road maps now for our work ahead.
Still, there's a lot more to do, and I expect it will take strong execution through 2019 and beyond before we get all our systems to the level that we need. But we've fundamentally changed how we run this company … We just finished a year of very heavy investment to get these systems [that can proactively identify harmful content] to a better place ... We ended 2018 with more than 30,000 people working on safety and security, up from 10,000 people a couple of years ago. This work will never be finished, but I now believe we've built some of the most advanced systems in the world for dealing with these issues.”
Here’s my takeaway: 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, one of the key questions is whether run-rate margins will be closer to the mid-30s (what the company guided for on the second quarter 2018 call) or closer to 50% (the reported result for fiscal 2017). Obviously, this has a big impact on the stock price. Based on 2019 guidance and what management has said about these investments, I’m of the opinion that we’re more likely to be end up near 35% EBIT margins than 50% EBIT margins, even three to five years out (“As we look out beyond 2019, we'll have expense growth more in line with revenue growth”).
In addition to my concerns around capital expenditures and margins, I’m also starting to wonder about the company’s approach to capital allocation. For example, Facebook spent $13 billion on repurchases in 2018. However, the pace of spend slowed materially in the fourth quarter -- despite the fact that the stock price declined significantly from the third quarter. Simply put, this does not make any sense to me. The lack of any discussion about this on the call isn’t encouraging either.
And it raises an important question for the future: Considering that Facebook is already sitting on $41 billion in net cash and will probably generate $90 billion to $100 billion in free cash flow over the next five years, what will it do with all this money? I do not believe a sizable deal is in the cards. Given that assumption, it seemed they would instead lean towards repurchases. All I can say now is if they plan on making repurchases a primary use of free cash flow, they should have acted in a big way when the stock went from $215 to $125. There’s nothing I can see that explains why Facebook would suddenly pull back after aggressively repurchasing shares in the third quarter.
Conclusion
As it relates to my model, I now assume lower free cash flow conversion than I did a few quarters ago (which primarily flows through as less aggressive repurchase activity). On the top line, I assume revenue growth continues to decelerate to a mid-teens rate (roughly in line with the pace of growth in the online ad market in the U.S. over the past five years). In addition, I assume the company ends up with operating margins in the range of 35 - 40%. Finally, I assume 70% of free cash flow is used to repurchase shares, along with a terminal multiple of 16x to 20x earnings. With those assumptions and a 9% discount rate, I end up with a fair value estimate in the range of $160 to $200 per share.
For full disclosure, I’ve held a small stake in Facebook over the past few months. At current prices, I’m unlikely to do any buying or selling. If the stock keeps climbing towards the high end of my fair value estimate, it’s likely that I would close out the position.
Disclosure: Long Facebook.
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John Rogers' Ariel Investments January Commentary
