Facebook (FB) recently reported financial results for the first quarter of fiscal 2019.
For the period, revenues increased 26% (and up 30% in constant currency) to $15.1 billion. That growth rate is slightly better than the mid-single digit percentage decline that management guided for after the fourth quarter. Growth was driven by a 32% increase in ad impressions, with the price per ad declining by 4% due to mix shift to Stories ads and geographies that monetize at lower rates.
Adjusted for a $3 billion legal expense accrued in the quarter related to an ongoing Federal Trade Commission matter, operating expenses increased 34% to $8.8 billion. Updated guidance implies that expenses will increase 37-45% for the year, compared to a prior estimate of 40-50% growth.
The outsized growth of expenses relative to revenues weighed on operating income, which increased 16% to $6.3 billion. As a result, operating (Ebit) margins contracted 360 basis points to 41.9%. While that’s still a pretty healthy decline, it’s much lower than the 1,100 basis points of margin compression that we saw in the fourth quarter.
Assuming a 14% effective tax rate (in line with Q4), adjusted net income was $5.6 billion, with adjusted earnings per share climbing by a mid-teens percentage to $1.9 per share.
Daily active user (DAU) and monthly active user (MAU) growth remained strong, with both up 8% year-over-year (compared to a 9% increase in the fourth quarter). It’s worth noting that DAUs and MAUs in the U.S. and Canada were basically flat year-over-year at 186 million users and 243 million users, respectively (these regions generate significantly higher ARPUs and accounted for nearly half of Facebook’s revenues in the quarter). In addition, CFO Dave Wehner noted on the call that these figures “broadly [paint] the right picture in terms of engagement as well.” To me, that was one of the most important disclosures on the call – especially in light of recent reports that suggested a large number of users had deleted the app or stopped using Facebook altogether.
Capital expenditures in the first quarter were $4.0 billion, an increase of 41% from the first quarter of 2018 – a period when capex increased 121%. The huge ramp in capex is leading to a significant divergence between net income and free cash flow. Considering what management has said recently, I do not expect the growth in capex to abate anytime soon. For that reason, free cash flow is closer to Facebook’s true earnings power than net income.
At quarter-end, Facebook had $45.2 billion in cash, cash equivalents and marketable securities (roughly $16 per share). It did not have any debt. Cash from operations increased 18% to $9.3 billion, with free cash flow up 6% to $5.4 billion. Surprisingly, the company repurchased just $613 million of stock in the first quarter. By comparison, it repurchased $12.9 billion of stock in 2018, or $3.2 billion per quarter. As I noted above, it has much excess cash on the balance sheet, and it is generating material free cash flow.
In addition, it seems highly unlikely Facebook would receive regulatory approval for a large acquisition, at least for anything close to its core business. That’s a long way of saying that I have no idea why the company was not more aggressive on repurchases over the past six months as the stock fell from around $215 per share to a low of around $124 per share. This also makes me question how much value an investor should place on that excess cash sitting on the balance sheet.
For what it’s worth, here’s what Dave Wehner said at an investor conference in February 2019 when he was asked about the company’s capital allocation priorities:
“The focus really is on making sure we're making the investments to grow the business. So, first is how do we make sure we've got the capital to grow. Secondarily, we want to make sure that we have a strong balance sheet. We are in an advertising business that does have potential for risk in a macroeconomic climate that's less favorable. So, we want to make sure that we're in a good place from a balance sheet perspective and to be able to use capital strategically if we see opportunities there. So, we want to have a very conservative point of view on all those fronts.
But we have had an opportunity, given the strength of the balance sheet and the margins of the business, to look at share repurchases. And I'd look at those in two ways. One is, we are issuing shares as part of our compensation program. We want to offset that dilution with some amount of share repurchase. And then we see, opportunistically, opportunities to do more than that, and so we've been in the market from time to time. In the fourth quarter, we bought back $3.5 billion worth of stock, and in the whole year, we bought back $12.9 billion. And we've got a new $9 billion authorization. And so that puts us in a position to be able to still be able to look at offsetting dilution as well as to be opportunistic going forward.”
At this point, all I’ll say is that actions speak louder than words.
Conclusion
When I wrote about Facebook in February, I said the following:
“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.”
After the first quarter, I’m slightly tweaking my expectations: With the ramp in operating expenses starting to slow, I’m more confident assuming some margin expansion in the out years (after the reset to the mid-$30s).
Notably, CEO Mark Zuckerberg specifically addressed operating expense growth on the call, saying that the company will continue to make the necessary investments in areas like safety and product innovation for the long-term, but that he also realizes “I’m running a company and you don’t want to have costs growing at a much faster rate than revenues for a long period of time.”
I won’t go into the specifics of my model, but my fair value estimate is on the order of $200 per share (roughly in line with what I said back in February). The stock has climbed another 20% over the past two months, and I think the case for buying here is a bit less clear. I continue to own a small position, but I would consider letting it go if the stock ran another 10% or 20% from here.
Disclosure: Long Facebook.
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