Facebook (FB) on July 24 reported financial results for its second quarter of fiscal 2019.
For the period, revenues increased 28% (and 32% in constant currency) to $16.9 billion. That was a sequential improvement from the first quarter and much better than the mid-single digit percentage decline that management had guided for. Growth was driven by a 33% increase in advertising impressions, with the average price per ad declining by 4% due to mix shift to Instagram Stories ads and geographies that monetize at lower rates (outside of the U.S.).
Adjusted for an additional $2 billion in legal expenses related to the Federal Trade Commission settlement (on top of the $3 billion accrued in the first quarter), operating expenses increased 39% to $10.3 billion. This was largely attributable to a more than 30% increase in headcount.
The outsized growth of expenses relative to revenues weighed on profitability, with operating income (Ebit) up 13% year-over-year to $6.6 billion (operating margins contracted roughly 500 basis points to 39%). Adjusted earnings per share increased by 14% to $2.0.
Daily active user (DAU) growth remained strong, reaching 1.59 billion in the quarter (up 8%). This has been fueled by growth in emerging markets such as India, Indonesia and the Philippines.
Yet, it’s worth noting that DAUs and MAUs in the U.S. and Canada increased slightly from a year ago (to 187 million users and 244 million users, respectively). As management noted on the call, the core Facebook app is showing stability in developed markets and growth in developing markets. This is important because the U.S. and Canada reported average revenue per user (ARPU) of roughly $33 in the second quarter – compared to a worldwide average of roughly $7 for Facebook.
Year to date, cash flow from operations increased by 27% to $17.9 billion. The pace of growth in capital expenditures has meaningfully slowed, with free cash flow in the first half of the fiscal year climbing 33% to $10.5 billion.
At quarter-end, Facebook held $49 billion in cash, cash equivalents and marketable securities (roughly $17 per share). It does not have any debt.
The company repurchased $1.1 billion of stock in the second quarter (and $1.8 billion year to date), with the share count declining by roughly 2% from a year ago. By comparison, it repurchased nearly $13 billion of stock in 2018, or more than $3 billion per quarter on average.
It is holding significant amounts of cash and generating roughly $20 billion a year in free cash flow (a number that continues to grow at impressive rates). In addition, it appears to remain unlikely that Facebook would receive regulatory approval for any large acquisitions (or would even want to test those waters), at least for anything anywhere close to its core business. For anything that fell well outside its core business, I’m skeptical that the money would be well spent.
That’s a long way of saying that I have no idea what Facebook plans to do with the tens of billions of dollars sitting on its balance sheet – along with the tens of billions in additional funds it will generate over the next few years. Based on its activity in the past year and a half, all you can assume at this point is that share repurchase activity will be sporadic and relatively immaterial. If the stock retested the levels reached in late 2018, there is little reason to believe management would aggressively repurchase shares. The same can be said for a special dividend. For that reason, I continue to question how much value an investor should place on the nearly $50 billion in cash sitting on Facebook’s balance sheet.
Conclusion
As noted on the conference call, better-than-expected top-line growth in the second quarter may prove temporary:
“Turning now to the revenue outlook. We executed well in the second quarter with a number of optimizations and product wins, particularly with the Facebook app that fell in our favor and helped combat the overall trend of deceleration. However, we continue to expect that our constant currency revenue growth rates will decelerate sequentially going forward. We also expect more pronounced deceleration in the fourth quarter and into 2020, partially driven by ad targeting related headwinds and uncertainties.”
As we look to the back half of the year and into 2020, it will be interesting to see what effect ad-targeting headwinds have on top-line growth. At the same time, we’ll see if the pace of expense growth starts to abate (or if not, how much further it takes down operating margins).
As CEO Mark Zuckerberg discussed on the first quarter conference call, he realizes that outsized growth in expenses is a relevant consideration for investors (“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”).
My thoughts have not materially changed from what I’ve said over the past few quarters. I own Facebook stock at current levels, but plan to head for greener pastures if it runs up another 20% or so from here. My lingering concern on key issues like capital allocation leads me to believe that this is unlikely to be a position I would want to own in size. Historically, I’ve found that this is a good sign I should have a short leash as the stock price approaches a price that I believe represents fair value.
Disclosure: Long Facebook.Ă‚
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