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The Science of Hitting
The Science of Hitting
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Facebook: An Attractive Asset at a Reasonable Price

A look at the company's 3rd-quarter financial results

November 01, 2019 | About:

Facebook (NASDAQ:FB) recently reported financial results for the third quarter of fiscal 2019.

For the period, revenues increased 29% (and up 31% in constant currency) to $17.7 billion. That growth rate was roughly comparable to what the company reported in constant currencies in the first half of the year. Ad impressions increased 37%, with the average price per ad down 6% (mix shift to stories and geographies like India, Indonesia and the Philippines that monetize at much lower rates than the United States). As noted on the call, ad impression growth was primarily driven by Facebook News Feed, Instagram Stories and Instagram Feed (“core feed products for Facebook and Instagram are growing nicely”). As shown below, Facebook is on track to generate more than $70 billion in revenues this fiscal year – a five-fold increase from five years ago.

Daily active users (DAUs) were up 9% in the quarter to 1.62 billion, with worldwide average revenue per user (ARPU) up 19% year over year and U.S. & Canada ARPU up 25%. As a reminder, DAU only measurers users on Facebook and Messenger, not Facebook’s other properties (Instagram and WhatsApp). As noted on the call, there are now around 2.2 billion people around the world using Facebook, Instagram, WhatsApp or Messenger every day on average, which is up from more than 2 billion at the start of the fiscal year. Despite media reports suggesting otherwise, it’s clear that the company’s platforms continue to attract engaged users.

Facebook is starting to do a better job controlling expenses, with operating income (Ebit) in the quarter climbing 24% year-over-year and Ebit margins contracting 140 basis points to 40.7%. Through the first nine months of the year, operating income has increased 18% on a 230 basis points contraction in margins (adjusted for the $5 billion Federal Trade Commission settlement).

The company ended the quarter with $52.3 billion in net cash (roughly $18 per share). Year to date, cash from operations has increased 26% to $27.2 billion, with free cash flow climbing at a faster pace (up 35%) on a slowdown in capital expenditures growth (that is expected to continue, with capital expenditures growing by 10% to 15% in fiscal 2020). As shown below, the cash sitting on the balance sheet has ballooned over the past few years.

Despite this, the company appears uninterested in increasing capital returns to shareholders. They’ve only repurchased $2.9 billion in shares year to date, or roughly 30% of what they spent over the same period in 2018. As I’ve noted in the past, I continue to be baffled by the company’s capital allocation decisions.

Conclusion

The company’s ability to sustain roughly 30% revenue growth on a growing base is impressive. And as we think about the years ahead, as well as the results the company has posted so far in 2019, I’ve concluded that the mid-30’s operating margin that they’ve discussed is simply too low (as you think about the 2020 expense guidance, note that they have a history of coming out with a big number and then cutting it back over the course of the fiscal year). There’s no reason why this business, with a revenue base that will probably double over the next five years (and that’s probably low), should not be able to generate higher profit margins. That’s a long way of saying that I think we are more likely to be around 40% to 45% in a few years than we are to be at 35%. For what it’s worth, here’s what the margin progression has looked like in the past few years.

As I look out over the next five years, I can see a reasonable scenario that leads to Facebook generating roughly $16 per share in earnings. In addition, my model also results in the company holding around $40 per share in net cash in the terminal period (I assume that free cash flow will be equal to 65% of net income, with about 40% of free cash flow being spent on share repurchases).

That setup leads me to conclude that the stock is still quite attractive at a current price of $190 per share. That said, I still have some lingering concerns, particularly around capital allocation and the risk inherent to this business over the long run (beyond what’s captured in my financial model). For those reasons, I plan on keeping this as a relatively small position in my portfolio.

Disclosure: Long Facebook.

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About the author:

The Science of Hitting
I desire to own high-quality businesses for the long-term. In the words of Charlie Munger, my preferred approach is "patience followed by pretty aggressive conduct." I run a concentrated portfolio, with the top five positions accounting for the majority of its value. In the eyes of a businessman, I believe this is sufficient diversification.

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