Facebook reported 3Q19 numbers recently. In general, they exceed consensus estimates very easily, with revenues of $17.65 billion outstripping expectations of $17.37 billion, and diluted EPS of $2.12 beating the estimated number of $1.76.
Importantly for a platform company that requires a ‘network effect’, the family of apps user metric (Facebook, Instagram, WhatsApp, or Messenger) also ticked up to 2.2 billion daily (from 2.1 billion) and 2.8 billion monthly (from 2.7 billion).
Yes, 2.2 billion people use one of FB’s products daily. That is actually stunning, but it is a metric that continues to grow.
Reported revenue growth was +28.6%, with constant currency growth of +31.7%. Again, very strong revenue growth for what is a $550 billion market cap company.
- User growth in the US and Europe has slowed sharply over the last three years, though monetization in these two markets (particularly for advertising revenues) continues to improve. User growth is now mostly coming from APAC or the ‘Rest of World’ region, where ARPUs (average revenue per user) are substantially lower, but beginning to trend higher. The monthly average users (MAU) of the platform now stands at 2.45 billion people — about 7.9% higher than last year.
- Global ARPU is $7.26, an increase of around 19% from 3Q18. As such, the vast majority of revenue growth is being driven by the monetization and no longer by growing the user base.
Beyond the revenue line, much of the current dynamics around profitability can be expressed by the following chart:
The solid red and blue lines represent the actual, absolute US dollar amounts of revenue and expenses (COGS + OpEx, excluding extraordinary items) over the last five years, whilst the dotted lines represent the growth in both (with percentages on the right axis).
Simply put, Facebook has seen expanding profit margins since late 2015, when revenue growth consistently exceeded profit growth up to the second quarter of 2018 — where the dotted lines cross again. This was the result where they acknowledged they need to step up investment in securing the platform, and the stock sold off aggressively over the following period. Current results still reflect this margin compression, but the pace of expense growth has slowed since peaking above 60% year-on-year in 4Q18. There was some concern on the buy side that FY20 will again see OpEx growth accelerate substantially, but the guidance seemed to imply expense growth around 35% — well below the ‘worst case’ concerns of cost growth north of 40%. This means margins will continue to compress, but as long as overall revenue growth remains well north of 20%, this should still translate into double digit profit growth. In that regard, one of the key factors we will have to monitor is topline momentum, as that will be critical for the market to support this narrative. At present, users, and by extension, advertisers, are not abandoning the platform, but the social issues around the platform will continue to garner headlines, particularly in a US election year.
Another way to monitor user stickiness is to track engagement, which can be done by dividing the daily average users by the monthly average users. Essentially, this metric is attempting to indicate what percentage of users of the Facebook platform of services (Facebook, Instagram, WhatsApp) use the service at least once a day, versus those who use it only on a monthly basis. US and European engagement has been slowly trending downwards for several quarters now, but this likely also has to do with the high penetration in those markets. (US MAUs have only grown by 3.4% over the last two years to 247 million, out of a potential user base of ~365 million in US and Canada combined.)
Looking at the result from a cash flow perspective, cash from operations (CFO) grew by 24.2% to $9.3 billion for the quarter, and cash conversion (cash from operations/adjusted net profit) remained very healthy at 152%. Free cash flow to the firm (FCFF) grew by 50% to $4.3 billion for the quarter, driven in part by the strong growth in cash flows and the slowdown of growth in CapEx spending. Even when extending the scope to cover the year to date, adjusted net profit is being converted to cash at an impressive 158% ratio, and CFO grew by 25.7% to $27.2 billion, with FCFF growing by 40.5% to $12.3 billion.
Finally, the balance sheet remains spotless, with the company sitting on ~$52.2 billion of cash and only $9.1 billion of debt. The debt is not related to actual issuance or bank funding – it’s effectively the property lease liability created by new accounting rules.
Despite this somewhat lazy balance sheet (never a bad thing, in my personal view), the company has generated a ROA (return on assets) of 18.4%, ROE (return on equity) of 24.4% and ROIC (return on invested capital) of 22.2% (when adjusting for the legal settlements they have entered into this year).
Clearly, the business is executing well. It will have some margin compression for a while yet, but the business model is delivering the excess returns on capital we look for in a structural compounder. The biggest risk is of the headline variety, spilling over into possible regulatory intervention at some point.
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Conclusion: despite the regulatory and headline risk, the company is executing well, and, most importantly, users and advertisers are still using the platform. Anything that threatens this dynamic is absolutely critical to our positive investment thesis, which is why doing the work to stay on top of the regulatory landscape is critical, as that’s where most damage can be done to the fundamental business model.
When it comes to valuation, FB appears cheap on all relevant metrics. This cheap multiple is most likely a reflection of market concerns about regulatory risk. In fact, in our research universe, on price-to-growth metrics, FB is undervalued.
On current consensus estimates, FB is trading on 21x FY20 EPS and offers prospective EPS growth of +21%. A PEG ratio of 1x. The EV/EBIDTA multiple is just 11.4x, remembering FB has around 10% of its market cap in cash. There is no dividend yield but there is an active stock buyback programme. Free cashflow is forecast at $21 billion in FY20.
From a technical perspective, FB has broken back above the 50, 100, and 200-day moving averages and looks set to challenge the all-time of $208.
This week has seen FB perform well on news they have developed payment tools for users and appear to be shying away from the controversial Libra cryptocurrency idea. Anything that the market feels lowers regulatory scrutiny on FB leads to the stock doing a little better.
FB is a top 5 holding in my AIM Global High Conviction Fund and has all the attributes of a sector dominant structural growth stock.
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