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Summary

  • Facebook’s Q1 earnings report sparks confidence in the company’s ability to generate strong growth in 2014 and beyond.
  • Whatsapp, Instagram and Creative Labs may become major growth contributors in the next few years.
  • My year-end price target of $90 is based on a 2014 EV/EBITDA ratio of 30.
  • Facebook has shown significant relative strength, as it has fallen far less than its peers, and it should lead the next market uptrend.

Facebook (NASDAQ:FB) has been trading in a tight range since the end of March, a consequence of a strong selloff in the internet and momentum space. Facebook's share price has been quite resilient, since most of its peers have taken a beating since early March (just look at the price charts of LinkedIn (NYSE:LNKD), Twitter (NYSE:TWTR) and Social Media ETF (NASDAQ:SOCL). This shows that the stock is under accumulation, and that it is preparing to be the leader of the next uptrend. The recent quarterly report has shown that the business momentum continues to be very strong, and that the future might be better than was previously anticipated.

Instagram, Whatsapp and Creative Labs - long-term growth drivers

Facebook has continued to surprise investors when it reported Q1 earnings and revenue ahead of expectations. The Q1 report shows that the strong momentum of the company's business should be sustained through the rest of 2014 and beyond. Facebook's CEO Mark Zuckerberg indicated on the Q1 conference call that the company has various apps which are at different stages of maturity. The core Facebook app is an "essential sharing infrastructure for the world" and the company has strong momentum in this maturing business, as the most of the growth is coming from mobile.

On the other hand, Messenger, Instagram and Whatsapp are going to be powerful growth drivers in the future. The company is focusing on driving user growth in these apps, and monetization is not a near-term priority, although there are initial monetization efforts, especially on Instagram, which may become an important advertising platform for the company in the future, as it is very visual by nature which may be of great value for potential customers. The recently announced mobile ad network is also an important step for the company's growth going forward. The mobile ad network will allow app developers to deliver targeted ads based on Facebook data and activity. This will certainly be a big opportunity for Facebook and its customers, as the mobile ad network will provide marketers and developers a greater reach and improve the relevance of the ads.

The third part of the product pipeline comes from Creative Labs which is in an earlier stage of development. The company is looking to rapidly launch new products and then refine them based on the community feedback. "Paper" is the first app from Creative Labs and the company is pleased with the initial response by users.

It is evident that Facebook is working hard on delivering long-term growth for its shareholders. I think that as soon as one major growth driver starts slowing down, others will take its place. Since mobile is the largest single growth driver for the company right now, I expect that the robust pipeline of products (Messenger, Instagram, Whatsapp, Creative Labs) will eventually start to monetize their platforms and drive the long-term growth of the company and its share price. Facebook is becoming a very powerful and influential company, and I see significant growth potential for the company going forward.

Valuation and price target

Facebook's EV/EBITDA ratio has contracted significantly in the previous two months. Since August 2013, Facebook has traded at a TTM EV/EBITDA ratio between 45 and 55, and the stock is currently trading at 29x its TTM EBITDA (the ycharts graph below shows the ratio at 35, but it has not calculated the Q1 results which boosted the TTM EBITDA by 17%). This is a serious contraction, and it points to expectations for lower growth in the future. Management also said on the conference call that they expect tougher year-over-year comparisons in the second half of the year. However, a solid product pipeline and the probable management conservatism should provide upside to current consensus estimates. In fact, consensus estimates have moved significantly higher after every earnings announcement since the summer of 2013. Facebook has significant growth potential, and the company may just be starting to take advantage of its massive user base, and even though the growth might slow down in the next couple of quarters, it will stay at a level that should justify the current valuation.

(click to enlarge)

Source: ycharts.com

Based on the previously stated facts and opinion, I expect Facebook to deliver 2014 EBITDA above $8 billion, as opposed to the current consensus of $7.4 billion. The company delivered earnings that were 15% to 41% above analyst expectations in the last four quarters, and my estimate is only 8% above the current consensus, and we have three more quarters until the end of the year. This leaves room for substantial upside for expectations going forward, and my estimate might prove as conservative too.

Based on these metrics, Facebook is currently trading at 20.4x its 2014 EBITDA, and 18.9x based on my EBITDA estimate for 2014. I believe that the potential growth slowdown is not going to be severe, and Facebook should deliver revenue growth above 40% in the rest of 2014 and at least 30% in 2015. This is pretty much in line with the current consensus estimates, and there is room for upside if the company pushes forward with monetization of its earlier stage platforms, which will likely be the key growth drivers in 2015 and beyond.

According to these assumptions, Facebook should easily keep its current valuation, which translates into 47% to 60% upside from the current price. That is how I arrived at a $90 price target. Should Facebook keep surprising on the upside, the stock could easily rise above $100 based on my ratio target.

Downside should be limited to 2014 EV/EBITDA ratio of 15, which translates into 20% to 25% downside from the current price. Investors have an asymmetric reward/risk investment proposition here, and the reward risk ratio is at least 2 to 1 at the moment.

Facebook should lead the next market uptrend

A look at the charts of Facebook and its major peers and social media ETF reveals the strength and resilience of Facebook's stock price. This means that investors are reluctant to sell Facebook, while they were readily selling their stakes in LinkedIn, Twitter and other social media and internet companies. This relative strength shows that Facebook might lead the next market uptrend, as one of the most innovative growth companies in the world. The sustained fundamental momentum should translate into strong share price momentum once the general market consolidation ends, and once the new uptrend starts.

(click to enlarge)

Conclusion

The recent selloff in momentum stocks has created a compelling buying opportunity for Facebook investors. The company could be trading north of $90 by the end of 2014. The strong product pipeline and the inherent strength of the current and maturing businesses should help the company to keep growing earnings and revenue significantly in the future. Facebook has also shown relative strength over its peers and should lead the next market uptrend.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in FB over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Source: Why Facebook Should Be Trading At $90 By The End Of 2014