I always look at equity investments from two different angles: (1) the quality of the company and its assets, and (2) the price of the stock. A less-than-impressive company can sometimes be a good investment if it passes criteria #2 but not #1. In these cases, the lower quality of the company or its assets is more than justly reflected in the stock price. Conversely, a good company can be a risky investment when it passes criteria #1 above, but not #2.
In my view, Facebook is an example of the latter.
At this point, I have no doubt in my mind that Facebook (NASDAQ:FB) is one of the most exciting and prosperous internet companies of the decade. The company has 1.6 billion monthly active users, or MAUs, on its flagship platform - a mind-boggling 23% of the entire planet's population. Add (and overlap) the user base of its other platforms (WhatsApp, Instagram and Messenger), and we are looking at 3.8 billion MAUs under the FB umbrella. Also, when it comes to FB, there is no shortage of innovation that could lead the company down a number of different paths over the next 10-15 years. Think about the applications of Aquila, FB's solar-powered aircraft designed to beam internet from the sky, or the company's Artificial Intelligence work that could be employed in image recognition and language learning, just to name a few.
But I'm an investor and an analyst. When it comes to searching for an attractive return for my money, I need to ensure that I am buying stocks at a low enough price to justify my investment - i.e., at a discount to what I perceive to be fair value. This is when the inner geek in me, fascinated by the technological advances introduced by companies like FB, gives way to the cold number-cruncher looking for alpha returns. And this is when I turn sour on FB.
The company currently trades at 32.5x forward (2016E), or about 45x trailing non-GAAP (2015) earnings. These numbers, in isolation, do not tell me much about whether FB is a cheap or expensive stock. After all, the company is still in its infancy or teenage phase, and I expect it to continue to grow aggressively over the next couple of, or maybe few, years. It is much easier to value the equity of a stable and mature company than it is to value the equity of a high-growth one.
So, to assist me in my analysis, I turn to the peer group. Not to Google (GOOG, GOOGL) or LinkedIn (NYSE:LNKD), but to the old technology titans that were once on the same high-growth path that FB is currently on, but that now, 15 years or so later, are the mature and established tech companies I expect FB to be about 15 years in the future. I am thinking Cisco (NASDAQ:CSCO), Oracle (NASDAQ:ORCL) and Microsoft (NASDAQ:MSFT). Yes, as unexciting as a company like CSCO might sound today, remember that it was once regarded as the builder of the internet's infrastructure.
As the table below indicates, this select "old-tech" peer group currently trades at a median forward P/E of 13.4x, and the companies are expected to grow their EPS next year at a median rate of 8.8%. But how were these stocks trading, and how were these companies expected to grow their bottom lines at the height of the Internet bubble (1999 and 2000), when valuations and growth expectations ran rampant? As the table suggests, the same peer group traded at a much higher median P/E of 82.2x, while EPS grew at a median 47.2% between 1999 and 2000.
Source: DM Martins Research, sourced from Company Reports and Yahoo Finance
The key takeaway from this quick analysis is that CSCO, ORCL and MSFT, in their infancy, resembled FB in terms of growth and valuation. And I believe FB, at maturity, may very well resemble the CSCO, ORCL and MSFT of today: that is, EPS growth in the high-single digits and valuation in the low teens.
So, back to FB's valuation question: at $102.10 per share, is it a good investment? First of all, I generally consider a stock a good buy when it trades at about 25% discount to fair value. Much less than this, and I might as well put my money in a well-diversified fund, like the SPDR S&P 500 Trust ETF (NYSEARCA:SPY). So to buy FB, I must believe that the stock is worth about $135 per share ($102.10 is roughly 75% of $135). At a 13.4x median P/E, the company in a "steady and mature" stage must, therefore, generate about $10 in EPS for a $135 stock price to be justifiable.
Can FB generate $10 in EPS in a "steady and mature" stage?
Last year, FB delivered $2.28 in EPS on a non-GAAP basis ($1.29 GAAP). To achieve $10 in annual EPS, therefore, the company needs to increase earnings four-fold by the time it reaches maturity. Let's look at the following pro forma income statement and do some math.
Source: DM Martins Research, sourced from Company Reports
In 2015, FB's average MAU reached 1.32 billion sets of eyeballs, peaking at 1.59 billion in December in a clear upward trend. How many monthly users can FB attract, in a steady and mature stage? How about 100% of the world's population of a certain age group that is capable of consuming beyond its basic needs for food and shelter - i.e. anyone in the world who advertisers might have an interest in reaching out to and doing business with? I think this estimate is extremely aggressive, but plausible.
The world population today comprises approximately 7.2 billion individuals. According to the U.S. Census Bureau, it is expected to grow at not much more than 0.5% per year over the next 35 years. So, let's call it flat in the medium and long terms, only to keep the math as simple as possible. Of this total, six billion people fall within the very broad age group of 10-89 years old. They can all be potential targets of advertisers willing to pay a company like FB for its viewers' attention.
Now, let's strip out from the six billion initial target audience those who live in poverty and extreme poverty. Even if this group is ever given reliable access to a computer connected to the internet, they are unfortunately unlikely to provide any monetary value or compensation to the great majority of advertisers willing to pay ad fees to FB. DoSomething.org, using compiled information from sources like the United Nations, UNICEF and the World Health Organization, reports that three billion people live on less than $2.50 per day (i.e., in poverty and extreme poverty), 1.6 billion people do not have electricity and 800 million do not have enough food to eat.
Given the statistics above, I find it hard to believe that more than 3.5 billion people worldwide will, over the next decade or two, ever become FB users with enough purchasing power to attract the interest (and the marketing dollars) of advertisers. However, to stress-test the model, I will assume that this is a possibility. In MAU terms, I am willing to accept that FB could more than double its monthly viewership, from 1.59 billion in 4Q15 to 3.5 billion, upon reaching a maturity stage.
Next, I turn to ARPU. In all of 2015, the company generated $12.95 in revenues per MAU, an impressive achievement. As the top graph in the set below indicates, the quarterly ARPU has been increasing significantly, from $2.14 in 4Q13 to $3.73 in 4Q15 (a 74% total increase over two years), after having moved down in 1Q15 and 2Q15 from a previous peak.
Source: Company's December 2015 10-K
Forecasting what the annual ARPU could be in about 15 years is a tough exercise. I see two opposing forces at play: on the plus side, FB owns 3 large platforms (WhatsApp, Instagram and Messenger) that create comparatively little revenue today, but that have significant revenue-generation potential in the future. This is not to mention Oculus and other side ventures that could become more materially profitable in the long run. On the other hand, the company has been growing its MAU base much faster in the Asia-Pacific (81% cumulative since 4Q12) and Rest of World (67% cumulative since 4Q12) regions, compared to 8% and 24% for North America and Europe, respectively. The problem is that the first two regions generated quarterly ARPUs of only $1.59 and $1.22 in 4Q15, respectively, versus the latter's $13.54 and $4.50. As FB's user base continues to grow faster in developing countries, the total company's ARPU is likely to decrease as a result of the revenue mix shift.
In my model above, I portray my belief that the net impact of these two opposing forces will result in ARPU that could be 50% higher than today's levels - $19.43 per year in the far future versus $12.95 in 2015. I understand that this assumption could be aggressive considering FB's current business model, but I try to account for the potential upside the company's other platforms could generate.
Assuming the above and that FB is able to maintain operating margins in line with 2015 levels (an astounding 56%), I calculate that the company might be able to generate $9.10 in EPS in a mature stage of its existence. Valued at 13.4x earnings, the stock would be worth, even under my relatively aggressive assumptions, $122 per share. Not too bad, but also not enough for me to be compelled to buy the stock at current levels. And I find the chances that I may be overstating FB's future EPS to be significant.
Could my assumptions be too conservative? Final words.
Notice that my conclusion above is rooted in a set of assumptions that can easily be challenged by a more optimistic and imaginative investor. For example, will FB rely as much on ad revenues in the future as it does today? Could Virtual Reality or Artificial Intelligence fundamentally change the company's business model and allow it to tap into broader and deeper sources of revenues? Could FB improve its already impressive margins through productivity improvements?
These are all possibilities. However, as an analyst, I must work with the information that is available to me today. And as an investor, I feel compelled to put my money where I believe there is a high likelihood that I will find alpha returns. I do not believe that FB is such a place.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within 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.