Facebook's Margins Will Drive The Next Leg

| About: Facebook (FB)

Summary

Facebook has taken a dive since Q3 earnings were released.

If you know Facebook's history, this is a time to accumulate and not a time to sell.

The market isn't pricing in the payoff of an investment year.

With Facebook (NASDAQ:FB) taking a nice dive in the last two weeks, I decided to read a few extra Facebook articles, including going back to my own business overview of FB to assert if this pullback is opportunity knocking or a harbinger to a bleak future for the company.

As I was reading - my article in particular as well as its comments - it dawned on me: Even if revenue does slow, the huge expansion of margins is going to drive an extremely profitable future for many quarters. It almost became habit to overlook how easily and how much further Facebook can expand margins to drive serious bottom-line growth with how well revenue has grown.

In plain English, where most growth companies focus only on revenue growth and expect profits later, Facebook is not only able to drive huge numbers on the top line, but also it operates so efficiently (read: software margins) it can turn a large profit naturally.

With Facebook saying - again - it will be an investment year next year, it means much of its revenue will hang a left and go right back into the company. This means the company will continue to work on its products to bring in users, as well as revenue, but much of the cash flow will be used to repeat the cycle.

That's the part that excites me as an investor in the company. When FB declared 2015 an investment year, it didn't actually slow Facebook, the company, down. Sure, the earnings beats weren't nearly as blowout as they were or as they are this year, and the stock didn't move 15% the day after each earnings as it was used to, but the fact is the company's investment into itself has never returned void.

I'm not worried about slowing revenue. With the company having driven revenue at a rate of over 50% in each of the last four quarters, along with an expectation of 46% growth for Q4, it really all depends on what "slowing revenue" really means.

Wall St. seems to think 40-42% revenue growth is still possible for Q1 and Q2. It definitely fits the definition of slowing, but is it really calling for the sky to fall?

I think not.

FB Profit Margin (<a href=

What I'm focusing on is Facebook's ability to invest and produce an even greater result on the other side than it did going in. As the company invested in 2015, it spent more on investments and R&D, so margins suffered. But, when Facebook exited the investment year, its margins expanded dramatically to the highest they have ever been.

It is a testament to its ability to create meaningful drivers of growth and not only bring in more revenue, but also make the drivers extremely profitable.

The way the market has reacted to this "warning" of slowing revenue and another investment year is in stark contrast to my conviction to now hold on to my shares longer than I originally planned. The market likes results quick and not two year out results. This much is clear by the subsequent decline in Facebook's share price following earnings a couple weeks ago.

However, for long-term investors like myself, it means the company is setting up 2018 to be hugely profitable and contain products and growth drivers, which are far more mature and monetized than they are today.

All this talk about investment and growth reminds me of an article I wrote in June of 2015 directly in the middle of another investment year. It is apparent to me much of the same bearish sentiment has made a return. To me this is odd.

If anything, Facebook has already proven it is able to invest and bring about profitable results, something not yet proven in my 2015 article. So when the company says 2017 will be another investment year, I am convinced as an investor to hold tight and watch what comes from it. Past results are no indication of future performance, this much is true. But I'm not just talking about financial numbers; I'm talking about the entire business model and operation of the company. With the same management team at the helm, it then makes a good case for why this next investment year should turn out to be just as good - if not better - than the previous one.

We can discuss P/E ratios, PEG ratios, and forward P/E ratios all day long, but none of those can be used singularly when a company, which owns the best products in social media, has a proven track record of high-margin outcomes.

Think about it this way: If the company issued a statement it is cutting back R&D and nearly all spending it would in theory drive net income through the roof and the stock should respond by soaring.

Or would it? Or, instead, should it?

I'm looking at this from a very positive viewpoint. The company, which can successfully invest in itself to drive greater profits, just a few weeks ago issued it was going to invest in itself more. So naturally profits will lag a bit during this coming year and costs will rise. But that should send the stock flying as it created an extremely profitable last three quarters for the company when it did it last time.

What is evident is the market is pricing Facebook to slow down next year. What the market is not pricing in is Facebook to accelerate the year after. This is why I take the side to buy Facebook on the dip, not to sell on the dip. In my case, I will continue to hold my shares and realize further outsized returns come this time next year and the year after.

If you'd like to be made aware of my opinion and analysis in the future on Facebook and other tech companies, then I encourage you to follow me by clicking the "Follow" link at the top of this page next to my name.

Disclosure: I am/we are long FB.

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.