Facebook's Profitability Has Further Room To Grow

| About: Facebook (FB)
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Summary

Facebook has developed methods to keep capital costs down.

This translates into improved profitability.

Facebook's management team also has other cost levers to meet quarterly earnings targets.

For those reasons, the long-term growth rate looks relatively attainable.

Facebook's (NASDAQ:FB) VP of Infrastructure Jason Taylor went into much greater detail about company efforts to reduce capital spend by improving efficiency in Facebook's datacenters. More efficient facility design, standardization of rackmount servers, less overhead and efficient component use were mentioned by Jason Taylor throughout the Credit Suisse 2014 annual technology conference.

Better facility and system design along with less overhead should translate into net profit expansion for Facebook. This will make it significantly easier for Facebook to grow its EPS going forward. The current five-year consensus earnings growth estimate is 36.36%. The growth trajectory looks relatively attainable as a result of improving profitability and revenue growth.

Jason Taylor (Facebook VP Of Infrastructure) goes onto mention how power efficient Facebook's datacenters are:

Now at Facebook, because we've designed our own servers and both servers and data centers that heat tax is only 7%, which means that we are using cold air from the outside, we're not chilling air at all. We're passing it across the servers, mixing it in a hot aisle and then evacuating it out the other side of the building. So in terms of raw thermal efficiency our data centers are second to none.

Datacenter cooling is one of the biggest on-going costs. In this case, Facebook mentions that it's not chilling air at all, which means that it's not running massive AC units.

Source: Intel

As you can tell, in Amazon's TCO (total cost of ownership) analysis, the cost of cooling makes up a huge chunk of the total cost of owning a server. In this case, Facebook mentions that the cooling aspect of its datacenter operation is extremely efficient, and by reducing this cost, the company is able to return to shareholders an even greater amount of profit or plough the cash into more productive areas like R&D, M&A and SG&A.

Source: YCharts

Source: YCharts

Clearly, Facebook's efforts are paying off, as the gross profit margin has improved significantly over the trailing-twelve-month period.

Also, Intel (NASDAQ:INTC) mentions in its presentation that the total cost of ownership for a server has dropped due to performance gains. If you look at a Haswell 10 core CPU, versus Haswell 6 Core CPU, you find that the total cost of ownership over four years drops by around $434,000, which indicates that faster performing CPUs drastically reduce cost. What this indicates is that as CPU performance gets better, the cost of owning a datacenter may drop, so as long as computing needs don't grow at a much greater rate than performance gains. In this case, Facebook's user growth and activity growth is decelerating. Therefore, it's entirely possible that the total number of servers needed to handle the same workloads become smaller. In this isolated case, Facebook's profitability will improve due to a combination of hardware refresh along with efforts from its own internal team to build more efficiency into its datacenter.

Jason Taylor also mentions:

The other key advantage is easier operations. So in a typical data center facility you might have a data center tech to server ratio of one to about 400 or 450. In our facilities it's somewhere between 1 to 15,000 and 1 to 20,000, so all of our servers are the same. They are all optimized for serviceability and we do work hard to make that easy. That also translates into operations, software benefits, just efficiency all up and down all of the consumers of the devices.

Facebook has significantly lower overhead when compared to other datacenters. This is pretty consistent with the company's operating performance that was recently reported in the most recent quarter. Certain expenses as a percentage of revenue have dropped, and of them cost of revenue saw the most significant decline.

Source: Facebook

Going forward, Facebook can trim other costs like R&D and SG&A to improve the profitability of the company. Admittedly, Facebook won't announce any headcount reductions anytime soon. Instead, companies in a rapid growth phase tend to increase costs at a slower rate than revenue growth. What happens is rapid profit margin improvement, which generates significantly higher EPS growth. This is why Facebook never missed analyst earnings estimate over the trailing four quarters.

Source: Yahoo Finance

I don't anticipate an earnings miss in the foreseeable future. The management team has tons of tools in its tool box to prop up earnings growth. Therefore, investors have a lot of downside protection as surprise quarterly earnings misses are extremely unlikely at this specific juncture in time.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.