Facebook: Don't Expect Endless Growth

Summary

• Facebook is the only company in its peer group that has been able to accelerate the growth rate of its user base over the past few quarters.
• However, I believe this trend to be unsustainable in the medium and long terms.
• Soon enough, all eyes will turn to monetization of the user base.
• Can FB generate enough revenue per user?

Facebook (FB) is on a roll. The company delivered the quarter of any CEO's dreams last month. It beat consensus on top and bottom lines, grew MAU (monthly active users) double digits and generated over $1.8 billion in free cash flow. FB outperformed on nearly every metric tracked by investors and analysts.

Credit: The Wall Street Journal

What intrigued me the most, however, was the growth rate in ad revenues. A 56.8% YOY increase in sales in 1Q16, tied for the highest since 3Q14, suggests that FB is far from showing signs of a slowdown. Digging deeper, I noticed a very interesting fact: FB is the only company within its peer group that has managed to grow its user base at an accelerating rate in the past several quarters. The chart below compares the growth of FB's MAU against that of LinkedIn's (LNKD) unique visitors, Netflix's (NFLX) domestic subscribers and Twitter's (TWTR) MAU. As early as 1Q15, FB's user base was growing at the slowest rate among its peer group. In 1Q16, the Menlo Park company turned the game around and grew MAU the fastest, in a steadily increasing trend.

Source: DM Martins Research, using data from SEC filings

But FB is unlikely to grow indefinitely

The graph above, however, also tells a less encouraging and more sobering story. It is unlikely that FB, or any other growth company for that matter, will be able to sustain this level of MAU expansion into the longer-term future. NFLX, LNKD and especially TWTR have all started to experience an expected slowdown in their user base growth.

In fact, as I stated earlier this year, a social media company, even one as dominant as FB, can only attract so many revenue-generating users into its platforms. I believe this number to be close to 3.5 billion individuals at most, the equivalent of twice my estimate for FB's MAU at the end of FY16. A more reasonable estimate for FB, however, would be closer to 2.6 billion users by the end of 2020, in my view. Although still impressive, this number implies a reduced average annual MAU growth rate of 11% over the next four years, with growth in 2020 slowing down into single-digit territory.

Sooner rather than later, the conversation around FB's top line growth will have to gradually but decisively shift to monetization of the company's user base.

Increase in ARPU holds the key to FB's success

In terms of ARPU (average revenue per user), FB has also been delivering astonishing results. Revenues per user increased 32.4% YOY in 1Q16, the highest growth rate since 2Q15, as the graph below illustrates - it also displays the evolution of LNKD's ARPU growth, for comparison.

Source: DM Martins Research, using data from SEC filings

Despite decelerating growth compared to 1Q15, I believe increasing ARPU will ultimately be FB's better chance at continuing to grow revenues robustly in the next 1-3 years. With non-ad products like Oculus Rift unlikely to move the needle in 2016 and probably 2017 (CFO David M. Wehner: "VR is still very early. It's not going to have a material impact on revenue in 2016"), monetizing its user base as best as possible will be crucial to FB's success, in my opinion.

The good news is that the company seems to have plenty of opportunities to do so. COO Sheryl Sandberg discussed, on the most recent earnings call, how immersive mobile ads have been gaining traction recently. The early stages of monetization of FB's Messenger could be right around the corner, although WhatsApp seems to be lagging a bit behind. Video ads will likely become more widely used and could bring in more dollars per ad impression. "Digital video ad spending is seen growing 28.5% this year to $9.84B," according to eMarketer. And FB is now starting to move video into third-party websites like Mashable and USA Today. These are all opportunities that could allow FB to leverage its MAU base without depending on it growing as much as it has been in the past several quarters (14%-plus YOY on average since 2Q15).

So is FB a buy?

I would not be surprised to see FB's MAU growth start to decelerate in the next few quarters. But I also expect the company to improve ARPU from the many monetization initiatives that it still has in the pipeline. So what is the net impact? Will FB manage to increase revenues at the current pace for many quarters to come? And does the stock look like a buy today?

To answer these questions, I projected FB's earnings in 2020 under two scenarios: best and base cases. See table below.

Source: DM Martins Research, using data from SEC filings and other Company Reports

Under my base case scenario, I assume that MAU reaches 75% of the world's population that is able to consume beyond the basics (i.e. above the poverty line) by the end of 2020. ARPU increases a solid 50% and non-ad revenues increase 25% faster than ad revenues, as products like Oculus Rift and other potential applications of AI and VR ramp up. Op margins, already high today, increase 100 bps as a result of economies of scale and share count increases only slight as a result of SBC-driven dilution (share-based compensation).

Valued at a P/E multiple of 20x 2020 EPS, I see FB's stock being worth about $128/share, which represents an annualized upside of 1.8% over the next few years from current levels. But even under my best-case scenario and using a rich 2020 valuation multiple of 25x, I don't see the stock returning more than 12% per year to long-term investors, at best.

Therefore, I maintain my same opinion from earlier this year that, while FB is a great company with very interesting prospects, the stock seems to be fairly valued and unlikely to produce much upside to investors in the longer term.

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.