Facebook (NASDAQ:FB) has made a believer out of many, and sentiment has dramatically shifted within the stock market on the company. Long-term bulls recall the times (not too long ago) when shorts were out in full force, especially immediately after the batched IPO. However, what followed that shaky start has been impeccable execution by Mark Zuckerberg and the management team. Plain and simple. There isn't any other way to describe three straight years of quarterly earnings that beat bottom line expectations other than excellent leadership and strategy. Those type of past results create a track record you don't want to bet against, but at the same time it also has elevated expectations and led to a share price that has dramatically outpaced the rest of the market.
As an investor, I personally don't generally dabble in technology, particularly the growth-oriented side of the sector. I like immediate value, companies where the market has set the bar so low that even crippled management teams can hurdle that bar. That doesn't mean I don't follow the tech industry with interest, and I've noticed a significant amount of cheerleading revolving around Facebook on both the retail and institutional side. Any time sentiment seems to shift toward "bulls can't lose" I can't help but take a curious look, so that is what I'm exploring here. The aim is to take a rational approach to what got Facebook to where it is today and what it needs to do to match current short-term earnings expectations (the rest of 2016 and 2017). In my opinion, what has been the company's greatest strength over the recent past may be its toughest hurdle to overcome going forward.
Looking back a little bit to two years ago, Facebook booked $2.6B worth of advertising revenue back in Q2 of 2014. Fast forward to Q2 of 2016, and that number has grown (massively) to $6.2B worth of revenue. One of the most interesting things to take away from the growth is geographical mix. Despite extremely tepid MAU growth of 10% from Q2 2014 to Q2 2016 within the United States and Canada, versus 30% consolidated MAU growth for the company overall, the revenue mix by geography (either by user location or advertiser location) has not budged an inch.
There is only one way that can happen, and that is from much higher ARPU growth from the United States then the rest of the world. Nearly $2B of that $4.6B worth of quarterly advertising growth between Q2 2014 and Q2 2016 came from United States and Canada. ARPU grew significantly within the United States and Canada, nearly tripling from $5.75/ARPU in Q2 2014 to $13.74/ARPU in Q2 2016. This growth has significantly outclassed ARPU growth in other areas of the world.
Revenue drivers that impact all of Facebook (e.g., increased ad load) don't explain continued wide disparities between regions. While there are some ancillary reasons to point toward (strengthening dollar is as an easy one, stronger user interest growth - time spent on Facebook - in the United States versus the globe is another), at the end of the day, the big theme is that advertisers continue to dump big money into targeting North American consumers. There is an arms race out there for online advertisement, and most of the money continues to get pushed into the big names within the space (Facebook, Google (NASDAQ:GOOG) (NASDAQ:GOOGL)). While the disparity between North America and up-and-coming areas like Asia is easy to explain (mature markets, consumers have more disposable income, etc.), the gap between Europe and North America has also widened. The story here isn't just as simple as pinning differences on developed versus developing markets.
The looming question then for investors to consider going forward is whether or not United States and Canadian ARPU can continue to expand. The gut reaction is to say no, but that would have been easy to say back in 2014 as well.
Reconciling 2017 Street Consensus
Wall Street is currently looking for $5.07/share in fiscal 2017. Assuming 3B in outstanding average share count (likely given continued dilution from employee stock options), our friendly neighborhood investment bankers are looking for something around $15.2B in non-GAAP net income. Like most coverage in the tech space, this is excluding share-based compensation and intangible asset amortization. GAAP earnings expectations are likely somewhere in the $11B range (stock-based compensation expense alone will run around $3.5B by itself in 2017). Assuming 45% GAAP operating margins and a 35% tax rate, the Street is looking for roughly $17B pretax income and $37.8B in GAAP revenue. Against what I see as general analyst consensus from available reports, this is basically in-line (although some see higher GAAP operating margin).
This would represent some slowdown in top-line growth from 2016 expectations (51% to 40%), but only marginally. Therein lies the rub for me. Even if you assume an acceleration of ARPU growth from 2016 levels into 2015 for the "rest of the world" as I'll call it (total revenue excluding United States and Canadian-sourced user revenue), Facebook will continue to need to see growth in otherwise mature markets.
To back that up with numbers, we can assume $13.5B in revenue from the "rest of the world" for 2016 (continued acceleration from already booked 1H 2016 revenue of $5.9B). That means Facebook would post 50% y/y growth in 2016 from the "rest of the world." Carrying that same rate of growth into 2017, Facebook would then book $20.2B in "rest of the world" revenue.
Given our earlier $37.8B GAAP revenue estimate expectation, simple math means we'd be expecting $17.6B in generated revenue from Facebook in the United States and Canada. Those areas are expected to generate $13B in revenue in 2016 give or take. As a result, Facebook would need to book 35% y/y growth in 2017 to generate that $17.6B revenue number. That number can be tweaked up our down depending on your margin assumptions, but there is no way around the indicated growth expectations.
Does this represent a slowdown from 2016 pace? Sure, from 45% to 35%. Is it attainable? It certainly is - but it is a high bar. At some point, Facebook investors will have to come to terms with the fact that they cannot expect ARPU growth like below to last forever:
*Facebook, ARPU per user, US and Canada geography, Q2 2016 earnings report
There will be an eventual topping out of ARPU in the United States and Canada. Will that come in 2016? 2018? 2020? That is a difficult question to answer. Given the headwind from ad-load growth flat-lining in mid-2017, I expect that it will happen sometime after that point, likely at or around the turn of the next decade.
Obviously, Facebook management is cognizant of this fact. I believe that is why you've seen Mark Zuckerberg and team put so much emphasis on global markets, particularly in helping get potential countries with both high GDP growth and low internet connectivity rates online. Advertisers want to target customers flush with cash to buy their products, but that can't happen until those consumers have access to the internet. Hence, initiatives like this one to improve rural connectivity in Africa. Facebook wants to get out ahead of these potential users and ensure that one of the first activities that they make after getting online access is to run to Facebook and create an account.
Like other high market cap technology companies (e.g., Amazon (NASDAQ:AMZN)), Facebook is now not too far off maturation. Earnings multiples will come down, and the next several years of final blistering growth are critical to ensuring that the company can grow into current multiples. Facebook can certainly look expensive on trailing measures, but if it can execute the next two years as well as it has the past two, shares still have value, even after the most recent run.
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