Facebook (NASDAQ:FB) is one of the leading social networking companies in the world. It comprises of Facebook properties that include the Facebook app and messenger, Instagram for sharing pictures and WhatsApp for messaging. Facebook derives 97% of its revenue from advertising (of which 84% is from mobile ads) and a small declining percentage of 3% from payments and other fees. The company is also involved in virtual reality hardware & software through its product called Oculus.
In October 2016, the stock took a beating as its management warned of a slowdown in revenue growth in 2017 and forecasted higher CapEx to grow its businesses. However, we believe Facebook will continue to be a high performer given the favorable industry trends, a strong management team, growing operational metrics, effective monetization through ad platforms and weak competition among social media peers.
- Industry Trends - Growing internet usage, rising consumer spending, shifting consumer preference towards smartphones and increasing digital advertising trends are all working in Facebook's advantage. The total internet users in the world represent only 50% of the total world population and usage is expected to increase in the coming years. It is interesting to note that scope for growth is present mainly in Asia and Africa regions (as they are less tapped) followed by Middle East and Latin America. As far as smartphone trends are concerned, a global median of 43% of world population owns a smartphone. Despite having more than 1 billion people, only 17% of Indians own smartphones, leaving room for ample growth. Consumer spending is on a steady rise in the US since the 2008 recession. Lower oil prices and increasing employment have contributed to higher disposable incomes. Global consumer spending is also expected to rise in 2017. Digital ad spending is expected to rise up from 31.8% in 2015 to 41.4% by 2019, of which mobile ad spending driven by social media is a major contributor.
- Strong Management team - The company's management team have historically displayed very strong strategic and execution capabilities. Their ability to innovate, acquire and integrate technology puts them in the top tier. The management continues to follow short and long-term plans to create an ecosystem of apps & features that can be monetized. In the short term, the company is expected to focus on video as a means to increase user engagement on its FB Messenger, WhatsApp and Instagram apps. The other focus is to provide a platform for access to daily news. It has launched internet.org, an internet gateway providing access to basic apps on the Internet, in 33 countries connecting 19 million people and continues to build cheap solar-powered technologies to beam internet to unconnected parts of the world. In the long term, the company plans to venture into various fields including virtual reality and artificial intelligence (AI). The company is targeting the gaming and education communities through virtual reality offerings like Oculus VR. Using AI, FB plans to understand and interpret newsfeeds on Facebook and add value to user experience through the application of AI. Most importantly, the company has made capex plans to fund these initiatives.
- Operating metrics - Facebook registered healthy growth in the user base (1.86 billion monthly active users and 1.23 billion daily active users) and increased user engagement through its various apps including Facebook messenger and Instagram. Massive reach of Facebook + Instagram demonstrated through share of internet minutes on both desktop and mobile. Facebook outpaced its competitors like Twitter (NYSE:TWTR) and Snapchat (NYSE:SNAP) in terms of average time spent per day (35 minutes for FB, 15 minutes for Instagram, 25 minutes for Snapchat and 1 minute for Twitter).
- Ad platforms - The focus on making ads more relevant and effective through innovative products like Dynamic Ads is helping increase the price per ad despite an effort to decrease the ad impressions and to reinforce quality over quantity. Focus on relevance and quality of ads has resulted in increase in revenue from advertising especially on mobile. Given user base is the most important asset, Facebook has introduced initiatives to reduce the number of promotional page posts in the News Feed to improve user experience. The initiative is a strategic choice to maintain and further increase the user base, which will help them to maintain a lead over competitors. Increasing the user base will ensure the digital ad expenditures of companies will be directed towards Facebook.
- Competition - Although Facebook faces stiff competition from other internet-based companies such as Google (NASDAQ:GOOG) (NASDAQ:GOOGL), it does not face an immediate threat from another social networking company. While Facebook has more than a billion daily active users, Twitter and Google+ are far behind at around 300 million users. Also, though Google as a whole has a far diversified portfolio, its social networking offering (Google+) is way behind Facebook in terms of its user interface and offerings. Moreover, Facebook's strong user base, rich data content and growing partnerships create a powerful networking effect with significant switching costs (people are unlikely to leave Facebook and therefore, pose fewer threats to Facebook's dominance among the social networking peer group unless they can take their network of friends, content, and applications with them).
- Impressive Valuations - Facebook has a FY18-20 estimated revenue and EPS CAGR for of 24.5% and 24.2% respectively with an impressive FY'18 estimated EBIT margin of 61.5%. Also, FB is really cheap at the current share price levels with a FY'19(e) P/E multiple of 19.9x and we expect it to go up owing to its expanding user base, increasing advertising demand, improved quality & relevance of the ads, engaging user videos, focus on mobile and investments to diversify revenue streams.
As usual, we must make note of some of the risks that may threaten the upward movement of the stock:
- Rising Expenses - The Company expects non-GAAP expenses to grow 47% to 57% this year as compared to 2016 owing to its planned investments in expanding its data-center and hiring of employees. Any announcement around further increase in Capex may affect the stock price negatively.
- Inability to capitalize on video ads - Although other competitors have a lot to cover in order to catch up with Facebook, complacency in video offerings may lead to loss of ads to YouTube, which is currently leading the average number of minutes spent owing to its focused video offerings.
Conclusion: Facebook is the world's largest and most profitable social media company with more than 2 billion users worldwide. It has built a lucrative user database that is highly valuable to advertisers and hence presents an almost un-breachable economic moat with strong profit margins and huge long-term growth potential. Facebook has consistently beaten revenue and EPS estimates over the past couple of years. Given its focus on relevance & quality of ads, increased user engagement, improved end user experience and effective monetization through mobile ads, it is expected to continue the strong performance in 2017 as well.
Additionally, with its diversification of revenue through Instagram, its focus on video monetization and its Facebook Lite offering to maintain growth in customer base, it is clearly the top pick among the social media peers in 2017.
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.