Facebook: Higher Growth In Digital Ad Spending Compels For High Valuations

| About: Facebook (FB)
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Summary

Global digital marketing would grow to $335 billion.

Facebook has a market share of 14%.

Base case warrants for 23% upside.

Facebook (NASDAQ:FB) is the largest and the most efficient social media infrastructure with an average growth of 56% over the last 5 years. The bulk of its revenue is derived from digital advertisement and the expected 15% growth in the global advertisement spending over the next five years warrants for higher multiples. The company’s ability to penetrate populous nations with a growing internet penetration in addition to growing digital advertisement market share has brightened the prospects of bullish case.

Revenue would lead the valuations

My narrative for double-digit growth in the future revenue of FB stems from the following arguments:

The ability of the company to pursue aggressive growth by partnering with local mobile network companies of large developing nations such as Indonesia, Pakistan, India, and Brazil.

For instance, in India, which is one of the largest populations with an increasing broadband penetration rate, Facebook has partnered with Reliance Communications and Airtel to offer basic Facebook internet services for free. Similarly, in Pakistan, Facebook partnered with Telenor, which is the second largest operator in the country. In Indonesia and Brazil, FB has partnered with XL Axiata and Oi respectively. Further, Facebook has similar arrangements with TMN in Portugal, Three in Ireland, Vivacom in Bulgaria, Bakcell in Azerbaijan, SMART in the Philippines, STC in Saudi Arabia and much more.

It is to be noted that more than 3 billion people of the world reside in these countries, accounting for ~40% of the world population. I expect a large portion of expected growth would come from South Asia and Asia-Pacific region.

The ability to monetize its platform on both featured mobile phones and smartphones. Thus, increasing user engagements and advertising inventory.

Feature phones still account for a large percentage of cellular device users in the emerging country. And Facebook is the only social media platform that has launched apps for its feature phone users. Thus, increasing the number of users on the platform.

Robust social database to discover key insights that can be monetized in a variety of ways such as better ad relevance, user utility and more engagements.

Facebook has the largest social database in the world with over 1.86 billion MAU (Monthly Active Users) and after the incorporation of Beringei, Facebook has following advantages in TSDB (Time series Database):

  • The efficient compression algorithm that would compress the data by 90%, which is 1.5 million data points per second.
  • Visualization integration
  • Fast exploration and debugging of system
  • Lower storage overhead

Global digital advertising spending to grow to $335 billion by 2020, whereas Forrester forecasts US digital ad spending would near $120 billion in five years.

Google (NASDAQ:GOOG) (NASDAQ:GOOGL) and Facebook attracted nearly most of the growth in U.S. digital advertising market in 2016. Further, as emarketer expects social and mobile advertising in the US to increase by 34.5% and 26.3% respectively in 2017, I believe Facebook would continue to clinch major portion of the digital ad spending in 2017. Additionally, emarketer forecasts Facebook market share of display and mobile ads would swell to 43.7% and 33.8% respectively till 2019. In my base case, I have done a conservative valuation by keeping FB’s market share of global digital advertising constant at 14%. Moreover, Facebook’s venturing into online video is poised to result in higher revenue due to following reasons:

  • Online video witnessed 114% growth in digital ad spend since 2014.
  • Approx. 35% (650m people) of the Facebook users are connected to the sports page, andFB has a data about how many people are attracted to what type of sports.

Margins to stabilize at 76% and marginal tax to settle at 30%

In my base case, I have assumed the margin to be constant. This is because FB is expected to increase its marginal dollar spend on “Sales and Marketing” for every additional dollar of revenue as the overall market space matures. However, this would be offset by savings originating from higher gross margins due to the scalability of the product. It is worth noting that I have excluded R&D expenses from the calculation of operating margins.

Marginal tax rate is determined after accounting for the following considerations:

  • Future expected revenue would be earned from countries with lower statutory tax rates than U.S. It is to be noted that average statutory corporate tax rate in South Asia is 26.7% against 35% of USA.
  • The effective tax rate would have been 33% in 2016, if we exclude tax credits emanating from share-based compensation expense and early adoption of ASU 2016-09.
  • Although I have not incorporated it into my valuation, the reader should be wary of the fact that FB has received Statutory Notice of Deficiency from IRS. If IRS prevails in the court, then FB would bear Federal tax liability worth $3.0 billion to $5.0 billion.

Valuation

I have assumed a target date of Dec. 17. With a cost of capital of 8.5% and terminal growth rate of 2.5%, following are the target prices under different scenarios:

  • Base case: Constant global digital market share at 14% with constant margins yield a target price of $171, up 23% from the last closing.
  • Bullish Case: Rising global digital market share to 18% till 2021 and constant margins warrants a target price of $280, up 67% from the last closing.
  • Bear Case: Dwindling global digital market share to 10% till 2021 and constant margins would give a return of $134, down 4% to the last closing.

Workings under base case:

https://static.seekingalpha.com/uploads/2017/3/15/36801566-14896347036906343.png

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.