Facebook: There'll Be No One To Stop Us This Time

Summary

• Facebook posted incredible Q3 results driven by the value of its advertising platforms.
• I think Facebook's network effect has made its product offering so strong that no one can truly compete.
• I am increasing my fair value to $195-210.
• In spite of governmental risk, I think shares look attractive.

I was sitting in my cube this afternoon when Facebook (FB) posted third quarter results. I nearly had a heart attack when I saw the results – revenue up a whopping 47% y/y to $10.3 billion and earnings per share of $1.59, an increase of 77% y/y. As a shareholder, my mind immediately flashed to Darth Vader in the beginning of A New Hope, saying confidently, “there’ll be no one to stop us this time.”

Not that I believe Facebook is an evil company, but after seeing this unprecedented acceleration, I am confident that Facebook is one of the most competitively advantaged companies I have ever seen. The company owns mobile advertising, and I believe growth will continue for several years. I have updated my model to incorporate this quarter’s robust results, and I believe shares are now worth $195-210. Let’s dig into why Facebook has more room to run after its 59% increase YTD.

Mobile Ownership and Pricing

Facebook undoubtedly owns mobile, and I believe this is a combination of the Facebook app and Instagram, though the less discussed WhatsApp will unlock significant value in the future. Mobile advertising increased a whopping 57% y/y, and it now contributes 88% of total ad revenue. Facebook surpassed 6 million advertisers, while Instagram recently surpassed 2 million advertisers.

With advertisers flocking to the platform after analyzing the high return on investment, price per ad increased 35% y/y. The addictive nature of Facebook and Instagram combined with less sensitivity to ads has made Facebook the owner of the new most valuable app properties in the world. Considering how effective these ads can be, Facebook may own the two best advertising assets in the entire world.

The formula for this is simple: the great data available and algorithms provide incredibly relevant ads that are worth paying for. I have some obscure interests, but not surprisingly, I receive multiple ads with products that very uniquely target me. The more usage grows, the better the ad algorithms get, and the better Facebook’s products become. This might be the best example of the network effect.

Source: FB Q3’17 IR

In fact, usage continues to grow, and it actually accelerated Q/Q in the US and Canada—Facebook’s most mature markets. Frankly, daily active user growth will eventually stall out, and Facebook will have to rely on bringing connectivity to more people to expand the network. These regions will bring in less revenue per user, so I do not anticipate this will be an important driver of growth.

Innovation Across Platforms

Call it innovation or call it copycat, but the instant stories, at least on WhatsApp and Instagram, are a hit. Snap (SNAP) stories, though still popular, are definitely losing some traction to Instagram, which is also doing a great job of monetizing these stories.

Going forward, CEO Mark Zuckerberg continues to preach about the importance of video and innovation in video. He hammered home the value of social content that drives social interaction, and I think we will see some interesting new video technology from Facebook in the next few years. Because video requires massive bandwidth and servers, I suspect Facebook and Alphabet’s (GOOG) (GOOGL) YouTube will be the primary winners of this form of video content. I think it may differ from the Netflix (NFLX) and HBO model.

Operating Leverage is Outstanding

Followers of mine know that Visa (V) is far and away my largest investment, and the thesis is primarily driven by a network-driven moat and operating leverage. This sounds pretty similar to Facebook. Facebook’s workforce is 47% larger than it was a year ago, and operating margins still increased by ~ 600 basis points, for the second best quarter in Facebook’s history.

Source: FB Q3’17 IR deck

Over the next few quarters, I believe we could see Facebook reach 55-60% in Q3 & Q4.

Increasing my fair value range to $195-210

Facebook’s third quarter was even better than I had anticipated, and I believe the results warranted an increase in my 2017 and 2018 numbers, which ultimately yielded a higher fair value range.

Facebook, though an incredible product and business model that will be nearly impossible to replicate, faces some existential risks. Businesses as influential and successful as Facebook always encounter regulatory risk. Congress is investigating the company closely for its role in the 2016 US Presidential election, and this could be the first of many influential roles Facebook plays in a major campaign. I believe the company must work hard to keep this sort of content off of its platform for both the sake of its users and the sake of its business survival.

However, I would take advantage of any regulatory overhang to purchase shares. I believe the company has more room to run, and it is clear that Zuckerberg along with COO Sheryl Sandberg form one of the best management teams in all of tech. Given the great management team, network effect, and ownership of mobile, I think I’d rather fight the Empire than try to compete against Facebook.

Analyst’s Disclosure: I am/we are long FB, V. 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.