Facebook: Concerns Overdone

Summary

• We have a unique take on Facebook's data "leak." We think it may actually be a positive development over the long haul.
• Facebook is a rare company with tremendous competitive advantages, a huge net cash position on the balance sheet, and considerable free cash flow generating potential.
• The company also seemingly has an open-ended opportunity from e-commerce to payment processing to movie streaming and beyond. It's hard to quantify these items in valuation.
• We believe Facebook's best days are still ahead of it.

By The Valuentum Team

We're still huge fans of Facebook (FB), even after the Cambridge Analytica data scandal, "Facebook Can't Stop, Won't Stop." There are a few reasons why our views differ from that of the market, however. For starters, we're viewing the potential for increased data regulation across social media, and the Internet as a whole, as a long-term positive. The greater that consumers end up trusting companies with their data, the better, in our view. In some ways, under a long-enough time horizon, one might actually view the recent seemingly major setback at Facebook as a "good thing."

Furthermore, we like that the executive team at Facebook is taking things seriously, and we think they are working hard to make things "right," and in doing so, they are making things better for consumers along the way. We'd be speculating if any monetary settlement may happen as a result of the Cambridge Analytica data "scandal" or if there may be more bad news on the horizon, but the company's balance sheet can handle it, and we don't expect recent negative headline noise to derail Facebook's tremendous fundamental and cash-flow-based "story" either. Advertisers need Facebook. This much we know is true, and we doubt this will ever change.

Second, we've often taken exception to the areas of emphasis on Facebook's stock analysis, as sometimes most analytics put a microscope on underlying metrics such as daily or active users or other user engagement metrics. At the end of the day, any internal metric must translate to free cash flow generation and end up in the valuation equation. Said differently, it's hard to be disappointed in an underlying metric if the share price is below one's price target or fair value estimate, for example. There's sometimes a lot of inconsistencies in tech analysis, but this has been the case for a very long time now. Tech companies sometimes tend to trade more on metrics or "noise" than on valuation, fair or not. This might change, but not anytime soon.

It's All About Facebook's Fundamentals

It appears many sell-side analysts have already hair-cut Facebook's price target following the Cambridge Analytica "scandal," but we're not reading too much into the revisions. For one, relative to price targets, we think fair value estimates, which are focused on calculating the intrinsic value of an entity on a discounted cash-flow basis are more helpful, "How Well Do Fair Value Estimates Predict Stock Prices?" Fair value estimates tell readers what the analyst thinks a company is worth. In any case, it looks like both Morgan Stanley (MS) and Deutsche Bank (DB) have cut Facebook's price target to $200 from $235, previously - still implying considerable upside though. From where we stand, we're still holding steady with our $238 per-share fair value estimate (derivation shown below), and while there may be some tough sledding in the near term, it's hard to argue with Facebook's long-term potential. That's what we're focusing on!

Image Source: Valuentum

It's also quite possible our fair value estimate might even be a little conservative. In a bullish long-term case, for example, we can even envision a scenario where Facebook could become the new "face of the Internet," and we could even imagine where significant e-commerce could be generated on Facebook, itself (direct to consumer). Why would Facebook users, for example, ever have to visit eBay (EBAY), Amazon (AMZN), or Netflix (NFLX) when they are already on Facebook? What we're trying to say is that Facebook could become much more than a social media hub. Given its network effect (a huge competitive advantage versus any new start-ups), the company has considerable open-ended opportunities across many verticals. It's hard to get this "optionality" into any valuation model, let alone a price target.

Untapped potential in areas such e-commerce, payment processing and streaming movies, for example, could make for a very compelling incremental long-term growth "story" at Facebook, even beyond its existing advertising-based business model, which admittedly could face some near-term stress. If Facebook ever really wanted to enter e-commerce, payment processing or streaming movies, however, could eBay or Amazon, PayPal (PYPL) and Square (SQ), or Netflix really stop it? Facebook has the larger customer base, and these customers visit its website constantly. How easy it would be to buy items on Facebook or watch movies on Facebook TV. Why do customers have to leave? The possibilities for Facebook's social network are seemingly endless.

Facebook's Range of Potential Outcomes

Image Source: Valuentum

As with any company's fair value estimate, we would view an assessment of Facebook's intrinsic worth in the context of a fair value range, or a range of potential outcomes. At the low end of the published fair value range ($179 per share), we may consider more of a bearish scenario with respect to current developments, and at the high end, a more optimistic view of Facebook's core business ($297 per share). However, we'd even view the high end of our fair value range as one that may not entirely capture all the company's future potential.

Even if some may say we're building castles in the air, Facebook is already a powerhouse. The entity is growing rapidly, generates substantial free cash flow, and has substantial net cash, and no debt on the books. The fallout with respect to the reported and alleged data "scandal" may be making a lot of headlines, but Facebook has an excellent combination of strong competitive advantages and fantastic cash-rich financials to weather the storm. Here's what we wrote as to why we think value investors are starting to salivate over shares, but note the emphasis on patience, too:

Facebook's fall from grace has been a dream come true for many value investors looking for a company with a pristine balance sheet and tremendous free cash flow generation. By a pristine balance sheet, we mean a huge net cash position (~$41.7 billion) and no debt. By tremendous free cash flow generation, we mean that Facebook hauled in $5.4 billion in free cash flow during the fourth quarter of 2017, more than 40% of revenue and nearly double that of levels just two years ago. For value investors, the stars are aligning for a rare find in a frothy stock market, and we can barely hold back our excitement!

But we are holding back. There is a saying that "only fools rush in," perhaps made famous by Elvis Presley, but still, the saying may be as relevant in love as it is in stock investing. Anybody that has been following the General Electric (GE) saga knows how important it is to veer away from falling knives, and while we think Facebook is far from a value trap, it does us no harm by waiting until the dust settles and the prevalence of "scary" headline news slows down. From Facebook facing a Federal Trade Commission privacy inquiry to CEO Mark Zuckerberg deciding to testify before Congress, the media waves will be overflowing with Facebook news, and most of it will be negative. It will.

Conclusion

All in, while we think patience is in order, we think the long term is still very bright at Facebook. As is often the case with companies under scrutiny by Congress or regulators, however, the technicals will be key to watching closely. The charts, they say, may know more than the numbers, sometimes. It's important to note that the Cambridge Analytica scandal is still developing, too, as even today, news hit the wire, clarifying just how many Facebook accounts had been affected. We're not saying there won't be downside to Facebook's price in the near term, but it is a rarity to find a company with such strong competitive advantages, a healthy balance sheet, and strong free cash flow generation - it's even rarer to find one on sale! We continue to include Facebook in Valuentum's simulated Best Ideas Newsletter portfolio.

This article or report and any links within are for information purposes only and should not be considered a solicitation to buy or sell any security. Valuentum is not responsible for any errors or omissions or for results obtained from the use of this article and accepts no liability for how readers may choose to utilize the content. Assumptions, opinions, and estimates are based on our judgment as of the date of the article and are subject to change without notice.

Analyst’s 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.

FB is included in Valuentum's simulated Best Ideas Newsletter portfolio.