Facebook: Short-Term Pain Equals Long-Term Gain

Summary

• The move toward Stories is painful in the short-term, but the right long-term choice.
• Facebook has something it's peers don't: pricing power.
• Say what you want, Facebook is killing its peers when it comes to cash flow.
• Valuation matters, and Facebook looks relatively cheap for the first time in a while.

If you ask the average investor what they expect from Facebook (NASDAQ: FB) stock in the future, you’re likely to figure out if they are a trader or investor. A trader looks at the company’s comments from the last earnings call and worries about slowing growth. An investor probably looks at the fact that Facebook stock has a compound annual growth rate of nearly 30% over the last five years. No matter which side of the fence you fall on, there are 3 numbers that suggest not only is Facebook doing fine, but that it could be relatively undervalued.

What’s the story?

In the short-term, there is a significant change being pushed by Facebook that bears the blame for the company’s slower growth. In an effort to drive better engagement, Facebook is pushing users to tell their story through the site or the app. “Stories” weren’t a piece of the Facebook puzzle a short time ago, but the company realized how well stories worked inside of Instagram and began making this a central feature of Facebook as well.

Comparing Facebook’s results to competitors such as Alphabet (NASDAQ: GOOG) or Twitter (NYSE: TWTR) yields a somewhat surprising result even with this shift in focus, more on that later. Facebook’s Stories feature is being used by “just” 150 million users or roughly 10% of the company’s daily active users.

By comparison, some of the major revenue drivers at Alphabet and Twitter are largely unchanged. The majority of Alphabet’s revenue comes from the company’s advertising and specifically paid clicks. Twitter generates most of its revenue from advertising engagements. Facebook is trying to separate itself from its competition. Users primarily go to Twitter to find out about events or follow celebrities. Google is ubiquitous with searches for information. Facebook wants to get back to being the network that connects users to other individuals.

Prior to the shift toward using Stories, and some tweaks to the Facebook timeline, the site was losing its core mission… to connect people. If Stories usage continues to grow, Facebook will be a way for individuals to see what is going on with their family, friends, and acquaintances in a format that is more meaningful. In the short-term, this presents a challenge as Facebook needs to show advertisements to make money. In the long-term, as the company learns how to monetize Stories in a more meaningful way, companies should be willing to pay more for ads because user engagement will be higher.

When advertisers speak, investors should listen

Of all the comments and articles about Facebook recently, one important metric seems to be largely ignored. This leads us to the first number to give Facebook investors a little perspective. Facebook was able to not only sell significantly more advertisements, but at a higher price per ad as well.

If we look at the most common metrics from Facebook, Alphabet, and Twitter, to gauge advertising health, there is a very specific trend playing out.

• Alphabet = Paid clicks up 58% - Cost per click down 22%
• Facebook = Number of ad impressions up 21% - Average price per ad up 17%
• Twitter = Number of ad engagements up 81% - Cost per engagement down 32%

In advertising there is a natural give and take that occurs. If a customer wants to buy more, the business may give a discount to generate greater sales. However, a company with strong demand doesn’t have to discount prices to generate sales growth. This latter scenario is what is happening with Facebook.

Of the three companies we’ve looked at, only Facebook was able to grow advertising numbers by a good amount, while also charging more. Alphabet and Twitter engaged in significant discounting to grow their numbers. This points to strong core demand for Facebook advertising and is something long-term investors should pay attention to going forward.

Cash talks

The second number investors in Facebook should look at, is the company’s core free cash flow per $1 of revenue. I use this figure to compare similar companies to see who is able to squeeze the most cash out of each sales dollar. To eliminate any confusion, I look at net income (adjusted for any unusual one-time events), plus depreciation, and minus capital expenditures to get core free cash flow. This strips away accounting adjustments that are non-cash and makes the comparison more meaningful.

Company	Revenue	Core FCF	Core FCF per $1 of Revenue
Alphabet	$32.7b	$4.7b	$0.14
Facebook	$13.2b	$2.6b	$0.20
Twitter	$711m	$46m	$0.06

Click to enlarge

(Source: 10-Q releases from each company)

Based on this comparison, Facebook is generating more free cash flow for each dollar of revenue relative to its peers. When the company talks about slower revenue growth or smaller margins, it helps to realize that Facebook is already producing roughly 40% more free cash flow per $1 of revenue than Alphabet and at a rate more than 230% higher than Twitter. Even if Facebook’s earnings growth slows, it seems likely the company can continue to produce more free cash flow on a relative basis for shareholders.

Valuation matters

The third number Facebook investors need to pay attention to, has to do with the company’s valuation relative to its peers. It seems like every few years, a set of companies comes along and certain investors claim that valuation doesn’t matter. When I see these comments, I try to remember Peter Lynch’s sage advice. He said that the P portion of the P/E ratio can’t get too far ahead of the E without something having to give. Looking at Facebook’s valuation relative to its peers, it’s possible investors over-reacted and the P part of the P/E dropped too far.

Analysts took down their estimates for Facebook significantly after the company’s earnings release. Next quarter’s earnings estimate has been slashed by 20%, the 2018 full year estimate is down 6%, and 2019’s full year estimate is down by 8%. Even with these adjustments, Facebook looks like a good value relative to its peers.

Company	Next 5yr Growth	Forward P/E	PEG
Alphabet	18%	25.5	1.4
Facebook	22%	22	1
Twitter	35%	41	1.2

Click to enlarge

(Source: Yahoo Finance)

On a relative basis, Facebook shares are 20% to 40% cheaper, compared to Alphabet and Twitter. On a larger scale, the S&P 500 currently trades at about 25 times earnings, with an expected earnings growth rate of roughly 15%, implying a PEG of 1.7. It’s true that many S&P companies pay dividends, which skews the numbers somewhat. However, it’s difficult to argue that Facebook isn’t undervalued, when the overall index sells at a premium to the shares.

The bottom line

When a fast-growing company hits a speed bump, it’s often management that determines if the car loses control and crashes, or if it’s a short-term event that worries traders. Facebook management is trying to guide the car back on track, by being transparent about why expenses are going up and revenue growth is slowing.

The company is adjusting its offerings to get back to its roots as a high-engagement personal networking platform. In the meantime, the company commands solid advertising growth in units and has pricing power. With strong cash flow growth, and a reasonable valuation, this short-term issue may represent one of the better entry points for Facebook stock.

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.