Facebook: Ride It Higher

Summary

• Shares of Facebook zoomed upward after reporting huge beats to top and bottom-line estimates in Q4.
• User growth also remained constant at 9% y/y (roughly flat to last quarter), defying fears that Facebook's numerous scandals would affect its user retention.
• Global ARPU also hit an all-time high of $7.37, helping to drive 30% y/y revenue growth.
• Facebook is heading into a year of massive investments into content and security, but Wall Street is still expecting robust EPS performance in the coming year.

After a long period of sitting in penalty-box territory, shares of Facebook (FB) are sizzling again. Expectations were so muted for a company embroiled in a number of difficult scandals last year that investors were probably willing to accept in-line results in Q4 - instead, Facebook delivered a resounding beat on both revenues and EPS, sending shares up double digits. In my view, Facebook is in for a long recovery rally ahead.

Data by YCharts

I wrote in a prior article that many of investors' largest fears on Facebook are overplayed. Facebook was one of few stocks to end 2018 with a negative double-digit performance, primarily out of the fear that cries of "Delete Facebook" that have plastered the media would eventually eat into Facebook's user base. In Q4, Facebook proved these rumors wrong: while the company's MAUs and DAUs continued to grow in the high single digits as they did over the past several quarters, Facebook is still far from bleeding active users.

2019 will be a year of heavy investment for Facebook. The company is planning to invest billions of dollars into content policing (to fight the "fake news" label) and address privacy/security concerns, while taking greater measures to unify and integrate its core platforms across Instagram, WhatsApp, and Facebook Messenger. Capex spending has already begun to trickle upward in the back half of 2018, cutting into Facebook's considerable free cash flow generation.

These investments, however, are no reason to back off a bullish position in Facebook. Operating margins and free cash flow may soften in 2019, but once these investments become embedded into Facebook's operating structure, it can return back to margin growth. It's worth noting as well that despite the well-publicized intention for greater capex and operating costs in 2019, Wall Street analysts are still predicting flattish EPS for FY19 (per Yahoo Finance), alongside robust 24% y/y revenue growth.

Facebook remains 25% below its all-time highs of $220, and it's trading at a reasonable P/E ratio of 22x. This is a company that, along with Alphabet (GOOG) (GOOGL), controls a whopping 62% market share of digital ad revenues (per a recent article in the Wall Street Journal, detailing the difficulties of other digital media companies in the wake of the Facebook/Alphabet duopoly). Despite prognostications that users will eventually ditch Facebook, there is hardly a viable alternative in the market for connecting with friends and sending messages. As such, Facebook's iron grip on users' internet time seems secure - especially as Facebook has made specific efforts to become a mobile-first company (mobile now represents >90% of Facebook's ad revenues).

Stay long on Facebook and keep riding the recovery higher.

MAU and DAU growth; ARPU rises as well

One of the most reassuring data points coming out of Facebook's fourth-quarter print is the fact that user growth remained stable. See the charts below:

Figure 1. Facebook DAUs and MAUs

Source: Facebook Q4 earnings deck

DAUs grew 10% y/y to 1.52 billion, on par with last quarter's 10% y/y growth rate; while MAUs grew 9% y/y to 2.32 billion, also roughly on par with last quarter's 10% y/y growth rate. On a net add basis, Facebook added 28 million DAUs on Q4 (greater than 24 million adds in Q3), while MAUs grew by 49 million (also greater than 37 million in Q3). These user metrics don't indicate a Facebook that is suffering from major user backlash, despite what the media would suggest.

Facebook's Mark Zuckerberg also noted on the Q4 earnings call that there are now 2.7 billion people in the Facebook "family" using Instagram, WhatsApp, or Facebook Messenger as well as the core Facebook platform, and 2 billion people who use these services daily. Here's some additional qualitative commentary from the earnings transcript on Zuckerberg's key focus areas for 2019:

Going into 2019, we're focused on four priorities: first, continue making progress on the major social issues facing the Internet and our company; second, build new experiences that meaningfully improve people's lives today and set the stage for even bigger improvements in the future; third, keep building our business by supporting the millions of businesses, mostly small businesses, that rely on our services to grow and create jobs; then fourth, communicate more transparently about what we're doing and the role our services play in the world. And I want to take a minute talk about each of these."

One more user-related note is worth pointing out: Facebook also enjoyed significant gains in average revenues per user (ARPU) in Q4, indicating greater monetization potential from the company's new services. ARPU hit $7.37 in the fourth quarter, up 19% y/y and a record high.

Figure 2. Facebook ARPU trends

Source: Facebook Q4 earnings deck

For a company that already has one-third of the global population on its platform, user growth will cease becoming a primary source of revenue expansion going forward, as Facebook's saturation is already high. Instead, ARPU will be the key to revenue growth - by adding new services and improving monetization across products, Facebook will be able to retain its current pace of double-digit revenue growth even as user growth slides down into the mid single-digits.

Q4 download

Here's a closer look at Facebook's full fourth-quarter results:

Figure 3. Facebook 4Q18 results

Source: Facebook Q4 press release

Revenues grew 30% y/y to $16.9 billion, far exceeding Wall Street's expectations for $16.4 billion (+26% y/y) by a four-point beat margin. In a quarter where many tech giants' revenues came in line or below expectations (such as PayPal (PYPL) and Microsoft (MSFT), to name a few), Facebook's beat was a huge surprise. As previously noted, Facebook's revenue growth was helped by solid gains in ARPU. Note, however, that revenue growth saw three points of deceleration relative to 33% y/y growth in Q3 (but last quarter, Facebook had missed analysts' revenue targets by half a percentage point). On a constant currency basis, however, Facebook's revenue growth would have been three points higher at 33% y/y.

Advertising revenues, needless to say, form the lion's share of Facebook's revenue base. In Q4, CFO David Wehner actually noted that average ad pricing fell 2% y/y. The number of ad impressions, however, grew 34% y/y - boosted primarily by ads on Instagram, as well as ads on the new Instagram Stories format. The company mostly shrugged off the decline in ad pricing, with Wehner noting on the Q4 earnings call as follows:

"The year-over-year decline in average price per ad reflects an ongoing mix shift towards product services and geographies that monetize at lower rates."

Despite the strong top line, Facebook did see a dip in operating margins, foreshadowing the heavy operating investments the company will make on content and security in 2019. Total operating margins fell eleven points to 46%, down from 57% in the year-ago quarter.

Figure 4. Facebook operating margin

Source: Facebook Q4 earnings deck

The company noted that total headcount grew by 42% y/y to 35.5k full-time employees. Most of the operating investments, as expected, were in "infrastructure, safety, and security," while the company also noted a seasonal bump in marketing expenses to promote hardware products (Oculus and Portal). Facebook also reiterated its expense forecast for "approximately 40% to 50% growth" in 2019 relative to 2018. When applying this against Wall Street's consensus for 24% y/y revenue growth in 2019, this implies further operating margin deterioration in the coming year.

Still, despite the margin contraction, Facebook managed to handily beat bottom-line estimates in the fourth quarter. Pro forma EPS came in at $2.38, representing 9% upside against Wall Street's consensus of $2.18.

Key takeaways

The bottom line on Facebook's stock: keep holding on for the recovery. The company has managed to pull through incredible public pressure and still deliver strong revenue and earnings growth, while retaining its pace of MAU/DAU growth. Much of the risks that seemed to plague Facebook last year have moved into the rearview mirror. The stock is still trading at a relatively low valuation compared to historical levels - there's still plenty of upside left.

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