It's time to take another look at my top pick for 2019 in Facebook (FB). I recently made another stock my top pick for the rest of 2019 due to the better risk-reward. In spite of the run-up this year, FB still has a lot more room to run as it was just playing catch up for a horrible 2018. Wall Street appears to have grown skeptical of the pessimistic guidance that management gave last year and is rewarding FB for continuing to churn out excellent growth. I continue to view FB as a conviction buy.
Trade War Volatility: Up And Down… and Up Again?
FB, like the rest of the market, saw its shares hit deep lows amidst the 2018 bloodbath. FB popped hard in February when it reported strong earnings and hasn't looked back since, except for the recent trade war volatility:
While some may be hesitant to buy after such a huge run, a close look at the underlying financials suggests that shares are still deeply undervalued.
Who Believes It Anymore?
FB has been posting rather strong numbers quarter after quarter, in spite of all the negative headlines and in spite of its own pessimistic guidance.
Analyst Mark Mahaney asked on the follow-up call, "it looks to me like revenue growth is stabilizing, not decelerating… So just tell us why that isn't the right read for the business going forwards, why revenue growth really should decelerate."
CFO David Wehner responded by noting that much of the guidance for deceleration in revenue growth came from one, anticipation that it may lose some pricing power in North America advertisements due to opt-out of third-party tracking which may impact its ability to target ads, and two, its actions towards increasing privacy such as being able to clear your history on Facebook. While I do anticipate that its push to a more private platform will impact its rate of growth moving forward, these comments seem to suggest that advertisers are still just as hooked on advertising on its platforms as its users are on using the platforms.
Further, recall that management had guided for operating margins to decline to the "mid-30s" in its second-quarter conference call last year. This quarter showed operating margins of 22%, but 42% after backing out the $3 billion in operating expense set aside for the ongoing FTC investigation. While that's a drop from the 46% seen last year, it's still a far cry from the 35% range. Revenues grew very strongly at 26% and its diluted EPS was $1.89 (again after adjusting for the FTC investigation), 11.8% higher than the previous year in spite of the operating margin compression.
As we can see below, operating margins indeed have come down each quarter YOY, but the declines have been much more moderated than the rapid descent to 35% that Wall Street seemed to have been projecting (otherwise why did shares collapse to below $130?):
In addition to ramping up operating expenses, FB is also investing heavily in capital expenditures - the first quarter this year saw increased capital investments on top of an already outsized 2018 capital expenditure spend:
(2019 Q1 Presentation)
This makes sense: if the company is going to be serious about improving the security and privacy of its platforms, then it's going to need the technological power to do it. CFO Wehner did suggest on last quarter's follow-up call that 2018 and 2019 saw increased capital expenditures due to the large investments in building data centers and as such the rate of growth should moderate moving forward. This would increase free cash flow and enable FB to return more cash to shareholders through share repurchases.
Why No Buybacks?
In the latest quarter, FB significantly pared back its repurchase program, buying back $613 million worth of shares as compared to $1.77 billion last year. While it is possible that this is due to the latest run-up in the stock price, shares are still significantly lower than their all-time highs and (at least to your author) still very undervalued. It appears to me that the reason for the low buyback amount may be directly due to its FTC investigation, which it estimates to range from $3 to $5 billion but booked $3 billion this quarter. The company had $9.3 billion in cash from operating activities, of which $3.8 billion went to capital expenditures. The remaining $5 billion or so after the small repurchases may simply be reflecting FB setting aside that cash balance for later. CFO Wehner did not say anything more on the follow-up call other than stating that the buyback can "vary quarter to quarter."
Balance Sheet Catalyst
FB has one of the strongest balance sheets around, as typical for the large tech titans. It most recently reported over $45 billion of cash and marketable securities on its balance sheet, but remember that it estimates up to $5 billion will be used for the future FTC settlement. This $40 billion net cash position provides an important "margin of safety" as it represents around 8% of the market cap. For a company with such consistent cash flows, FB should be able to even take on net leverage, perhaps in the range of one to two times EBITDA. Throw in the fact that it would deserve a very high credit rating and one can see how $100 billion in share repurchases (based on $29.7 billion in EBITDA in 2018) at 4% interest rates would bring the share count down dramatically.
Why is FB maintaining the large cash position? This is a mystery as FB's management has not really given much hints behind its thinking. I have some ideas. Perhaps FB is trying to build an "emergency" position in times of a recession or financial hiccup. But this does not seem likely considering it has not put the cash to use amidst the scandals of last year. I think that the most likely reason is that FB is trying to safeguard itself from competition - should a serious social media competitor surface, it may seek to simply buy it out early and remove the competition. As a current shareholder I think that it is quite expensive to keep cash earning low interest for such a scenario which may not happen soon nor happen at all, but on the flipside such a competitor may indeed threaten its existence. At the end of the day, having a large cash position is a high-quality problem and I eagerly await the day I wake up to news that the company announces that it is raising debt with an ultimate aim of being leverage neutral and using the proceeds to buy back debt. This has been the strategy of technology peers Apple (AAPL) and Microsoft (MSFT), and both names have seen premium valuations arguably due to their (in my opinion) smart capital allocation decisions.
Do Not Forget About Emerging Markets
As we saw above, FB continues to show strong growth in its key markets, in spite of the negative headlines. That said, I believe that long-term future growth may primarily come from the rest of the world excluding North America and Europe. As we can see below, ad revenue per user for the rest of the world is significantly less than the amount seen in US and Canada:
(2019 Q1 Presentation)
This is in spite of the fact that rest of the world users make up the bulk of its user base:
(2019 Q1 Presentation)
As the global economy improves, I expect that economies in other parts of the world to ramp up online advertising spending in tandem. This is a long-term secular tailwind which many bears may be overlooking due to rest of world revenues being rather muted at the moment.
Valuation and Price Target
At recent prices, FB trades at just under 24 times trailing EPS of $7.77 per share. Considering that operating margin compression is expected to moderate in 2020, this is a very reasonable multiple for a company continuing to grow revenues north of 20%. If we project $68 billion in revenues in 2019, which represents 22% growth over 2018, and an unrealistically low 35% operating margin, then we arrive at $7.26 in 2019 EPS, suggesting a modest decline from 2018. If we then project 19% revenue growth in 2020, as well as 35% operating margins, then we arrive at $8.96 in 2020 EPS. This suggests that shares trade at just over 20 times 2020 EPS estimates which I view to be very cheap considering their long and high growth runway. My 12-month price target for FB is $224, or 25 times my estimates for 2020 EPS.
As stated above, FB's strong balance sheet may not lead to increased shareholder returns if, for example, it is maintaining such a large cash hoard because of fear that another social network competitor may surface. In this case, while the cash hoard does provide a margin of safety by preparing the balance sheet even in face of poor economic conditions, the cash balance might not lead to the increase in leverage and share repurchases that I indicated in the balance sheet thesis. It is still too early to know management's true intention for the cash hoard, but I continue to reiterate that it is a high-quality problem to be arguing what to do with a $40 billion cash pile. As long as FB continues to deploy significant amounts of earnings towards share repurchases, I am not worried about a growing cash hoard.
FB faces great regulatory risks and regulatory uncertainties regarding data privacy. It is unclear if and when the US will impose restrictions or guidelines and the impact that they will have on its bottom line. I have strong conviction that the secular tailwinds from online advertising will more than compensate for such risks, but readers must be aware that the fast and easy growth of the past may not repeat in the future.
FB may face a strong competitor in the future, one which may not agree to be taken out. There isn't really any competitor right now so I view this to be the least likely risk, and I have confidence that the top talent at FB can continue to innovate and keep its platforms relevant and engaging.
Despite the strong stock performance this year, FB continues to show strong growth and this looks likely to continue for many years. I reiterate my conviction buy rating.
(TipRanks: Buy FB)
Disclosure: I am/we are long FB, AAPL, MSFT. 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.