Facebook: Q2 Showed Growth In All Key Metrics: Reiterate Buy

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About: Facebook, Inc. (FB)
by: Blue Sky Capital
Summary

Facebook shares have fallen 9% since rising to $205 after Q2 results, though still up 8% in the 5 months since our initiation at Buy.

Excluding one-offs like the FTC penalty and a tax ruling, Facebook grew its EPS at low-teens year-on-year in Q2, despite its costs rising by 39%.

Continuing strong growth in the number of users, the number of ads and revenue per user show the power of Facebook's structural drivers.

We continue to believe Facebook can grow earnings sustainably at a double-digit CAGR, potentially accelerating to 15-20% after 2019.

At $185.37, Facebook is on a similar valuation to other quality large-cap stocks with much lower growth. We re-iterate our Buy recommendation.

Introduction

Facebook (FB) shares have fallen 9.4% since their 19Q2 results in late July, despite initially rising to $205 amid a positive Wall Street reaction. (Since our Buy recommendation in March, shares have still risen by 8.2%, outperforming the S&P 500 by about 450 bps.) We believe the Q2 results were in fact highly positive for our investment case, and outline our reasons below.

FB Share Price & Volume (Last 12 Months)

Source: Bloomberg (13-Aug-19).

Buy Case Recap

As outlined in March, our Buy case is based on our view that FB is a multi-year compounder capable of grow its earnings at double-digits, potentially 15-20% p.a., after an investment phase in 2019.

We believe Facebook's ad revenue growth will continue to be strong, driven by powerful structural growth in the number of users, the number of ads per user and revenue per ad. Specifically, over the medium term, we estimate that the number of users will grow with a CAGR of 10%, while the number of ads per user and revenue per ad will each grow with a CAGR of 3-5%.

While we are not able to monitor all of these metrics directly, we believe that measures like the ratio of Daily Average Users ("DAU") to Monthly Average Users ("MAU") will help indicate the strength of FB's franchise.

19Q2 Results Highlights

FB showed another quarter of strong growth in its user base in Q2, with Facebook-only MAU growing 8.1% year-on-year, and Facebook-only DAU growing 7.9% year-on-year.

Revenue growth was also strong, with revenue growing 27.6% year-on-year (32.0% in constant currency) in Q2, driven by the number of ads growing 33%, offset by revenue per ad falling 4% due to mix. The negative mix impact was a result of FB's growth, which was faster in regions and ad surfaces with lower average revenues.

FB's earnings were impacted by an additional $2bn accrual ($3bn was already accrued in Q1) for the $5bn penalty in its privacy case settlement with the Federal Trade Commission ("FTC"), as well as by an one-off $1.1bn tax expense from a Ninth Circuit Court ruling (in the "IRS vs. Altera" case) related to stock-based compensation.

Excluding these one-offs, FB's EBIT grew by 13.0% and EPS by 14.2% year-on-year in Q2, and by +14.4% and +12.9% respectively for H1. Notably, FB has achieved this low-teens earnings growth despite a 39% year-on-year increase in costs and expenses, thanks to the size of its revenue growth.

Further details from FB's 19Q2 results are as follows:

FB 19Q2 Results – Group Key Items

Source: FB results press release (19Q2).

We will review each driver of FB’s revenue growth in turn below.

Growth Drivers - Number of Users

FB's growth in number of users was strong in Q2, although slightly below our medium-term assumption of a CAGR of near 10% (for the FB family of apps).

Facebook-only MAU was up by 8.1% year-on-year, again driven by growth in Emerging Markets, but numbers in Developed Markets also increased, as shown below:

Facebook Monthly Active Users (Since 2017)

NB. Figures for Facebook and Messenger only, and exclude Instagram & Whatsapp.

Source: FB company filings.

Including the whole FB family of apps (for example Instagram and WhatsApp), MAU was 2.7bn in June (from 2.5bn in the prior year, or about 8% up); DAU for the FB family of apps was 2.1bn.

Engagement among FB users (as measured by the DAU/MAU ratio) remained stable in all regions, though levels in APAC and Rest of the World were still significantly lower than that in the U.S. & Canada. While the group DAU/MAU ratio varies slightly from quarter to quarter, this is due to its natural volatility, as well as a mix effect from growth being faster in lower-DAU/MAU regions:

Facebook DAU/MAU Ratio (Since 2017)

NB. Figures for Facebook and Messenger only, and exclude Instagram & WhatsApp.

Source: FB company filings.

In particular, while the DAU/MAU ratio in the U.S. & Canada (FB's most mature region) showed a dip year-on-year, this is purely superficial, as the DAU and MAU figures showed that the number of people who use Facebook daily in the U.S. & Canada is still growing, albeit not as fast as the total number of users who use Facebook at least monthly, thus driving down the DAU/MAU ratio:

FB DAU/MAU Ratio – US & Canada (Since 2017)

Source: FB company filings.

FB DAU & MAU Numbers – US & Canada (Since 2017)

Source: FB company filings.

Growth Drivers - Ads Per User and Revenue Per Ad

In 2019, FB is growing the number of ads per user strongly – the total number of ads was up 33% year-on-year for H1, while MAU only grew by 8%:

FB Ad Revenue Growth & Components (2012-18)

NB. 19H1 no. of ads growth is based on the average of +33% in Q2 and +32% in Q1.

Source: FB company filings.

The growth in the number of ads is driven by the relatively new Instagram Stories, as well as by Instagram Feed and Facebook News Feed. As shown above, FB had pursued this type of growth previously in 2012-13 (then with the relatively new Feed), before then reducing the number of ads in 2014-15 to drive revenue growth through price instead.

Revenue per ad was down 4% year-on-year due to mix, as a result of FB's growth being faster in regions and ad surfaces with lower average revenues.

While this is different from our medium-term assumption of both the number of ads per user and revenue per ad growing with a CAGR of 3-5%, the combined growth is higher, and we believe the two growth rates will revert to a more even mix in the long run.

Ad Revenue Per User

Ad revenue per MAU shows the combined effect of the number of ads per user and revenue per ad. As shown below, the U.S. & Canada has the highest figure, and was still the fastest-growing in $ terms in Q2:

FB Ad Revenue Per MAU ($) (Since 2017)

Source: FB company filings.

However, when indexed to their 17Q1 level, ad revenue per MAU can be seen to grow at roughly the same trajectory in the U.S. & Canada and in Europe, while the growth rates in APAC and Rest of the World have been impressive too:

FB Ad Revenue Per MAU – Indexed (Since 2017)

Source: FB company filings.

Other Initiatives

FB is involved in a number of other initiatives, including Payments, e-commerce and blockchain (through the Libra Association), but all of these are at relatively early stages. While some of these initiatives are already in the trial stage (e.g. WhatsApp Payments in India and Checkout in Instagram), they are not expected to be a material driver for the P&L in the near term. We regard these initiatives as source of further upside to our investment case built around FB's ad business.

Valuation

In our Buy case, we believe 2019 will mark the low-point of FB's earnings growth, due to the dramatic increase in investments in costs and capital expenditure, related to improvements in privacy and security, as well as new products and new geographies.

With 2019 YTD financials heavily impacted by one-offs like the FTC penalty and the tax ruling, we continue to value FB using its 2018 full-year financials. In calculating FB's Price / Earnings ("P/E") and Free Cash Flow ("FCF") Yield, we exclude FB's $43.6bn of cash (net of $5bn for the FTC penalty), worth 8% of its current market capitalisation.

On 2018 financials, FB is on 21.9x P/E and 3.2% FCF Yield, as shown below. This gives FB a similar valuation to many quality large-cap stocks that have significantly less growth potential, making FB attractive by comparison:

FB Net Income & Cashflows (2014-19H1A)

Source: FB company filings.

(In our previous article, we have shown how normalizing FB's capital expenditure and share-based compensation costs in 2018 gives us a $15.5bn figure for its normalized FCF. While capital expenditure is high in FY19, management has reduced its FY19 outlook from $17-19bn to $16-18bn.)

Conclusion

FB's 19Q2 results showed continuing strong growth in its number of users, number of ads and revenue per MAU, indicating that FB's structural drivers remain powerful.

Excluding one-offs (FTC penalty & tax ruling), FB managed to grow its EPS at low-teens year-on-year, despite a 39% expansion in its costs. We believe such double-digit earnings growth will continue, and will potentially accelerate to 15-20%.

At $185.37, FB is trading at 21.9x P/E and 3.2% FCF Yield (on 2018 financials), similar to many quality large-cap stock with significantly less growth potential, making FB's valuation attractive.

With the resolution of FTC privacy case, we expect the upcoming antitrust review (also by the FTC) to be equally moderate in its consequence.

FB will be a multi-year compounder, sustainably growing its EPS at double-digits (possibly accelerating to 15-20%), which will in turn generate a double-digit annual return for investors (eve with no re-rating upwards).

We reiterate our Buy recommendation on the stock.

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.