Seeking Alpha

Facebook Stays On Course

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About: Facebook, Inc. (FB)
by: Kwan-Chen Ma
Summary

Facebook has stayed on course to increase investment in product development, data security, and content management even at the expense of revenue deceleration and margin contraction.

Investors appear to be impressed by Facebook’s commitment to repair its damaged reputation. Facebook stock price starts reacting to improved financials.

Facebook stock prices become increasingly more sensitive to free cash flow than to revenue, suggesting that Facebook may finally get over its growing pain.

Facebook's stock price should easily break $200 again in 2019.

In the next two years, the stock is expected to rise from $200 to $275, with a 17% annual rate of return.

Few months ago, I wrote an SA article on estimating Facebook’s (FB) future target prices, using then analysts’ forecast financials. Since the model’s forecast prices turned out to be reasonably accurate (Figure 2B below) and the current forecasts of forward financials have changed somewhat from March, it may be worthwhile to update the forecast prices. (Figure 2B below is taken from “Facebook Stories Is A Stock Price Story,” March 3, 2019.)

Stay On Course

The good news is that, regardless of the continuous public criticisms, Facebook continues to beat the top line and bottom line estimates as well as the guidance. For 2Q, user growth, longer engagement and increasing ARPU all validate the strong moat baseline model. Specifically, Facebook has aggressively chased Live Stories and messaging monetization. With less reliance on News Feed ads, growth has slowed down but engagement has risen. More than 2 million advertisers are using Stories. The 2H higher volume may offset the low ad pricing which has pressured the sales growth in 1H 2019. The monetization of Stories looks promising in 2H 2019 if Facebook is allowed to integrate Messaging and Instagram by regulators.

It may seem counter-intuitive. But Facebook decided to stay on course to its original commitment in increasing investment in product development, data security, and content management even at the high expense of revenue deceleration and margin contraction. As a result, the revenue growth rate has been consistently guided down from 40% to high teens into 2021 (Figure 1A). Gross margin is expected to drop from 88% to 80% by the end of 2020 (Figure 1B), also reflecting the $5 billion fine from the recent FTC proposed settlement. While operating expense was guided up from 45% to 49.4% back in July 2018, it is expected to stay at the high level till 2021 (Figure 1C).

On the bright side, the market seems to shed off recent FTC’s proposed $5-billion fines on Facebook privacy violation, as people like to use Google digesting a $5-billion fine from the EU in just a quarter as not a critical story to Facebook. Although it does not seem that Facebook got out of the woods yet, just last Friday, New York State Attorney General Letitia James announced the Facebook probe, which is also being supported by six other states and the District of Columbia.

Valuation Consequences

At this time, I will revise the future target prices based on the new forecast financials. From previous posts, Facebook's stock prices are known to positively relate to analysts' forecasts of future revenue, EPS, and free cash flow (Figure 2A-2C).

Free Cash Flow Is More Important than Revenue

However, after Facebook’s earnings expectation has dropped more than 40% after July 2018, shareholders have started paying more attention to future revenue estimates than to gross margin estimates. The less emphasis on profitability couldn’t come at a better time since Facebook reaffirmed its intention to improve quality, security, and credibility of its product even at the expense of gross margin. Another encouraging sign for shareholders is that Facebook stock prices become increasingly more sensitive to free cash flow, the ultimate measure of true value to investors (Figure 2C), and Facebook’s free cash flow is expected to increase into 2021.

The “story” messaging from the positive relationship between forward financial estimates and stock prices should give investors more comfort, since it suggests that Facebook's stock prices have reflected underlying fundamentals after all, even though there may have been occasional "breaks" over time. Furthermore, since Wall Street analysts, as a group, tend to give forward estimates routinely many quarters into the future (till 4Q 2021), it may be informative to investors if future Facebook prices can be estimated with the corresponding forward financial forecasts. That being said, the premise of this exercise is that the analysts' consensus estimates need to be unbiased as a group and over time. Therefore, based on the Street's current estimates of the financial metrics for last 28 quarters and next 10 quarters, I was able to estimate Facebook's "forward target prices." The steps I came up with this forecast price can be found in the previous post.

In Figure 3, I showed how the Facebook target prices should have moved historically (in solid red line) and in the future. The average target price is computed based on the consensus estimates of forward financials, where the high and low price range is derived based on the high/low forward financial estimates. As of now, Facebook is trading around $190 which is at the low end of the current price target (in green circle), where the current fair value should be around $230, implying there is $40 upside in the near future.

More importantly, this model provides the predicted target price path for next two years, based on the current estimates of the forward financials. If the current estimates of next 2-year financials materialize, Facebook stock price looks to move from $190 to $275 in two years (red dotted line in Figure 3), with an approximate +/- 15% high/low range of $183-$322 (Figure 3 in black and blue).

Of course, it should be cautioned that although Facebook is predicted to show a drastic price appreciation given the current forecasts of future financials, the forecast is not able to take into account potential political risk. Given the extraordinary antitrust risk that Facebook faces, any resulting analysts' revisions on forward financials can easily shift the predicted target price path in Figure 3 upward or downward.

Takeaways

It may easily happen in 2019 that Facebook's stock price may break $200 again. Street analysts have been very optimistic about Facebook's long-term fundamentals, assuming that the FTC’s 5-billion fine has been baked into the forward financials, e.g., margin and EPS; Stories' volume growth will overcome price weakness, and the regulators will allow Instagram and messaging to be integrated and monetized. Most financial metrics have shown signs of improvement almost a year after the infamous Facebook downside guidance.

Regardless what you think of Facebook’s business model or CEO Mark Zuckerberg, one should be impressed by Facebook’s commitment to improve company’s credibility at a significant cost of revenue growth and profitability. There is some evidence that the market has also been impressed. As a result, Facebook's stock price may hit $200 soon. In the next two years, the stock is expected to rise from $200 to $275, with a 17% annual rate of return.

Incidentally, since the forecast price was estimated based on the premise that analysts’ forecast financials will materialize. Given the fact that Facebook has a track record to routinely beat the estimates, the estimated target prices should be on the low side.

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.