Is Facebook A Buy Today In The Face Negative News Flow?

Summary

• Facebook released blockbuster Q4 results, but the stock moved in reverse on a mix of anti-trust, iOS 14/privacy, and regulatory concerns.
• Facebook shares trade at a similar earnings multiple to the S&P 500 despite having far higher growth expectations.
• Facebook is showing real operating leverage as SG&A and R&D continue to shrink as a percentage of revenue, leaving potential for upside in earnings estimates.
• Facebook's privacy and anti-trust concerns are real but are likely fully reflected in the stock price by now.

Facebook (FB) has had a rough few months of negative headlines. From the December FTC anti-trust lawsuit, to iOS 14 changes requiring users to opt-in for FB to gather information, news licensing battles, even biometric privacy concerns, it doesn't seem a week goes by without a new negative headline.

I believe this negative sentiment has created a significant buying opportunity, where Facebook now trades at a Price/Earnings in-line with the S&P 500, despite having far higher expected growth. This has created an opportunity for patient, long term investors willing to tune out the near term noise.

Facebook's business is strong - especially Instagram - does its valuation make sense?

Facebook had an extremely strong year, growing operating earnings 36% on a 21% increase in revenue.

I believe next years earnings estimate of $11.12/share will prove conservative, even with the general premise that people will spend less time and money online and more time and money on activities, vacationing, and at restaurants. FB CFO David Wehner expressly guided to this recently.

But taking a longer term view, Facebook is currently expected to grow earnings at nearly 15% for the next 5 years, and I believe there is potential to grow faster than that. This is what investors should focus on, rather than the near term issues.

A Key Theme: Operating Leverage

Similar to arguments I made with both Google (GOOG) and Amazon (AMZN), I believe Facebook is reaching an inflection point in its business where both Capex and Operating expense growth will start to flatline, leading to a significant increase in operating income and free cash flow. We are already seeing this happen in the past 2 years.

Expenses are still increasing in absolute terms, but shrinking as a percentage revenues. R&D spend in 2020 was an eye-watering $18.5 billion, more than double the $7.7 billion spent in 2017, yet you rarely hear any narrative about Facebook's technological moat like you hear about companies like Tesla (TSLA), who only spent $1.49 billion on R&D in 2020 up a whopping 8% from what they spent in 2017.

Data by YCharts

I think this is a trend that will accelerate, but you wouldn't know it by the analyst estimates, which have revenue and EPS growing at similar rates for the next 5 years.

If Facebook can increase revenue as expected, I believe EPS will grow at a much faster rate, especially if FB uses to excess cash flow to reduce share count, which it seems to be getting more serious about with adding another $25 billion authorization. Like many high growth companies, there likely also exists substantial opportunities to streamline and reduce costs, if and when revenue growth finally decelerates.

I do not believe any of this is reflected in current estimates, making it an even better opportunity.

Will regulation or a break up hurt Facebook?

In early December, the FTC and the majority of states sued Facebook charging it as an illegal monopoly. Potential remedies could include a forced divesture of Instagram and WhatsApp.

In assessing the risk to shareholders, I focus on the likelihood of the FTC states prevailing, and the harms if they do.

Likelihood of the FTC prevailing and forcing spin offs of WhatsApp and Instagram

I believe the likelihood that the FTC prevails is low. The last time the FTC successfully forced a breakup of any company this size was the 1984 breakup of AT&T (T) into the "baby bells." Relevant that the FTC lawsuit against AT&T was filed 10 years earlier, in 1974, so this process can take a long time to play out.

The most notable case since then was Microsoft (MSFT) in 2000, and even after a breakup was ordered in 2000, Microsoft ultimately walked away with a slap on the wrist.

Especially compared to these two landmark cases, I believe proving that consumers were harmed by Facebook to the extent a breakup is merited is a huge stretch.

Impact to Shareholders if a breakup were to occur

While there certainly are strong synergies and network effects between Facebook's major platforms, I believe each of them is unique enough, and holds a commanding enough presence in their particular niches, that they could function effectively independently as well.

Looking at similar history here is important. In the 12 years after AT&T was broken apart, shareholders who held onto the 7 baby bells received a 900% return with dividends reinvested, shattering the returns of the S&P 500 over the same period.

I'm not trying to imply these situations with FB and T are similar, or that FB would have as good of an outcome, but simply illustrating that divestures aren't close to fatal either. Spinoffs generally create value, and it would not surprise me to see that happen with FB.

Ultimately, I agree with KeyBanc on this, that the most likely outcome would be increased regulatory scrutiny on future M&A deals - which is a real negative, consider FB's past successes with acquisitions.

Conclusion

I see many similarities in the Facebook Q4 Results and the Google Q4 Results as both beat revenue and EPS estimates significantly. While Google has impressively outperformed since the beginning of 2021, Facebook has gone in reverse.

Data by YCharts

Facebook is not without its problems. The headline issues are real, as is the growing feud with Apple. But I believe the current fears are overdone and is providing a huge buying opportunity, and FB ends up above $400/share by the end of 2022.

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.