- Facebook is among the few tech titans to see meaningful share price appreciation this year. So far, the stock is up ~20% in 2021.
- Facebook recently reported very strong Q1 results, boosted by normalization in ad revenue.
- However, I see potential risks in Facebook's user trends as growth in Facebook's most lucrative market, the U.S., stagnates.
- Facebook is appropriately valued at ~26x FY21 EPS, with few near-term catalysts that can keep powering its recent rally.
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It hasn't been the easiest year in the stock markets for tech giants, but Facebook (FB) is sailing above its peers and doing just fine so far in 2021. The world's largest social media giant is up ~20% year to date, rising a fresh ~5% after the company reported blowout Q1 results. In a quarter that has seen many internet stocks disappoint sharply on earnings (Netflix (NFLX), Spotify (SPOT) are a few of the notable examples), Facebook's outperformance stands out, even though I see hints of the same risks that are plaguing all consumer internet names: weaker user trends ahead of the reopening.
I have been bullish on Facebook for years. In February of this year, I recommended buying Facebook as the stock temporarily dipped to the $260-$270 range, a trade that has worked out well. But now, after digesting the company's latest Q1 results and acknowledging the company's latest rally, I'm turning my stance on Facebook to neutral - as I believe investors will have an opportunity to invest in this stock at a lower price down the road.
Key near-term risks and valuation update
Risks to Facebook are numerous, and I won't rehash the most common ones here (the recent iOS update, competition from other social media platforms being the most common). But in particular, coming out of the Q1 earnings print I see two additional risks that mute my enthusiasm for this stock:
- Stagnating U.S. user growth. Facebook is a global company, and the U.S. only represents a small slice of Facebook's overall user pool. Yet this minority also drives the majority of Facebook's advertising revenue, and dramatically outweighs users from other regions in terms of ad revenue per user. We saw a small and temporary lift in users amid the pandemic, but now that number is on the wane. Right now, Facebook's revenue growth is being driven by easier comps against a pandemic-impacted 2020 that saw ad prices crumble. But going forward, we need fresh user growth in order to drive revenue growth.
- Cost estimates are increasing. Despite being massively profitable for years, Facebook has never really put much emphasis on the bottom line. In the wake of the Cambridge Analytica scandal in 2019, the company's shares sank in anticipation of the fact that Facebook would (and it did) pour billions into rolling out improvements to platform security and content policing. Management has indicated that it intends to ramp up spending again in 2021, which may hold margins lower.
On the cost piece, here's Facebook's guidance statement on costs for the current year:
We expect 2021 total expenses to be in the range of $70-73 billion, updated from our prior outlook of $68-73 billion. The year-over-year growth in expenses is driven by investments in technical and product talent, infrastructure, and consumer hardware-related costs. We remain committed to investing for long-term growth and our expense outlook reflects the underlying strength of our business and the compelling investment opportunities we see across our products, including consumer hardware."
A ramp in spending and a slowdown in EPS growth rates may put a damper on enthusiasm for Facebook stock, which is already looking pretty pricey. At current share prices near $323, Facebook trades at a 26.4x P/E ratio based on Wall Street's FY21 EPS consensus of $12.23 (data from Yahoo Finance).
Considering the risks of heightened spending (the ~$2 billion spend increase on the lower end of Facebook's updated cost guidance translates to about ~$0.70 per share in EPS, based on ~2.87 billion current shares outstanding) plus stagnating user growth, I don't think there will be much opportunity for Facebook shares to re-rate much higher from here.
User growth issues
Let's now dig into the user-growth conundrum in a bit more detail. Overall, Facebook's top-line user metrics seem healthy, but when we dig into the U.S. trends, we see some areas of concern.
Overall DAUs in Q1 grew 8% y/y to 1.88 billion, slightly shy of Wall Street's expectations of 1.89 billion. This also represents a three point slower pace versus 11% y/y DAU growth in Q4. Similarly, MAUs grew 10% y/y in Q1 to 2.85 billion, two points slower than 12% y/y growth in Q4 and slightly shy of the Street's 2.86 billion consensus.
So Facebook's user base is still growing - but when you dig into the geo trends underneath that, it's really Asia and the "rest of World" that is driving that user growth. The U.S. and Europe, meanwhile, are more or less stagnating. You can see in the DAU chart above that U.S. and Canada DAUs of 195 million have flatlined over the past two quarters, and are actually down versus 198 million DAUs in Q2 of 2020 (when usage of Facebook and Instagram was at its highest in the immediate aftermath of the pandemic). Q2'20 was also the last quarter that Facebook grew DAUs in the U.S. - each quarter after that has represented a decline.
Why this is worrisome is because U.S. and Canada users generate significantly more ARPU than their other counterparts. A U.S./Canada user brought in $48.03 in ARPU in Q1 (up 32% y/y, driven by a recovery in ad pricing), which is more than 3x what a European user brings in its terms of revenue. It's also about 12x what an Asia-Pacific User is able to generate in per-user revenue, and ~18x more than what a "Rest of World" user is worth.
Taken together, the U.S. generated 47% of Facebook's advertising revenue in Q1, despite being only a ~10% slice of the user base. While it's true that ARPU is gradually climbing upward in Asia and Rest of World, it'll be a long time before either of these regions generates close to what a U.S. or Canada user generates in ARPU. So here's the basic gist of the problem: Facebook looks like it's still growing its DAUs and MAUs at a high single digit or low double digit pace, but the mix of that growth is slanted toward low-ARPU regions. In the meantime, Facebook's cash cow users in the U.S. are seemingly peeling off - either to other platforms like TikTok and Snap (SNAP), or just decreasing their usage overall as the economy reopens and there are more interesting things to do than scrolling past a news feed all day.
With Facebook already trading at ~26x this year's earnings (or ~22x next year's earnings) while facing the risk of U.S. user deceleration plus heightened spending that may put pressure on margins and earnings growth, I'm more inclined to stay on the sidelines for Facebook until share prices come down. Given Facebook's outperformance vis-a-vis other tech giants so far in 2021, and the fact that I see few fundamental catalysts on the horizon that can keep fueling Facebook's rally, locking in gains is the best move here.
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