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Facebook - A Good Buy For Long Term

|About: Facebook, Inc. (FB)
Summary

Facebook has reported more than expected financial results for the third quarter.

Revenue reported for the third quarter was $17.65 billion, which is an increase of 29% year over year.

Facebook was able to generate strong financials despite various backlash, especially in North America surrounding election integrity, political speech, data protection, the spread of misinformation and disinformation. But this backlash.

The stock price is undervalued based on its current financials and business outlook.

Overview:

Despite all the backlashes, Facebook was not only able to survive, but also generate healthy fundamentals. Facebook has also been slapped (or could be in future too) with major fines, such as $5 billion for privacy violations by FTC, 4% of the company’s total revenue by the EU for GDPR violations, etc. Due to this Facebook is at the risk of decorating its reputation, but that doesn’t stop its user base, which is the basic component for its growth, from using Facebook and its properties (mainly Instagram, Messenger and WhatsApp). Keeping in mind the user base as a major determinant for its strong fundamentals, Facebook has also been able to exploit the growth opportunities at all levels. Late 2019 to 2020 would be the period in which Facebook could be under a strong scrutiny. Facebook is currently undervalued considering its currents fundamentals and business outlook.

But as mentioned earlier, regarding the backlashes faced due to for privacy violations, data breach, etc., it might take more time than expected for the market price to move towards its fair value.

Fundamentals:

The users aren’t bothered about the hefty fines and reputational risks faced by the company. Their increasing user base, especially the region where the ARPU is lower, such as Asia Pacific, generates strong fundamentals. That growth was primarily due to an increase of 37% in ad impressions across all Facebook's properties. The major factor for this impression growth was less internal promotion in international markets, particularly Asia-Pacific, which unlocked ad inventory for outside bidders. As shown below, Asia-Pacific notably saw the fastest user growth of all of Facebook's reporting regions.

User Growth:

Source: Seeking Alpha - 2019 - Q3 - Earnings Call Presentation

Source: Seeking Alpha - 2019 - Q3 - Earnings Call Presentation

Revenues and Earnings growth:

We can see the growth, beating the analysts’ estimates, in Facebook’s reported revenues and earnings as well.

Source: Seeking Alpha - FB - Earnings Surprise (Quarterly EPS) - Actual vs Consensus

Source: Seeking Alpha - FB - Revenue Surprise (Quarterly) - Actual vs Consensus

Profitability:

Key profitability ratios are much better as well, compared to its sector median.

In TTM Facebook Sector Median

Gross Profit Margin

81.85% 52.57%

EBIT Margin

34.49% 9.42%

EBITDA Margin

42.76% 20.44%

Net Income Margin

27.08% 4.08%

Source: Seeking Alpha

Valuation:

For the DCF model the following assumptions for the key value drivers are shown below:

Revenue Growth:

Year 1 to 5 Year 6 to 10
CAGR of Revenue 23% 10.18%
Terminal Revenue Growth Rate 2.05%

The revenue growth gradually decreases once the user base gets saturated globally and attains a terminal Revenue Growth Rate of 2.05%. Moreover, we should factor in the case of fines and legal costs, which might lead to loss of advertising revenue.

Pre-tax Operating Margin:

Pre-tax operating margin in year 10 35%

Even though Facebook has been able to deliver impressive operating margins for the revenue it generates, the growing concerns regarding data security of its users is one of the major threat for the company, and the management has decided to improve data security across its organization, even at the expense of making a profit. Hence, these higher costs from data privacy measures might reduce operating margins.

Tax Rate:

The marginal tax rate used here is 25%, the statutory tax rate of the country the company established in.

Model Results:

Terminal cash flow $ 70,438.68
Terminal cost of capital 7.75%
Terminal value $ 12,35,766.26
PV(Terminal value) $ 4,83,222.72
PV (CF over next 10 years) $ 2,22,307.67
Sum of PV $ 7,05,530.39
Value of operating assets $ 7,05,530.39
- Debt $ 12,731.16
- Fines, and legal & other costs $ 6,000.00
+ Cash $ 48,596.00
+ Non-operating assets $ -
Value of equity $ 7,35,395.23
- Value of options $ 200.99
Value of equity in common stock $ 7,35,194.24
Number of shares $ 2,854.00
Estimated Intrinsic Value per share $ 257.60
Market Price $ 190.05
Price as % of value 78.95%

Trading at roughly 21% below its estimated intrinsic value coupled with strong fundamentals, Facebook seems to be profitable business with better growth opportunities ahead.

Current Growth Drivers:

With reference to the third-quarter earnings call, the management has mentioned two key growth drivers for the company.

1.Stories ads:

In their third-quarter earnings call, Mark Zuckerberg said "Stories is obviously one of the biggest growing areas for us and continues to be a big driver". Facebook’s COO Sheryl Sandberg has also mentioned that around 3 million of the company's 7 million advertisers are now running Stories ads across Facebook, Instagram, and Messenger, but with also an emphasis on the importance of News Feed ads.

2. Messaging to stories ads:

The company’s update on Stories ads that will take users straight to Messenger to initiate a conversation with a business might be another growth determinant. This integration is useful for Facebook advertisers and could be particularly appealing for businesses with longer conversion cycles.

Why Facebook is undervalued?

Facebook has consistently reported numbers above expectations along with good growth stories to tell for the forthcoming quarters, but the stock price is below its valuation, moreover, there is no clear evidence of the competitors being a major threat, even though it is not a monopoly. It is the company's public relations problems that have triggered it to be undervalued. If things get worse there might be increased regulation or even a breakup of the company, despite the lobbying efforts. So unless Facebook ensures the data protection of its users and a commitment on increasing fact checks on the contents shared in its platforms, it might take more than expected time period to realize its value in the market.

Conclusion:

Ignoring the short term uncertainty in its stock price, Facebook seems to be a better candidate for long term investment.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.