Disclaimer: please do not base your investment decisions on any other people’s opinions in the world except for yourself.
Evening Everyone,
I have recently been amazed by how significantly the market can be irrational and merciless. Everyone knows about the recent 20% drop in Facebook, right? Here I would like to look closer into the figures and see whether they are indeed frightening (as with, arguably, Netflix) or the investors are simply panicking and opening room for discounted purchasing.
Once again, I will attempt being objective as much as it is physically possible and concentrate on the figures (but don’t promise due to being biased on this stock [it is a significant part of my portfolio]).
Overview
Facebook is a huge machine. It owns very many things that it is even hard to list (FB itself, WhatsApp, Instagram and many more). If curious, have a look. This week, the company has issued its quarterly report with financial results. The numbers grew, but not exactly in line with Reuters analysts’ expectations: the operational expenses increased significantly, whereas the revenue and the user base growth were slower than the forecast. Although this was already evident from the report for the first quarter, we can now figure out whether Facebook’s business model’s performance has deteriorated or not.
Active Users
Facebook has increased the number of Daily Active Users by 11% compared to the second quarter of 2017: from 1.32 to 1.47 billion users. Albeit analysts had expected 1.49 billion. This slowing growth is now lasting for five consecutive quarters.
The growth of active Facebook users in millions. In brackets - growth to the same period a year ago:
| Year | Q1 | Q2 | Q3 | Q4 |
|----------------------------------------------------------------|
| 2016 | 1090 (+16%) | 1128 (+16%) | 1179 (+17%) | 1227 (+18%) |
| 2017 | 1284 (+18%) | 1325 (+17%) | 1368 (+16%) | 1401 (+14%) |
| 2018 | 1449 (+13%) | 1471 (+11%) | TBC Oct 2018 | TBC Jan 2019 |
Another long-term problem is that the company has, arguably, reached the user limit in the US and Canada - 185 million. The growth has also slowed due to the Cambridge Analytica scandal: some users publicly deleted accounts in Facebook earlier in 2018. Whilst it turned out not being a big deal (the share price got back to its pre-scandal position in 60 days), the problem is that the US and Canada users bring (!) 47% of all revenue. Therefore, if the user base does not grow and raise the advertising revenue organically (more users = more money), Facebook now must invest into R&D-ing the algorithms that will help advertisers target potential buyers more precisely. And only then FB could increase the cost of advertising that would compensate slower user growth.
Now we established that the US and Canada user base growth is slowing down a lot, let’s look at other regions too. In general, the growth of new active users is slowing everywhere across the globe, but not as severely as in North America.
The growth of active Facebook users by region in millions (comparing to the same period the year before):
| Period | US and Canada | Europe | Asia | Rest of the world |
|----------------------------------------------------------------------|
| Q3 2017 | 185 (+4%) | 274 (+7%) | 476 (+29%) | 433 (+15%) |
| Q4 2017 | 184 (+2%) | 277 (+6%) | 499 (+26%) | 441 (+14%) |
| Q1 2018 | 185 (+2%) | 282 (+5%) | 529 (+24%) | 454 (+11%) |
| Q2 2018 | 185 (+1%) | 279 (+3%) | 546 (+20%) | 461 (+10%) |
Revenue
Facebook increased its revenue by 42% compared to the second quarter of 2017: from $9.3bn to $13.2bn. Analysts had expected $13.36bn (FB was $0.16bn or 1.2% short).
It is becoming harder to earn money: the user base is heading towards its limit in the US and Canada. GDPR being a pain in the back in Europe, whereby users can restrict the extent to which Facebook can use their data. And at the end of the day, users’ data is Facebook’s bread and butter, ultimately, the core source of income the company generates from the advertisers. It is rather evident that more bearish news than bullish (animal’s definitions can be found in this great post) are being featured about Facebook recently, but we will get to the positives later.
Facebook’s revenue in billions and % comparison to the same period the year before:
| Year | Q1 | Q2 | Q3 | Q4 |
|----------------------------------------------------------------------|
| 2016 | $5.38 (+52%) | $6.43 (+59%) | $7.01 (+73%) | $8.81 (+51%) |
| 2017 | $8.03 (+49%) | $9.32 (+45%) | $10.33 (+47%) | $12.97 (+47%) |
| 2018 | $11.97 (+49%) | $13.23 (+42%) | TBC Oct 2018 | TBC Jan 2019 |
As you can see, quite healthy growth numbers even in the span of 3 years, but only when looked at in isolation. The problem is that Facebook was unable to compensate slower user growth with higher advertising prices - revenue growth per user also slowed down in all regions. And GDPR will only make it worse in Q3 and Q4.
To give you some context into the significance of the American users (bearing in mind that only about 12.5% of all users are American), see Facebook’s revenue on a per-user basis by region in USD:
| Period | US and Canada | Europe | Asia | Rest of the world |
|---------------------------------------------------------------------------|
| Q3 2017 | $21.2 (+35%) | $6.85 (+45%) | $2.27 (+20%) | $1.59 (+31%) |
| Q4 2017 | $26.76 (+35%) | $8.86 (+48%) | $2.54 (+23%) | $1.86 (+32%) |
| Q1 2018 | $23.59 (+38%) | $8.12 (+50%) | $2.46 (+24%) | $1.68 (+32%) |
| Q2 2018 | $25.91 (+34%) | $8.76 (+39%) | $2.62 (+23%) | $1.91 (+29%) |
Profit
Facebook’s profit went up by 33% compared to the second quarter of 2017: from $3.9bn to $5.1bn. As well as the revenue, it slowed down - the company increased its operational expenses by 50%.
Two quarters ago, the management has warned the investors of potential costs increasing due to the war against fake news. Moreover, Cambridge Analytica scandal and GDPR already have and further will inevitably lead to additional expenses on equipment and specialists to comply with regulations and avoid future data security issues.
Facebook’s and its close competitors’ Ratios
| Ratio | Facebook | Alphabet | Twitter |
| -----------------------------------------------|
| EV/EBITDA | 22.4 | 25 | 629 |
| EV/CF | 21.9 | 20.1 | 393 |
| Debt/EBITDA | -0.2 | -0.3 | 0.4 |
| ROIC | 39% | 14% | 2% |
| Revenue Growth | 46% | 25% | 11% |
Ratios explained in detail (worth reading if you are still not bored yet)
- EV/EBITDA: The less, the better, close to or less than 10 is often a severe undervaluation. 10 rarely happens with Technology stocks as they are often valued by future potential than current performance.
- EV/CF: Same as EV/EBITDA but considers real cash flow instead of accounting profit. Once again, Technology are slightly diffirent to the other sectors and often have higher margins than other companies due to lower operational costs. Hence greater cash flows that usually exceed the profit from the Income Statement.
- Debt/EBITDA: At least how many years the company will need to repay the debts. Under 3 - usually fine. Over 5 - risky. Facebook’s debt is so low that it can repay all of it with its current cash pile. Absolutely 0 risk in case of recession or higher interest rates.
- ROIC: Profitability. But excluding one-off costs and revenues (ever tried to “exclude from summary” one of your Monzo transactions? This is that). 15% and over is generally fine. Facebook’s is absolutely marvelous. More about ROIC here if interested.
Conclusion
The US stocks industry has existed for a long time and is the most robust in the world, and yet, is very often illogical and irrational. If the results of a said company do not match with the analysts’ forecast, the share price falls inadequately (Facebook underdelivered the expected revenue by 1.2% and lost 20% in value overnight). Although Facebook continues to grow faster than anyone in their sector, there are three “howevers”, which you have seen a number of times in this post:
- Facebook failed to secure the data of the US users and lost its trust. Some users have deleted their accounts, others have revised the processing settings. Facebook is hungry for data so that advertisers could target their audience more accurately and not go to other advertising platforms.
- GDPR. This will most likely damage the revenue growth in the region, which is the second most important after Facebook’s domestic market.
- Facebook does not share profits through dividends and buybacks. Therefore, investors are demanding abnormal growth rates to compensate.
To say that no one expected a 20% drop is a severe underestimation. Many investors are panicking (the prices still kept going down even after the 20% fall on day 1), but let’s wait for a second and think without emotions. The fall has taken place and been priced for (rather expensively), it is far too late to panic. Looking at the positives: Facebook is still growing faster than most of the companies in its sector, notwithstanding its huge valuation. It has a very healthy balance sheet, ridiculously low debts (read: recession proof / monetary policy contraction [rising interest rated] proof), and strong ratios. It has fascinating fundamentals, which one should not discount when making a decision on whether to buy or sell. For a long-term investor, it is still worth taking a careful and weighted consideration, especially given potential monetisation of WhatsApp, and further expansion of many other brands Facebook possesses. Facebook.com (as a social network) is quite likely to live in a bear market in perpetuity from this point, but it will be replaced with other services, hence Facebook itself (as a conglomerate) still has plenty of room for growth in its sector. For sure, the management will do everything in their capabilities to use Facebook’s huge capital to retain its position in the market and prove to investors that the stock is still viable despite its original brand gradually disappearing from people’s lives.