Facebook security analysis - Q2 2018


(Vladislav Kozub) #1

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:

  1. 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.
  2. GDPR. This will most likely damage the revenue growth in the region, which is the second most important after Facebook’s domestic market.
  3. 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.


Tesla security analysis - Q3 2018
Tech bubble
Snapchat's taking on Netflix / HBO with original TV shows
Microsoft security analysis - Q4 2018
(Matteo) #2

Again great analysis! Thanks!
Actually I have one question, where and what you use to get all the data to make this great analysis?
Basically I think it would be interesting to know the behind the scene on how you do it. Especially for people new to investing.

Thanks again for this analysis, it was very instructive!


(Vladislav Kozub) #3

Thank you, that is a great question!

Most of the the metrics I used came from FB’s recent report on their “Investors’ relations” page, past data is also there.

So these would be their accounts and there I took the data on users and per-user revenue. Some of the qualitative assumptions and facts are either common sense or the news and a bit of Wikipedia, which was linked at the start. I do not think there was anything else. These big companies always make it easy to analyse themselves, providing top quality raw data.


(Vladislav Kozub) #4

6 posts were split to a new topic: Stock Screeners


(Matteo) #6

Thanks again @Vlad!
That is really interesting!
I don’t know why I was imagining many websites to get all the raw data, instead they offer already a wealth of them to make analysis.
Smaller companies, comparatively, that I saw so far offer less back data than FB like 3-5 years. Is still possible that I didn’t understand things right ;-).

Out of curiosity what do you use as stocks scanner?


Stock Screeners
(Sergey) #7

@Vlad

Thank you for your work. An interesting read!

Do you have an opinion on whether it is a Buy or a Sell right now?

Have you tried making a DCF for FB?


(Justin T) #8

I’m a buyer too. 20% fall was too much. Suck it up. This machine is going nowhere. It will dominate yours and your children’s lives. Be brave. Dig deep. Hold on. It will serve you well in the end.


(Vladislav Kozub) #9

@szb, I certainly would not recommend anything, but can only say that I doubled my position with FB last week. Albeit that is my tolerance for risk, I will not suffer if FB will become a new MySpace in the next 5-10 years, if I feel I need to withdraw my position, I will. Which is why one should not base their decisions on people’s recommendations. I did not do DCF as it did not come to my mind back then. Might do it when looking at another security, thanks for suggesting :slightly_smiling_face:


#10

#11

Whilst I feel that’s the obvious next step for them to take, I can’t stand ads on apps and so I’m extremely turned off by this approach. I don’t want to see ads on a service for sending folk messages. Looks like I’ll be getting something like Telegram :kissing:

ETA: Would be interesting to see how non-intrusive they will be in the app itself.


(Christopher) #12

@Lkinsman I’m totally with you on in-app ads; invasive, unwieldy and they make for a very grubby UX.

As i’ve understood it from the article, on the face of it the WhatsApp user experience wont change, i.e. there’ll be no adds in app. Rather, Facebook’s platform becomes a conduit for communicating with customers who are users of WhatsApp. The big concern for me is data sharing; contacts, location, etc, with businesses and other organisations that want to use this new tool. And what’s next? Cue chatbots…

Published last week, the DCMS Committee’s Disinformation and ‘fake news’: Interim Report, linked below makes for some pretty wild, and in my view, required reading.


#13

I’ve just re-read the article (was up late last night) and yeah it seems you’re right, the UX won’t be changing much, however the data sharing is also a big concern and I try to avoid letting apps access my location, contacts, etc where possible unless it’s obviously necessary. Will read your suggest reading document later today, thanks!


#14

Instagram has a lot of influencers, could be massive if combined with allowing brands to find influencers.