Facebook (NASDAQ:FB) shares have been stuck in the $125-$225 trading range since July of 2017.
As you can see, if you bought the stock in July of 2017 you aren’t making much money since making that investment. Facebook’s inability to breakout, can be pinned on concerns of slowing growth, regulation, and operating margin contraction. While these concerns are valid to some extent, throughout this entire period of time I believe Facebook shares have been undervalued. But the market isn’t reflecting that. There is a saying for stocks like Facebook. The longer the band, the bigger the breakout/breakdown. Facebook has been stuck in a trading band for the last two-and-a-half years. Eventually, when price action catches up to fundamentals, the price action will be exacerbated to the upside or the downside. A good example of this is Tesla (NASDAQ:TSLA). Tesla was stuck in a trading range for years, before finally breaking out of that range.
Reasons To Worry
There are a few reasons that investors have been selling Facebook’s stock recently. While coronavirus has driven the market in general down, there are some Facebook-specific issues that are causing a decline in the stock.
- Google Chrome update
- Instagram user growth deceleration
- decelerating 1H ad spend likely
- brunt of regulatory effect ahead
- slow WhatsApp monetization
The first problem Facebook is running into has to do with Google Chrome’s recent update regarding third-party cookies and web-tracking. On February 4th, Google Chrome ran an update that greatly restricted third-party cross-site tracking. Third-party tracking and web cookies are part of what makes Facebook’s targeted ads so much more valuable than competitive platforms. Facebook’s “edge” over other internet advertising platforms. The removal of third-party website tracking services means that Facebook’s edge begins to dull a bit. While Facebook operates at a much greater scale, and can still leverage behavior on other platforms under the Facebook umbrella, the loss of Chrome for third party tracking is definitely a big deal that should not be downplayed. As a result, expect tracking to weaken a bit, and potentially end-demand for advertisements on Facebook could weaken. That being said, Facebook remains atop the totem pole for digital ROI, it’s just that the gap is shrinking.
The second problem is Instagram is beginning to see some problematic trends developing. A recent eMarketer report shows that Instagram user growth has been drastically decelerating, and will continue to decelerate in the years to come. Obviously, as a platform gets bigger, the growth rate will decelerate, but the trend is worrisome nonetheless. In 2019, Instagram saw 6.7% Y/Y user growth, versus 10.1% Y/Y user growth in 2018. Decelerating user growth yields decelerating revenue growth. A continuation of this trend could lead to a continued deceleration in top-line expansion. Here are eMarketer’s expectations for domestic user growth:
Again, keep in mind this is domestic growth, not international. International should be the growth going forward. According to eMarketer, Instagram’s revenue hit $9.45 billion in 2019, and is expected to grow 46.6% in 2020 to $13.86 billion, and further grow to $18.2 billion in 2021. Keep in mind this is domestic revenue, and these estimates were published before coronavirus related impact hit.
The biggest problem with Facebook right now is the coronavirus and its impact on advertiser budgets in the next two quarters in particular. Facebook has an ecosystem of 8 million advertisers. Because of the size of this ecosystem, it is safe to assume that a whole variety of small, medium, and large size marketers use the platform for advertising. The introduction of coronavirus globally, not just in China, has caused the downright closure of a lot of small business, and the degradation of larger businesses. Large enterprises, particularly in travel, entertainment, and CPG (consumer packaged goods) represent 30-45% of Facebook’s overall revenue. January and February were pretty normal and healthy months on the domestic small business side. March is where the government began clamping down on small businesses, and will be the month that small businesses see drastic change. Think of it like this: You own a restaurant that was operating well in January and February. All the sudden, you are forced to close down shop in March. Your revenue has (likely) gone to zero, and you are looking to cut costs to survive this drought of business. The first, least necessary cost that you would cut is marketing. Now imagine this trend playing out across the vast majority of small business advertisers domestically. The good news for Facebook is that they have two strong months of small business demand preceding the weak March. The bad news is that the brunt of the impact will hit in Q2. With regards to larger businesses, many of them (especially the cruise lines and airlines) are suspending a lot of their operations. This will mean more budget cuts towards advertising. This is an ecosystem wide issue, not just Facebook in particular. The smaller players in social media will likely have it harder than Facebook, but it will still be a rough quarter. Turning to Q2, the economy will likely partially or fully shut down, so the majority of the negativity around Facebook’s numbers will come in Q2.
In the past, I have greatly downplayed the risk of regulation on Facebook. While I still believe Facebook will not be broken up on anti-trust concerns, regulation is already here, and here to stay. Regulation is not just coming in the form of $5 billion FTC fines. It is coming in the form of changes in Facebook’s ad targeting policies. These changes are coming both in the form of domestic regulation (think about CCPA) and internationally (think about GDPR). These aren’t just fines these are changes in the underlying advertising models in these areas where regulations are imposed. If regulation roles out in greater scale than it already has, then Facebook could see even greater changes to their advertising model. Regulation is only here to stay at Facebook, and investors need to understand that.
Finally, Facebook is having trouble monetizing their billion plus users on their WhatsApp messaging platform. Facebook has been trying to monetize their WhatsApp platform for years, ever since Facebook purchased the messaging platform for $20 billion. Recently, we found out that Facebook is scaling back their WhatsApp ad teams, and deleting code from WhatsApp that would add advertisements to the platform. While WhatsApp could move into payments, which it is, monetization progress appears to be slow. Keep in mind, this is supposed to be a key growth driver to the Facebook story. So, monetization progress seems like it is beginning to stall.
1H’20 and FY’20 Estimates Are Too High
Despite all of these headwinds, especially the 1H ad spend decline, it seems like Facebook estimates remain elevated. While January and February were likely normal months for Facebook, March will probably shape up to be disastrous. In Q4, Facebook grew revenues at a clip of 25.6%. The consensus expectation for Q1 is that top-line growth decelerates to just 22.4%. Facebook guided for a low to mid single digit deceleration in Y/Y top-line growth. With a relatively weak March, Facebook will probably come in at the bottom of this guide. So, assuming a 5% sequential deceleration, we get to a revenue growth rate of 20.6%. Assuming this growth rate, we get to revenues for Q1 of $18.186 billion, versus the $18.46 billion consensus. Ordinarily, a miss of this scale on revenues likely wouldn’t deter investors, and if numbers come in a little bit light, the stock might not move much. That is, until Facebook gives us some commentary surrounding guidance. Considering the brunt of coronavirus is ahead of Facebook, with quarantine ramping up in Q2, Facebook should see another large deceleration. From Q1 to Q2 for last year, Facebook saw 9.6% sequential revenue growth. Analysts are anticipating this trend will accelerate this year, with 10.7% sequential growth from Q1 to Q2. To expect sequential growth while coronavirus shuts down the global economy is preposterous. Facebook will face three full months of negativity in Q2, versus the one month (March) in Q1. For this reason, and Facebook exposure to cash-strapped small businesses, I believe Facebook will face sequential negativity in revenues to the tune of 15%. This gets me to $15.458 billion in Q2 revenue, versus the consensus $20.43 billion. Ouch.
Now, let’s look at the back-half of 2020. Back half numbers are going to be affected by coronavirus. The Trump Administration recently said that coronavirus could fade out by July or August, the beginning to middle point of Q3. Personally, while I am no epidemiologist, I believe that we are not at the bottom yet. I believe the economic bottom is in Q2, with slow yet steady recovery in the quarters to come. This should be reflected in back half numbers. Last year, Facebook saw 4.5% sequential growth in revenues from Q2 to Q3. I believe that Facebook should see a more accelerated sequential growth rate this year, because advertiser demand could be spring-loaded as the economy returns to work. I am modeling ~6% sequential growth, to $16.385 billion in Q3. Finally, in Q4 I expect Facebook will return to some level of normalcy. I’m modeling out Q4 numbers at 15% growth to $24.244 billion. Again, there is a gradual improvement in Facebook’s numbers that will take continue to accelerate into 2021 as the comps get easier. But for 2020, even assuming some level of a back-half recovery, the numbers are clearly not good right now. Keep in mind, these numbers imply Y/Y growth for every single quarter this year. I get to around $74.273 billion in 2020 revenue. Again this assumption, which is below the lowest estimate on the Street could prove to be aggressive in there is no 2H economic recovery. In addition, the decrease from Q1 to Q2 could be greater than I predict.
If you assume gross margins of 81.5%, with no material gross margin erosion likely and non-GAAP OpEx of $39.744 billion, then operating margins come out to ~38.1%. Remember when Facebook came out in the summer of 2018 saying mid-30s operating margins. If you factor in potential fines, then sure. But if you back out one-time charges this year of $5 billion (the FTC fine), OpEx was only $28.94 billion, and the operating margin was 41%. In 2019, OpEx numbers grew at a rate of 34%. My 2020 number assumes an acceleration to 37.3% in Y/Y growth. This is because of Facebook’s continued platform content moderation expansion is causing accelerating cost growth. Particularly if you consider the upcoming general election and pressure on Facebook mounts regarding election interference.
The Long-Term Story
Facebook is beginning to see their trends decelerate in terms of revenue growth, and their ability to differentiate themselves from competing advertiser platforms. In a worst-case scenario Facebook’s ability to utilize third-party tracking is completely removed. That being said, Facebook still has strong access to their own user data on their different platforms (core Facebook, Instagram, WhatsApp, etc.). Facebook remains better positioned than their smaller social media counterparts.
Facebook has much greater scale, and multiple Facebook Family platforms to cross-reference from. So, even if third-party tracking is removed from Facebook, the company should still have a large competitive lead on smaller competitors. That being said, platforms that offer a niche product for niche advertisers could offer better ROI than Facebook.
In addition, Facebook has the call options of messaging monetization, cryptocurrency, VR/AR, and even eCommerce. Overall Facebook is well-positioned over the long-term to succeed despite potential platform issues.
Turning to my valuation of Facebook shares. My price target on Facebook shares is based not on relative valuation, but on discounted cash flows. For the sake of this model, my terminal value is not exit multiple based, my WACC is 10%, and my terminal growth rate is 3%.
Going forward however, the focus is going to be on the recovery. Will there be some sort of pent-up demand from advertisers in 2021 as a result of the coronavirus. For some specific product categories, I can definitely see pent-up demand, but across the board, no. Small-businesses and small-business marketing could take many years to recover as a result of COVID-19. We have already seen many closures of small-businesses nationwide, and it will take time for Facebook to return to these strong growth levels. That being said, the first three quarters of 2021 will have very easy and manageable Y/Y comps. In 2021, I am anticipating 24% Y/Y growth as a result of these easier comps. As small business spending picks up in 2022 (personal prediction) Facebook’s revenue growth will not decelerate as harshly as I would normally expect, down to just 19% Y/Y. In the years after that, the trend should continue to decelerate.
With regards to OpEx, I believe Facebook will leave spending plans relatively unchanged. Considering Facebook is extremely well positioned on a cash basis to weather the coronavirus storm, I believe the company is very well positioned to continue along with its operating expense expansion plans. As a result, I’m not really moving my targets on OpEx from my last update. Finally, my tax rate is 18% in-line with management’s 2020 tax rate guidance. So let’s look at the numbers.
(Source: my estimates)
Compared to consensus, my estimates are very bearish, but I believe that considering the current economic climate and recovery timing, they are realistic. Now, converting these earnings numbers into cash flow numbers.
(Source: my estimates)
Facebook shares have sold off drastically, and for good reason. That being said, I reiterate my optimism overall on the stock. I believe it is fundamentally undervalued. That being said the stock could sell-off harder in the short-term as the Street assesses the coronavirus damage.
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.
Additional disclosure: Please do not interpret this as financial advice. I am not a financial advisor. Do your own due diligence before initiating a position in any of the aforementioned securities.