After a year filled with negative media headlines, Facebook (NASDAQ: FB) reported their full year earnings recently. Despite constant bashing by the press, the business reality and the financial numbers spoke for themselves. Facebook reported top and bottom line beats which left analysts revising their target prices (surprise surprise) on the company.
Here are some key highlights from Facebook’s press release:
– Q4 Revenue grew 30% or 33% on a constant currency basis year over year.
– Daily active users (DAUs) increased 9% year over year.
– FY2018 revenue grew 37% and net income grew 40%.
The Cash Machine
Facebook’s business model whereby users provide free content on Facebook and Instagram has created an enormous network effect and has attracted businesses to buy ads at a low cost – where people gather, that’s where advertisers want to be.
This asset light business model has enabled the company’s gross margins to be at 83% for FY2018 and consistently above 80% for the past few years. This has given the company huge flexibility on its operating expenses.
Free cash flow, which is essential in any business as it gives the company ability to reinvest the cash, make acquisitions and buy back shares, has always be maintained above 40% of the revenue before taking a hit in FY2018. Facebook still remains a cash generating machine. With increased spending on security and other capital expenditure, it wasn’t really a surprised that the free cash flow over revenue generated took a hit. However, that margin still remains very high.
Source: Derived from Facebook 10-K report
In additon, the compounded annual growth rate (CAGR) of Facebook’s free cash flow from 2013 to 2017 was a whopping 49% year on year. That metric itself was unbelievable. FY2018 was the first year that Facebook experienced a deceleration in free cash flow growth rate. However, as mentioned earlier, its free cash flow to revenue margin is still very high. And Facebook certainly has plenty of cash sitting in the business. Its quick ratio stands at 7 times.
Source: Derived from Facebook 10-K report
Source: Morningstar – FB
As of result of constant hammering from the media, the valuation ratios have fallen dramatically. PE and P/CF were almost halved. It was definitely cheap compared to historical standards. Furthermore Facebook has a net cash per share of $9.78. At Facebook’s current share price of $165.04 (as of 12 Feb 2019), deducting net cash per share of $9.78, this brings the “actual” stock price to $155.26.
Business Reality vs Media Frenzy
As investors, its important to differentiate the business reality against the media frenzy. The media will always be there to sell the news. A headline that reads “The End of Facebook is coming” will always certainly attract more attention than Facebook reporting business as usual. In fact, the picture below is the cover of Barron’s which printed that “Facebook is worth $15”. That was the headline in September 2012.
There will be always possible qualitative mispricing of businesses in the stock market. Therefore, the key is understanding the resilience of the business model and the strength of the moat. As long term investors, we should be hoping for stock prices to fall, unless you are planning to sell off your shares in the near term.
There’s not many places for advertisers to go if they were to leave Facebook. Google and Amazon are two examples of the other such places with a large audience, but Facebook still provides a good ROI for advertisers. Moreover, exciting developments ahead will strengthen Facebook’s network effect. Some key pointers mentioned in the 4Q18 conference call include payments on WhatsApp will be available in more countries, Facebook Watch will “become more mainstream” and perhaps the most exciting development will be the commerce and shopping aspect integrated into Instagram.
Just a comment on the concerns of tech regulation, in the long run, it will be a good thing. It will strengthen the company’s moat and add a barrier of entry to potential competitors. Operating expenses will increase but other competitors will also face the same situation. Facebook’s huge free cash generation and high gross margin puts them in the driving seat in navigating the costs associated with regulation.
Facebook has increased its share back program by $9 billion. With the company generating far more cash than it is using, it is very possible to expect more share buybacks in the near future…
For now, the economic moats protecting Facebook still remains intact.