Facebook: Digesting Outsized Expense Growth

Last week, Facebook (FB) reported results for the fourth quarter of fiscal 2019.

Revenues in the period increased 25% to $21.1 billion, while the total for the year was at $70.7 billion (+27%).

As shown below, Facebook’s annual revenues have more than doubled over the past three years.

Despite a number of press reports that have suggested otherwise, daily active users (DAUs) and monthly active users (MAUs) both continue to grow (each up high-single digits in the fourth quarter). There are now more than 2.2 billion people who use one of the company’s services (Facebook, Instagram, Messenger or WhatsApp) on a daily basis – an increase of 11% over the past year. To put those numbers in context, consider that an additional 60 million people around the world joined that group in the past ninety days.

With help from increased user growth and engagement, the company reported a 31% increase in ad impressions, offset by a 5% decline in the average price per ad. The decline in ad pricing reflects ongoing mix shift towards Stories and users in developing markets, both of which monetize at lower rates than the current base. That said, the continued growth in average revenue per user is broad based, with every geography reporting upwards of 15% increases in the fourth quarter.

As I’ve noted in the past, a big part of the story is outsized expense growth. Operating costs increased by roughly 35% in 2019 (adjusted for one-time items like the FTC settlement), with the outsized growth relative to revenues resulting in a few hundred basis points of margin contraction. As a result, earnings per share (EPS) growth for the year was in the single digits. Depending what you think about the current pace of spending on capital expenditures, that figure may be overstated as well. Clearly this is not what investors are hoping for.

The company’s guidance doesn’t alleviate any of those concerns. They expect $54 billion to $59 billion in expenses in 2020, implying an increase of more than 30%. Based on realistic revenue growth expectations, that suggests operating margins will contract by a few hundred basis points in 2020 as well. This is materially impacting the company’s ability to grow earnings. By my math, the company will generate $6 billion to $7 billion in operating income growth from 2018 to 2020 on roughly $30 billion in incremental revenues.

In addition, the company’s capital allocation decisions continue to baffle me. At year end, Facebook was sitting on more than $50 billion in net cash. In addition, they will probably generate $90 – $100 billion in free cash flow over the next five years. Despite this, they spent just $4.2 billion on repurchases throughout 2019 – about 30% of what they spent in 2018.

What will the company do will all this excess capital? I’m still skeptical that any large acquisitions are in the cards. The regulatory risk is too high, especially after the Instagram deal. That leaves dividends or repurchases, but management has not shown any real interest in either route as of late. That suggests tens of billions of dollars will simply sit stranded on the balance sheet. In my opinion, investors who are valuing those dollars as akin to cash in their pocket are making an analytical error.

<p class="canvas-atom canvas-text Mb(1.0em) Mb(0)–sm Mt(0.8em)–sm" type="text" content="Conclusion” data-reactid=”39″>Conclusion

At the end of 2018, I said the following about Facebook:

“I expect the company to continue spending aggressively on these priorities. Everything management has said and done over the past few quarters leads me to believe this is not temporary (as Zuckerberg said on the fourth quarter call, “I believe that these investments are the right thing to do and will make our community and business stronger over the long term”).

For investors, it matters whether run rate operating margins at Facebook will be closer to 35% (what the company guided to on the second quarter 2018 call) or closer to 50% (the actual result for fiscal 2017) has a big impact on the stock price. Considering that the investment ramp will likely coincide with a continued reduction in revenue growth, I’m of the opinion that we’re more likely to be end up at 35% EBIT margins than 50% EBIT margins, even 3 – 5 years out.”

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