Facebook Shares May Still Be Undervalued

Source: GuruFocus

Increasing selling, general and administration expenses have been the primary driving force behind this deterioration of margins.

Source: Company filings

A deeper dive into the financial statements reveals that the company has ramped up hiring of qualified security experts to put an end to the privacy breaches that led the company to pay billions of dollars in fines to authorities.

In the third quarter of 2018, Mark Zuckerberg confirmed that the company would be doubling its security staff by adding contractors and security engineers by 2020 – a promise that the company has kept so far. He went on to highlight that the management is doing what it has to do to regain the trust of users:

“We’re judging our success by how proactive can we get, so what percent of the stuff that we’re taking down are we identifying before other people identify it for us. We’ve started issuing transparency reports so we can be held publicly accountable on this.”

Capital expenditures have also grown in the last couple of years as the company invested billions of dollars to develop systems to identify security threats. On the other hand, Facebook also started using Artificial Intelligence (AI) to identify malware threats, and the company is continuing to invest money to enhance the efficiency of such initiatives.

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Source: GuruFocus

Expenses incurred to facilitate the development of these systems were also one of the reasons behind the declining margins.

Even though investors do not welcome a setback to profitability arising from a deterioration of margins, in Facebook’s case, there is nothing to worry about for long-term investors. A higher headcount to ensure the security of its social media platforms and investments to improve the systems in place will benefit the company in the long run and will help restore lost faith among users around the world. Also, the company will be in a much better position in the future to avoid regulator crackdowns and multi-billion-dollar fines, which is another positive for investors.

<p class="canvas-atom canvas-text Mb(1.0em) Mb(0)–sm Mt(0.8em)–sm" type="text" content="The outlook is promising” data-reactid=”100″>The outlook is promising

Facebook’s average revenue per user has grown in each of the last 10 years on a global scale. If we dig into the details, it’s evident that the company is earning a much higher revenue in the U.S. and Canada in comparison to other regions.

Source: Company filings

As evident from the above illustration, Facebook has a long way to go in terms of per-user profitability in regions outside the United States. Facebook had only 189 million users in North America in the third quarter compared to 627 million in the Asia-Pacific region and 519 million in other regions of the world. This is a clear indication that Facebook still has a massively under-monetized user base.

According to data from eMarketer, global digital ad spending will grow significantly in the next couple of years. Facebook is one of the go-to platforms for businesses to advertise their products on, which makes the prospects of the company attractive.

Source: eMarketer

This expected boost to revenue and earnings from the growth of the online ad industry is just one aspect that investors should be looking at. There are many other avenues of growth for the company.

For example, Facebook released a dating service in the U.S. in September 2019, and the online dating market is poised to grow for many years to come. For the first time in history, online dating has risen to the top as the most common way that couples meet today.

Source: Visual Capitalist

According to data from Pew Research Center, the growing access to the internet in emerging countries, the growth of smartphones and high-speed internet facilities will drive the demand for online dating applications and services in the future. These will act as tailwinds for Facebook to gain users to its new platform, and the company will likely expand this service in other regions of the world as well. According to a post published on the Facebook website, its dating service is currently available in 19 countries, including the U.S., Canada, Singapore, Thailand and Brazil, and it will soon be available in Europe as well.

WhatsApp and Instagram also remain under-monetized, but the company is now focusing on bringing in revenue from these two platforms. For instance, Instagram Shopping was launched to enable on-site shopping. Influencers will now be able to sell products on the platform itself rather than directing users to third-party websites. WhatsApp Payments is also a new feature that the company is planning to roll out in the future in a bid to develop this platform as a one-stop-shop for business owners.

In summary, Facebook might not be able to grow the number of users on its platforms as fast as it has done in the last decade, but the company is in a great position to grow its earnings in the next decade by better monetizing its user base.

<p class="canvas-atom canvas-text Mb(1.0em) Mb(0)–sm Mt(0.8em)–sm" type="text" content="Valuation” data-reactid=”133″>Valuation

Facebook shares are trading at a price-earnings ratio of around 33, which might seem a bit high. However, it’s well below the average multiple at which shares have traded in the last five years. In addition, the company is still growing at double-digit rates, which justifies a higher earnings multiple.

Considering the cash-rich nature of the business, a discounted cash flow model was used to derive an intrinsic value estimate for shares. The below table summarizes the revenue growth expectations in the next 5 years.

Source: Reuters and author’s projections

The other major assumptions used in this model are as follows:

• Average EBITDA margin of 52.5%
• Capital expenditures to represent 22.7% of revenue in 2019 and decline to 15.3% in 2023
• Tax rate of 26%
• Cost of capital of 10.5%
• A revenue multiple of 7.3 to calculate the terminal value

With these assumptions, the intrinsic value estimate comes to $276.22 per share, which is an upside of 37.4% from the market price of around $207 on Friday.

<p class="canvas-atom canvas-text Mb(1.0em) Mb(0)–sm Mt(0.8em)–sm" type="text" content="Conclusion” data-reactid=”149″>Conclusion

Facebook is one of the most followed companies on the stock market, and yet there are times when its shares do not represent the true value of the company. The company has monopolistic characteristics in the social media industry, and according to Ali Mogharbi, the Morningstar analyst covering Facebook, the company will not face any serious threat from a competitor for at least the next decade. This advantageous position allows the company to earn a high return on investment.

There is no long-term debt on the company’s balance sheet, which significantly improves the ability of Facebook to aggressively pursue growth opportunities and seek debt financing if required. The eventual monetization of its user base outside North America will act as one catalyst for shares to reach their value estimate.

Disclosure: I own Facebook shares.

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This article first appeared on GuruFocus.