Big Can Get Bigger: updated thoughts on Facebook

by Travis Johnson, Stock Gumshoe | July 28, 2016 2:06 pm

Checking in on my largest personal holding

Do investors have a tendency to overreact to trends and fad worries?


Despite all the concerns about Facebook (FB) losing “eyeball time” to Pokemon Go or losing the “cool kids” to Snapchat or just saturating the market and getting overvalued, Facebook AGAIN blew out earnings expectations this quarter (reported on Wednesday evening) by doing dramatically better on the top line and bottom line than analysts had expected.

And it wasn’t close, and it wasn’t some sneaky financial engineering to make the numbers look better: If you look through the analyst expectations about average user metrics and revenue metrics, Facebook beat[1] on almost every single one of those metrics, almost everywhere in the world. And not by a whisper, but by a shout.

As I’ve noted before, being staggeringly huge doesn’t mean you can’t get bigger — particularly if you’re part of a duopoly (with Google) that’s got mobile digital advertising and internet advertising in a vice grip. Being the fastest-growing provider in a large market (mobile advertising) that itself is growing quickly means the ceiling is probably a lot higher than you want to believe. Growing market combined with growing market share creates “double growth” — and they grew even faster by also increasing the average revenue per user by increasing the “ad load” (the number of ads each user sees).

Yes, it’s hard to conceive of a $350 billion company that can grow rapidly, and the growth will almost certainly slow as they become larger, but the practical limit on Facebook’s revenue and earnings is not some expectation that a company can only grow to some pre-imagined size. The practical limit is the size of the market in which it operates, whether that market is growing, and whether the company can continue to take market share without sacrificing margins.

Digital advertising is a fast growing market around the world, with annual revenue of roughly $200 billion (depends who you ask, of course — it’s just shy of $70 billion in the US, with more than 60% of that now coming from mobile traffic), and Facebook has something like 10-15% of that market.

If they grew to take on as large a market share as Google, that would mean Facebook more than doubles their market share and reaches annual revenue of something in the neighborhood of $60 billion. That’s very hypothetical, of course, but also very possible…. revenue has gone from $5 billion three years ago, when they had almost no market share in digital advertising, to $19 billion now. Revenue growth has not been consistent, but it has been high — it hit 70% when they were much smaller a bit over a year ago, then came down a bit to the 40% neighborhood a few quarters ago, and now it’s accelerating again to 60%+ thanks to better global growth and the power of rolling out their video advertising.

Maybe there won’t be another lever to pull to get growth going again next time it starts to slow, that concern has come up before — but that has been a losing bet since Facebook went public. Having a growing user base of people who are using your service more each year gives you a lot of levers… especially if you have a visionary management team investing for future growth, and a skyrocketing share price and investment in technology and innovation that keeps the best engineers coming through your front door. And all that is before WhatsApp or Messenger produces any meaningful revenue, and with Instagram still not nearly as ad-heavy as the Facebook core app.

Yes, the arguments for betting against Facebook seem reasonable… just like they did a year ago, and two years ago. Here are a few of those arguments:

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Everyone already owns it, and all the analysts already rate it a “buy,” so where’s the next buyer coming from who will pay more than you did?

The stock is expensive. It’s now valued at about 20X annual sales. Which is obviously absurd in a theoretical sense, and requires us to believe that they can keep fantastic growth going.

Revenue growth will slow, they’ve gotten a boost lately from video ads, and from increasing the number of ads in the News Feed as they tweak the system to see what works best and doesn’t alienate users… and those are “one time” improvements that aren’t part of a linear progression. They’ll need more tweaks or innovations, or else they need to just get better pricing for their ads and get more people to use Facebook products more often.

User growth has to slow, because they’re running out of people on earth who have eyes and can get internet access and have some sort of device… the most appealing advertising markets are already pretty well saturated with Facebook users. There is more user growth to be had, of course, as the population keeps growing and getting more connected, but the most appealing growth is in China… and Facebook is not welcome in China. (Of course, we could have said much the same thing when they reached one billion monthly active users four years ago, and now they’re at 1.7 billion.)

And the stock-based compensation is ridiculous, and doesn’t show up in those fantastic growth numbers — stock-based compensation is going to be over $3 billion this year. That means employees are getting a lot of stock, which I’m sure keeps them happy with the shares flying over $130 after the earnings report (yes, it has come down off that high now), but it also means that the real performance, if you believe that giving away bits of the company to employees is the same as paying them actual money, is obviously far less impressive than the “adjusted” performance.

But you know what? Wall Street, despite all the lip service, hasn’t actually cared about stock options and stock-based compensation for 20 years, and betting that they’re suddenly going to care and drive down FB shares because of it is foolish. (When I say “ridiculous” I don’t mean that as a social commentary — I think more companies should give their employees “skin in the game” as part of compensation, but I also agree with most rational thinkers that Wall Street should get around to thinking about that as an actual expense. I think the best way to do that is by having the company effectively buy any shares that they want to give to employees on the open market, but that certainly goes against the “options” philosophy in Silicon Valley that keeps so many bright engineers toiling at a thousand startups or “me too” companies in hopes of that possible multimillionaire payday.)

And on the top line, I do believe that Facebook can keep the growth going even if the revenue will obviously not grow at 60% or more every year — even if it slows down to half that growth rate, which is quite possible, the growth will be extraordinary and make the current share price seem eminently reasonable.

Regardless of worry about whether a company is getting “too big,” the likeliest outcome, when you’re dealing with a large and dominant duopoly in a large and growing market, is that the companies who are in that duopoly will continue to do better. And despite the fact that their costs are going up as they invest in future growth, their margins are improving — revenues were up 59%, while “total costs and expenses” were up just 33% (not counting the $3 billion in stock-based compensation, naturally)… that’s how you get to 186% growth in net income for the quarter.

Continued success is not a certain outcome, of course, but investing is about trying to calculate your odds of success, judging the amount of risk you’re taking, and betting accordingly, and Facebook and Google are winning in a marketplace that seems increasingly to be “winner take all” business — almost a natural monopoly. We understate how hard it is to break into that kind of marketplace — Twitter is but one of many examples of competitors that could not take a meaningful bite out of the apple that Facebook and Google are gobbling (TWTR reported this week too, and it was another trainwreck — there’s no plan, there’s no growth, and no one seems to have a vision). It’s not just size and luck and timing, Facebook and Alphabet are working hard to grow and control digital advertising, and so far no one else can keep up.

Yes, I might eat my words someday — the world of technology is full of competition, and barriers to entry come crashing down as technological advances draw the juice away from the established market leaders.

And I sympathize with those who don’t like to pay up for growth stocks. But Facebook this past quarter grew their average revenue per user by 11.7% over last year… that’s huge, and the growth per user is fastest in the parts of the world where they have the most growth potential and have not yet hit the maximum possible user base.

Growth may not continue at that pace, and the stock came off the highs post-earnings pretty quickly because of folks who are taking profits or who are wary that the year-over-year growth rates will likely slow sharply as they hit tougher comparisons in the next couple quarters (and Facebook has warned investors to expect that), but the operational excellence and top line growth is just extraordinary for a huge, scalable business like this that is taking share.

There are usually warning signs before a company loses market share, particularly when you look at margins and profitability, and it’s usually not wise to sell a stock because you think “it just can’t keep going up” … particularly when it keeps beating your expectations and reporting real revenue and earnings and margins that also keep going up. Watch it maybe, use stop losses maybe, but enjoy the ride. Facebook, thanks to that big surge after earnings, is again my largest personal holding, and I’m not selling any of it.

If you’d like a more pessimistic view, this is the summary of the most pessimistic analyst note I saw after the earnings:

Facebook downgraded to Neutral at Monness Crespi & Hardt following earnings (123.34)

“Monness Crespi & Hardt downgrades FB to Neutral from Buy on prospects of diminishing upside. By virtually all measures, the word ‘beat’ is an understatement when evaluating cos’ 2Q16 results. Despite the dominance of the platform, favorable secular trends, and emerging opportunities in new digital categories, firm sees diminishing upside to rev prospects during their projection horizon. Rating change is based on: (1) impressions and pricing — although pricing growth improved sequentially to 9%, up from 5% in 1Q16, they are unsure if any momentum in a mix shift to mobile is sufficient to offset pressures to impression growth as gains from greater ad load moderates. Moreover, ad pricing on a like-for-like basis has the potential to temper as well, by our measure; (2) capex — by becoming video first, firm believes capex costs will only escalate from here in order to build the infrastructure necessary to support streaming, thereby slowing free cash flow advances; (3) emerging opportunities — firm is quite optimistic on opportunities related to Messenger, Oculus, VR/AR, and search, but material incremental monetization may take longer than expected; and (4) valuation — firm’s prior valuation at 30x 2017E EPS pegged their target at $130, on par with the pre-market trading range following the quarter. They recognize we may be premature, especially given the scale of the platform and targeting capabilities, but at this time they see it prudent to take some profits.”

I wouldn’t argue strongly with any of that, and every investor has to make their own decisions about when to take profits on a successful investment (selling is hard, there’s no way around that), but when you have a leading company like this by the tail and they’re still taking market share, I think our tendency as investors is to take profits too early, and to be too pessimistic about growth. That doesn’t mean “buy FB at any price,” nor does it mean the stock can’t go down… but I’m holding both shares and call options on Facebook, it will likely remain my largest holding for at least the near future, and you can’t have my shares for $125 or $130 (drive it up to $150 or $160, maybe we’ll talk and I’ll think about doing some rebalancing).

And to close, let me just compare Facebook to another growth company in a completely different business (we can compare it to Google later, but Google reports tonight so we have to wait a bit): Pepsico (PEP)

Pepsi is a strong global company, with roughly a 20% market share in the global soft drinks business. The overall business is perhaps growing at a couple percent a year, and Pepsi is trying to take share from both Coca Cola and from smaller companies around the world, and their revenues are probably going to grow a little faster than the global soft drink market. Analysts think they’ll grow revenues by about 3%, and that they can grow earnings at about 10%. PEP is trading at 21 times next year’s forecasted earnings.

Facebook is a strong global company, with roughly a 12% market share in the global digital advertising business. The overall business is growing at more than 10% a year in much of the world, though the least lucrative parts of it are also probably growing the most quickly (overall, the media advertising market is growing at more than 5% a year[2] — and most of the growth is coming from Digital). Digital advertising is taking share from print and television, and also likely expanding the size of the overall marketing spend, that’s a tremendous tailwind in a world where top-line growth is otherwise hard to come by. Facebook is expected to see revenue growth of more than 30% next year, and earnings growth of 28% (that may change, since most analysts will likely raise their expectations a little post-earnings), and FB is trading at 27 times next year’s forecasted earnings.

Facebook is not cheap, it’s not a “value stock,” it doesn’t pay a dividend. But it’s not trading at a valuation that’s wildly out of line with other mega cap companies who rely on global consumers… and it’s growing dramatically faster. Paying for growth is a risk because it’s a bet on the future, but it’s a risk I’m happy to take when the growth is this good.

P.S. Now that we’ve seen Alphabet/Google’s earnings as well (I’m adding this note after the close today), we can see that the story of Google and Facebook increasing their combined share of digital marketing dollars continues — Google, I think, is the cheaper play here, they have substantially lower growth potential over the next five years than does Facebook, but they should grow faster than the economy and faster than the overall market as digital marketing continues to grow… and they’re still carrying the valuation of an “average” company (if you back out their large cash and investment portfolio of ~$125 billion), mostly just because they’re so huge. I like both and have no intention of selling either, but my Google position is less than half as large as my Facebook position.

Disclosure: In case it’s not clear from the above, I am invested in Facebook, Alphabet and Apple of the companies mentioned above, including both call options and common stock. I will not trade in any of those stocks for at least three days following publication of this note, per Stock Gumshoe’s trading rules.

  1. Facebook beat:
  2. media advertising market is growing at more than 5% a year:

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