Alex Hughes

Written by Alex Hughes, International Analyst, StocksInValue

Article first published in StocksInValue


With 15% of the world using its service every day, Facebook demands a spot on the international watch list.
Despite trading over 54x times earnings, we do not think Facebook is extremely priced today, and hence we do not see any obvious investment opportunity. However, we think it is worth keeping an eye on due to the immense optionality embedded in its platform.

The Business

When Harvard student Mark Zuckerberg founded Facebook in 2004, he was confronted with the same chicken and egg problem that all network businesses face: how do you attract users before you have content? Instead of attempting to roll out a social network for the world, Facebook scaled up by monopolising small market segments, giving the site credibility and content and aiding its expansion into larger segments of the market. The first target was Zuckerberg’s peers within Harvard University (it took a month to get 50%) which enabled it to then monopolise Ivy League universities, then all universities, then all high schools, then all US citizens, the developed world, and now the world.
Today, over 1 billion people log on to Facebook every day. It is valued at $321 billion on the NASDAQ exchange, matching Exxon Mobil.
In many respects Facebook is an “everyone wins” business. Members connect with their friends for free. Advertisers receive a high return on investment from targeted advertising, and Facebook generates significant returns that allow it to continually improve its service. Facebook reported post tax profit of $3.7 billion for FY15, a 25% increase over the prior year. Analysts expect 69% growth into FY16, supported by the dual tailwind of rising users and rising revenue per user.
While North America is the smallest geographical segment, it encompasses a user base that is worth the most to the company. Facebook generates $17 of revenue per North American member, nearly 3 times what it gets in Europe and 9 times that in emerging markets. US consumers have the highest purchasing power, so Facebook has the ability to charge more and advertisers have the incentive to pay it. US advertisers are also more aware of the benefits of online advertising, so online’s share of the total advertising spend is comparatively higher. Indeed, a rise in revenue per user for those outside North America represents an important part of Facebooks long term growth story, along with continued user growth and the introduction of new products.

Figure 1: Daily average users
Source: Annual Reports
Figure 2: Advertising revenue per daily average user
Source: Annual Reports

 
However, the potential for advertising is not unlimited, forcing management to walk the tightrope between advertising dollars and user experience. As Facebook members will know, the level of advertisements in the “news feed”, the algorithmically ranked series of stories individualised for each user, has certainly increased. For some it is already too much. The question is how far they can push it before users go elsewhere. This will be a trial and error process for management, fortunately online businesses can simply test small segments of their user base, comparing the response to an untested control group.
What is clear is that Facebook’s position gives it immense optionality. When it listed in 2012 for $104 billion (exceeding CBA today) it had just $1 billion of expected earnings. While a PE of 100x is typically excessive, it was clear that investors were paying for a significant amount of untapped earnings power.  Some of that has been tapped since, with the rise in display advertising, however much remains.
Facebook is one of just a handful of companies to have the ability to scale new consumer products quickly. Just consider that it can promote a new product to more than a billion people for essentially no cost. Facebook launched Messenger in 2011 and it now has over 600 million users. Free VOIP video calling, which launched in 2015, rivals competitors like Skype and Viber and appears certain to gain significant traction. While it is unclear where management will take it, Facebook’s scale, user trust and distribution capability is very valuable indeed.
Facebook’s financial resources also arm it with further optionality. Operating cash flow hit $9 billion in FY15 while idle cash tops $18 billion, enough to pay a 30% premium for Twitter plus $3.7 billion left over for a rainy day. If someone encroaches on Zuckerberg’s turf, as happened with Instagram, he has shown he is willing to complete large scale acquisitions to protect his castle.
In its quest for global domination, Facebook is challenged by the lack of internet connectivity for a significant portion of the developing world. To foster continued user growth, Facebook has established internet.org, a service that builds internet infrastructure in developing regions in partnership with local governments. Local users get ‘free basics’, access to a limited number of sites for free; Facebook undoubtedly tops the site list.
Another interesting area to ponder is artificial intelligence. In order to teach machines to think like us we need to feed them a lot of data. Facebook is among the best positioned in this field, armed with the greatest amount of the population’s information a company has ever achieved. Just consider that consenting members gift their age, gender, location, social circles, interests, preferences and consumption patterns to the company for free. Facebook has established FAIR, its A.I division, in an attempt to establish and monetise new AI technologies. Who knows whether this will amount to anything, its just another growth option within the company’s grasp.

Valuation

While appearing optically expensive at 54x FY16 earnings, Facebook currently trades within the realm of reasonableness. This is largely a function of the high enduring growth rates the company is likely to achieve.

Figure 3: Consensus estimates
Source: Thomson Reuters

 
Consensus currently expects earnings to compound at 38% out to 2020. We have no strong reason to question this assumption. By adopting these estimates and assuming a 10% discount rate, 2% annual share dilution and a 3.5% terminal growth rate, Facebook is worth $117; in line with the current price of $114. To purchase Facebook with the hope of outsized returns, one must expect near term earnings to exceed consensus, employees to be given less of the business each year or the terminal growth rate to exceed 3.5%. For us, this falls into the too hard basket.

Figure 4: Market value per monthly user
Source: Annual Reports

 
As another cross check, we present the value the market is currently ascribing for each monthly user of Facebook, Twitter and LinkedIn. Ultimately, what matters is how much shareholders pay for each user and how much cash flow can be extracted from them. On this metric, the market is valuing each Facebook member at slightly above $200 which represents 18x revenue per user. At just $35 per user, Twitter is screening comparatively cheap following a sharp selloff in its share price. With disappointing user growth, the market is currently questioning the scalability of Twitters model. However, $35 per user does seem cheap in comparison to the $55 per user Facebook paid for WhatsApp in 2013, a business in the highly competitive mobile messaging market. As a completely unique business with many endearing features, could 2016 be the year Facebook buys Twitter? Time will tell.
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