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Morningstar | Facebook Reported Mixed 2Q Results and Disappointing Margin Guidance; Lowering FVE to $186. See Updated Analyst Note from 26 Jul 2018

Facebook reported slightly mixed second-quarter results with revenue in line with our internal forecast but below consensus. The firm did beat expectations on the bottom line. However, Facebook's guidance of margins trending to the mid-30s during the next couple of years as the company will be investing further in innovation, content creation, and data protection, was disappointing. Total revenue growth was hampered by slower growth in monthly and daily active users due to the implementation of GDPR in Europe, partially offset by higher revenue generated per user. While margins remained at impressive levels, they did narrow year over year, as we had expected and noted in our previous reports. In light of the soft profitability guidance, we are lowering our fair value estimate for Facebook by 6% to $186.

We remain confident that wide-moat Facebook will successfully roll-out new products for users and advertisers and the firm can continue to more effectively monetize its users as the company begins to offer more premium video content not only on Facebook Watch but also on Instagram's IGTV. Plus, we believe the firm will realize return on its investments in content quality management and data security in 2020 and beyond, resulting in longer-term margin expansion. With the stock down about 20% after hours, we now view shares as slightly undervalued when compared with our new $186 fair value estimate. We recommend waiting for a wider margin of safety, likely in the $150-$160 range, before investing in this wide-moat and high uncertainty name.

Total revenue came in at $13.2 billion, up 42% year over year. Revenue from advertising remained strong, growing 42% from the prior year to $13 billion. While demand for the firm's ad loads continued to grow, as indicated by higher ad prices and ads sold, the slowdown in user growth represents a bump in the road for Facebook revenue growth.

Facebook's total monthly average user, or MAU, count slowed for the third consecutive quarter to 11% year over year, and in Europe it inched up only 4% from last year compared with the 7% average the last four years. Plus, Europe's MAU count declined sequentially by one million users, which we think is mainly due to the implementation of GDPR in that market. U.S. and Canada MAUs were up 2% year over year and flat sequentially. While we expect some recovery in Europe's user growth, we do see slower growth in those two user-saturated markets, U.S. and Europe. Asia and rest of the world markets experienced stronger MAU growth, but showed deceleration like U.S. and Europe. As changes in daily average users, or DAUs, were similar to MAUs in the quarter, overall user engagement stayed at around 66%, which we view as positive.

While user count was disappointing, we note that Facebook continues to monetize its users more effectively than any other social platform provider. The firm's average revenue per user, or ARPU, grew 26% year over year, driven by 34% growth in the U.S. and Canada, 40% in Europe, 23% in Asia, and 29% in other markets. Plus, Facebook continues to maintain pricing leverage as advertisers still view the platform as the one that generates the highest return on investment. Ad prices increased 17% from last year, while ad volume sold went up 21%.

In our view, given that Facebook owns the two most valuable social-networking properties, growth in Instagram users may continue to partially offset slower Facebook user growth. In addition, we think migration of users or usage away from Facebook may simply shift toward the Instagram platform. While Instagram user count is not included in Facebook's MAUs or DAUs, management said the app's user count is now at one billion. Unlike the Facebook platform, we see room for additional Instagram ad loads per user to accommodate the increasing number of advertisers on the platform, raising Instagram's ARPU. We further expect Instagram ARPU growth acceleration due to the rollout of its video content app, IGTV.

Facebook's second-quarter operating margin came in at 44%, down about 3 percentage points from a year ago, mainly due to the firm's lower gross margin as more investments are made in content creation and data security. In addition, as a percentage of revenue, Facebook's marketing and sales spending went up to levels not seen since the first quarter of 2016 as the firm continues to repair its image post data privacy issues and the Cambridge Analytica scandal.

Based on management's guidance, we lowered our top- and bottom-line projections. While we did not make significant adjustments to our revenue estimate, we did slash 2018 and 2019 operating margin to 43% and 37%, respectively, down from our previous 45% and 44% assumptions. Facebook is planning to spend much more on headcount and technology for content control and data security than we initially expected. In addition, investments in R&D are likely to increase as Facebook will be pursuing more innovation to further monetize its users, especially in saturated markets such as the U.S. and Europe. We also expect sales and marketing spending as a percentage of revenue to inch up during second-half 2018 and in 2019, further pressuring Facebook's operating margin.

We expect 2020 operating margin to remain around 37% but are projecting a return to margin expansion in 2021 and 2022. We remain confident that the firm will successfully roll-out new products for users and advertisers. In addition, we believe Facebook can continue to grow its ARPU as the company begins to offer more premium video content not only on Facebook Watch but also on Instagram's IGTV. For this reason, we expect revenue growth to average around 17%-18% per year in 2020-2022, possibly creating operating leverage. Plus, we believe the firm will realize return on its investments in content quality management and data security. While currently those require much higher headcount, we think a larger portion of those processes can become automated over time, thereby creating an option to lower headcount and create further operating leverage. We have modeled a 22% five-year CAGR for Facebook generating annual average operating margins of 39%.