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Morningstar | Facebook Reports Strong 4Q Results; Increasing FVE to $190; Shares Undervalued. See Updated Analyst Note from 30 Jan 2019

Facebook’s fourth-quarter results easily beat our internal expectations and the consensus as the daily average user count grew sequentially in the largest ad spending markets (U.S. and Europe), even though the firm remains in the midst of addressing data security and privacy issues. In our view, Facebook’s network effect moat source remains intact as demonstrated by further improvement in user monetization during the quarter. We remain convinced that further growth in Instagram, IGTV, and Stories users will continue to attract advertisers to Facebook’s platform. Management did not change its 2019 guidance and expects further deceleration in top-line growth. In addition, it sees higher capital expenditure along with expense growth outpacing revenue growth in 2019. After making only slight adjustments to our projections and taking into account time value of money (as we rolled our model forward), we upped our fair value estimate of wide-moat Facebook by 2% to $190 per share, representing a 2019 enterprise value/adjusted EBITDA multiple of 13. As of the Jan. 30 closing price, Facebook shares were in 4-star territory and remained attractive. We note that in reaction to the fourth-quarter results, those shares are approaching 3-star territory as they were up more than 10% in after hours trading.

Facebook’s total ad revenue grew 30% year over year to $16.6 billion during the quarter, driven by strong 66% user engagement and increases in both demand for and supply of Facebook’s ad inventory. Facebook’s overall monthly active users, or MAUs, grew 9% to 2.32 billion, while daily active users, or DAUs, also increased 9% to 1.52 billion. We were impressed with the firm’s DAUs’ return to growth (sequentially and year over year), especially within the higher ad spending markets of the U.S. and Europe. It appears that Europe’s GDPR policy is no longer impacting Facebook’s Europe user count negatively. Other revenue was $274 million, up 42% from last year as according to management, the firm sold more of its hands-free video calling hardware, Facebook Portal, during the Holiday Season than it had expected.

Monetization of users continued to improve as the average ad revenue per user, or ARPU, increased 19% from last year. In the U.S. and Europe, that number grew 30% and 24%, respectively. We expect continuing growth in ARPU during the next five years, although at only a single-digit five-year CAGR given that increase in user count will be mainly driven by growth in lower ad spending markets. Plus, we expect decline in prices due to the ad inventory mix shift toward what appears to be the lower-priced Stories ad load. According to Facebook, the Stories feature on Instagram alone had more than 500 million DAUs, which will likely further attract ad dollars. In addition, by the end of 2018, Facebook already had over two million advertisers purchasing its Stories ads (across Facebook and Instagram), compared with its overall seven million active advertisers. During the quarter, demand for Facebook’s overall ad inventory remained intact as ads sold grew 34% from last year. However, ad prices did decline 2% year over year as sale of Stories ads continues to increase.

Gross margin of 83.5% was 411 basis points lower than last year, mainly due to higher content acquisition and management costs, along with further spending on the data privacy front. Operating margin declined to 46% (from 57% last year) due to higher R&D and marketing expenses as Facebook continues to work on overall product integration, new product development (such as the all-in-one virtual reality gaming system which will be released in Spring of this year), data security, and further efforts to improve the firm’s image to current and potential users. As the firm plans to further invest in R&D and content creation, in addition to data security, we see average operating margin declining during the next five years. Our projections represent a five-year CAGR of 17% for total revenue and a five-year average operating margin of 36%.

Overall, we remain confident that with its strong network effect moat source, which has resulted in more than 2.3 billion users, Facebook will continue to attract advertisers to its platform. In addition, we are pleased with the company’s further investments in product integration and data security, along with the introduction of new social network products (such as Stories, IGTV, and Watch) during the last 12-18 months, all of which we believe will help the firm to maintain and further monetize its users.