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Morningstar | Facebook Slightly Missed on Revenue but Beat on the Bottom Line; Maintaining FVE; Shares Undervalued. See Updated Analyst Note from 31 Oct 2018

Facebook’s third-quarter results came in mixed as they missed slightly on the top line but beat our expectations and consensus on the bottom line. The narrow miss on revenue was mainly due to the user count decline in Europe, which was a result of GDPR. We note that the firm’s total daily and monthly user counts still beat our expectations. In our view, no decline in Facebook’s U.S. users was reassuring as it displayed that this wide-moat name’s network effect moat source is intact. More importantly, albeit data and content issues that have surrounded the firm this year, advertisers continue to spend on Facebook as ad loads and ad prices both increased and further drove impressive double-digit growth in revenue generated per user. We expect to see similar monetization in Facebook’s newer products such as Instagram and Stories in one to two years. Management’s guidance indicated slightly better than expected revenue growth in the fourth quarter while margin for next year may be coming in a bit lower than we had modeled. The two offset one another and did not impact our fair value estimate of Facebook. We are maintaining our $186 per share fair value estimate. We currently view Facebook shares as attractive as they are trading at a 21% discount to our fair value estimate.

In our view, Facebook is now transitioning from complete dependency on News Feed to providing more options for its users which could improve monetization in the long-run for a few reasons. First, we think that with a strong network effect moat source, Facebook will be able to attract users to its Stories (whether on Facebook or Instagram), Facebook Watch, and Instagram and its IGTV. As the firm maintains more users on its overall platform, it is more likely that user engagement will stay at the current 66% level, which has been the case for the last 11 quarters. Second, with stability seen in user engagement, we remain confident Facebook can effectively monetize its new products to partially offset deceleration in News Feed ad revenue growth during the next 12-24 months. While ad prices on Stories and Instagram currently trail those of News Feed, with further user adoption, demand for the ads will grow, possibly driving prices higher. And third, we think there is further room for growth in the amount of ad inventories sold on Stories and Instagram. We must note that although the firm is experiencing slowdown in ad revenue and user growth, monetization of users on News Feed remains impressive as shown by the 20% year-over-year growth in revenue generated per user.

Facebook reported $13.7 billion in total revenue, which represented a 33% year-over-year growth. Ad revenue came in at $13.5 billion, up nearly 34% from last year. As expected, slowdown in user growth drove deceleration in overall ad revenue growth.

While growth in monthly average users, or MAUs, slowed, we view the 10% increase from last year as impressive. Although, we must note that such growth was driven mainly by an increase in Facebook's users in Asia-Pacific and other non-U.S. and non-Europe regions. Sequentially, the only region that experienced a decline in users was Europe (down by one million MAUs) as impact of GDPR continued for the second consecutive quarter. Facebook’s daily active user, or DAU, count grew 9% from last year, and its quarter-over-quarter changes were similar to changes in MAUs, which resulted in user engagement impressively remaining at around 66%.

Revenue generated per user increased 20% from last year to $6.10 as growth in developed and high ad spending regions such as the U.S. (30%) and Europe (29%) continued.

Demand for Facebook’s ad inventory remained high as indicated by the 7% increase in ad prices while ad load sold was up 25%. While ad inventories sold will likely increase as Facebook begins to more aggressively monetize Instagram, IGTV, Stories, and Watch, we expect slower ARPU growth as ads on those are priced lower than those on News Feed. We think over time, increase in demand will likely push prices higher, partially offsetting the impact of less ads purchased on News Feed.

On the margin front, the firm’s third-quarter margin of 42% was down almost 8 percentage points from last year, given the firm's lower gross margin due to higher costs associated with content acquisition and data security. Like the previous quarter, Facebook’s marketing and sales expenses increased significantly as a percentage of revenue (up more than 270 basis points to 14%) due to the firm’s efforts to not only minimize the impact of data issues on user count but also due to Facebook’s more aggressive marketing of its latest social networking products.

Management provided slightly better than expected guidance for the fourth quarter as it expects revenue growth to slow to mid to high-single-digit percentage points sequentially. For the year, Facebook expects total operating expenses to grow 50%-55%. In addition, the firm is likely to have between $14 billion and $14.5 billion in capital expenditure. Regarding 2019, Facebook guided for 40%-50% growth in operating expenses and $18 billion-$19 billion in capital expenditure. Growth in operating expenses this year and in 2019 will be driven mainly by increase in headcount and higher depreciation expense due to more capital expenditure.

We adjusted our model accordingly and while we now expect a slightly higher five-year revenue CAGR (23% versus our initial 22% assumption), based on management’s guidance, we think operating margin likely will be lower in 2019 than we had previously assumed. We have modeled average operating margin of 38% through 2022, slightly lower than our initial 39%.