Let’s cut to the chase. Facebook (NASDAQ:FB) is collapsing like no other stock has collapsed before. Facebook stock dropped more than 20% in response to disappointing second quarter numbers. That equates to a $120 billion wipe-out in valuation, which is the biggest single-day wipe-out in stock market history.
But, the sell-off is way overdone. Facebook stock is a buy on this dip and a hold for the long-term. I realistically see prices north of $200 by the end of this year, and $300 within the next five years.
Here’s a deeper look.
Why Facebook Stock Collapsed
Headlines are everywhere on why Facebook stock collapsed, so I’ll be brief here.
Revenues missed expectations, which is rare for this growth giant. Overall user growth was anemic versus last quarter (less than 2%). North America user growth was flat quarter-over-quarter. The European user base actually contracted quarter-over-quarter.
Operating margins fell as the company upped investments into Stories and vetting harmful content. This compression is expected to continue, and operating margins are expected to compress all the way to the mid-30’s (from 40%-plus over the past several quarters).
Worse yet, revenue growth is expected to decelerate in the back-half of the year to around 35%, versus 40%-plus over the past several quarters. The revenue slowdown is largely attributed to the shift from a News Feed ad focus to a Stories ad focus.
All together, user growth is slowing, revenue growth is slowing, and margins are falling. That is why FB stock dropped 20%.
Concerns Are Overstated and Shortsighted
In the big picture, near-term concerns related to stagnant user growth, slowing revenue growth, and falling margins are dramatically overstated and unnecessarily short-sighted.
User growth is flat. That is somewhat obvious, no? The Facebook platform already has more than 2 billion monthly users. There really aren’t that many more to get.
Plus, Facebook platform user growth doesn’t matter all that much anymore. Facebook is much more than just the Facebook platform. It is an ecosystem of four apps, all of which have more than 1 billion users and one of which (Instagram) is growing at a 30%-plus clip.
Thus, in the long run, slow Facebook user growth (or even Facebook user churn) should be offset by robust growth at Instagram, WhatsApp, and Messenger.
As for slowing revenue growth, that is a near-term phenomena. Revenue growth is slowing because the company is shifting its focus from News Feed ads to Stories ads. That is a smart move. Engagement is moving from News Feeds to Stories, so Facebook needs to shift its monetization strategy to focus on Stories.
The bad thing is that management doesn’t think that early-stage monetization rates on Stories will be as high as late-stage monetization rates on News Feeds. That seems obvious, but ad dollars always follow engagement. Thus, if engagement does go to Stories, monetization rates over there will ramp, and revenue growth will come roaring back.
Moreover, wherever engagement goes, Facebook wins. They own the biggest News Feed app in the world (Facebook). They also own the biggest Stories apps in the world (Instagram and WhatsApp).
On the margin compression side, what you have is the aforementioned revenue slowdown coupled with big investments to drive Stories monetization rates higher and to clean up the Facebook platform. Those are good investments, and they are near-term in nature. Over time, they will peel back, margins will come roaring back, and everything will be fine.
Plus, Facebook has been beating the “higher expenses” drum for a while now. Each time, it results in near-term compression, long-term expansion for Facebook stock; it’s the same situation here.
Top-Down Analysis Implies
My top-down analysis implies a year-end price target for Facebook stock of $220.
The global advertising market numbers roughly $600 billion. It is growing around 8% per year. About 40% of all ad spend went to digital ads in 2017.
That is up from roughly 30% in 2015. Digital ad share is expected to hit 50% by 2020, and then 50%-plus thereafter. Clearly, the digital advertising market is still a secular growth space.
Facebook’s dominance in this secular growth space is only growing.
In 2015, the global digital advertising market was $160 billion in size. Facebook’s ad revenues were $17 billion, implying 10.6% market share. In 2016, the digital ad market grew to $190 billion, while Facebook’s ad revenues grew to $27 billion.
That implies 14.2% market share. In 2017, the global digital ad market grew to $230 billion. Facebook’s ad revenues were $40 billion. That is a 17.4% market share.
Even in 2018, if you assume 35% revenue growth in the back-half of 2018, Facebook’s revenues should be about $57 billion this year. The global digital ad market is expected to be $270 billion this year. That implies over 21% share.
In other words, not only is the digital ad market growing at a rapid rate, but Facebook’s share in that market has grown by 11 percentage points over the past four years. Granted, over the next five years, market share expansion will slow thanks to bigger competition and tougher laps.
Let’s say Facebook’s share of the global digital ad market grows by five points over the next five years, implying 26% share in five years. The digital ad market at that time is expected to be $430 billion. A 26% slice of that pie implies revenues of nearly $112 billion. Assuming operating margins normalize back to 45%, that should flow into earnings per share of $14.75 in 5 years.
A growth-average 20X forward multiple on that implies a four-year forward price target of over $290. Discounted back by 10% per year, that equates to a $220 year-end price target for Facebook stock.
Bottom-Up Analysis Implies
Meanwhile, my bottom-up analysis implies a year-end price target of $210 for Facebook stock.
As noted earlier, the metric that really matters when it comes to Facebook isn’t monthly active users on the Facebook platform. Rather, it is the number of users within the Facebook ecosystem. That number is six billion right now, up from roughly 5.3 billion a year ago (+13% year-over-year).
I think that number can grow mildly to seven billion by 2022, implying a meager 3% annual growth rate. New users will come from continued robust Instagram growth, offset by mild Facebook user loses.
Within 5 years, I expect all seven billion of those users to be monetized via ads. The rate of monetization will be lower than on the core Facebook platform. But, it will still be high because each platform has more than 1 billion users.
Last year, Twitter’s (NYSE:TWTR) ARPU was $7.40. But, that was when revenue trends were struggling. This past quarter, Twitter’s ARPU was up nearly 20% year-over-year. At that rate, Twitter’s ARPU should be close to $9 this year. That will inevitably grow over the next several years.
Each one of Facebook’s apps has more than 3X the amount of users as Twitter. Thus, monetization rates on each of Facebook’s apps should be higher than Twitter’s monetization rate. From that perspective, I think a reasonable ARPU across all of Facebook’s apps in five years is $15.
A $15 ARPU on seven billion users implies revenues of $105 billion in five years. Assuming operating margins normalize back to 45%, that should flow into earnings per share of $14 in 5 years.
A growth-average 20X forward multiple on that implies a four-year forward price target of $280. Discounted back by 10% per year, that equates to a $210 year-end price target for Facebook.
Bottom Line on Facebook Stock
The big sell-off in Facebook stock is a gross overreaction to slowing growth concerns which are unnecessarily short-sighted. Buyers of FB stock on this dip will be handsomely rewarded.
As of this writing, Luke Lango was long FB.