The Fate of Facebook Stock Will Come Down to Its Risks

By any fundamental measure, Facebook stock is undervalued; the question is if it should be undervalued

By the numbers, Facebook (NASDAQ:FB) stock looks far too cheap. Its 2019 earnings per share, excluding a settlement with the Federal Trade Commission, should come in over $8 per share. Back its out over $18 per share of cash, and Facebook stock is trading at something like 22 tines this year’s earnings.

Facebook Stock Will Come Down to the Risks
Source: justplay1412 /

That’s basically the market’s average multiple. Yet Facebook is growing much faster than the market. Its revenue should rise 26% this year and at least 20% in 2020.

Indeed, there is no shortage of tech stocks with lower growth and substantially higher valuations. Microsoft (NASDAQ:MSFT) is one. Smaller names like Intuit (NASDAQ:INTU) and Adobe (NASDAQ:ADBE) might qualify as well. Simply considering growth and valuation, there are few better stocks out there than Facebook stock.

To some extent, investors have come around to that realization. FB stock has gained 53% so far this year. But its shares also trade below their July peak — and they haven’t returned to the all-time highs they reached in 2018.

There are reasons for that, and Facebook stock faces real risks going forward. One of those risks became quickly and stunningly apparent last year.

I’ve argued for much of this year that Facebook stock was too cheap.  But with Facebook stock price back at $200, the outlook of FB stock is increasingly dependent on the extent to which  Facebook can avoid, or at least mitigate, those risks.

Will FB’s Spending Slow?

The biggest hit to Facebook stock ever came last July. In fact, it was the biggest hit to any stock ever. On Jul. 26, 2018, Facebook’s market capitalization fell a staggering $119 billion in a single trading session. The decline easily eclipsed one-day losses during the dot-com bubble-era  by Intel (NASDAQ:INTC) and Microsoft.

The catalyst was a statement FB made on its earnings conference call, Facebook said its  operating expenses would rise meaningfully in 2019. That guidance mostly has come to pass: excluding the FTC settlement, total costs and expenses have risen 35% so far this year, while FB’s revenue has climbed just 27%.  Facebook stock price may not fully reflect this news.

After Q3, Facebook said its expenses would rise rather sharply again. Its total expenses are expected to increase to $54 billion to $59 billion in 2020 from $41 billion to $43 billion in 2019 (again, excluding the FTC settlement).

At the midpoints, that’s a 35% increase — roughly equivalent to the percentage increase through the first three quarters of 2019 . And the guidance suggests that the company’s margins will further compress in 2020, resulting in relatively lower profit growth.

But this time around, the market has shrugged at the guidance. One key reason for that might be that analysts don’t believe the company. The Street appears to think that Facebook is being conservative about 2020.

Those analysts probably need to be right for Facebook stock price to reach new highs. The concerns about its margin compression are legitimate; Facebook’s spending on security and user safety isn’t going to slow. To drive the earnings growth needed to move Facebook stock higher, the company needs to be able to cut its other costs.

Are Regulators Coming?

Another obvious risk is on the regulatory front. The FTC already has fined Facebook $5 billion. One FTC commissioner said this week the settlement didn’t go far enough.

Regulators in Europe are watching both Facebook and Alphabet (NASDAQ:GOOG,NASDAQ:GOOGL) closely. Federal antitrust authorities in the U.S. have opened their own investigations, as have state attorneys general.

So far, political risk has been mostly much ado about nothing for Facebook stock. Both the June revelation of the federal antitrust probes and the drama surrounding the company’s Cambridge Analytica scandal simply created buying opportunities. The $5 billion fine is less than 1% of Facebook’s market capitalization.

For now, political risk still seems relatively minimal. A federal government that can’t agree on anything seems unlikely to agree on how to manage Facebook. The step of actually separating the company from its WhatsApp and Instagram businesses seems extreme and to require more political capital than it’s worth.

Many Americans are outraged at Big Tech, but there’s little evidence yet that politicians have the stomach for a years-long legal battle that would likely dwarf the infamous Microsoft antitrust case that took nearly a decade to resolve.

Still, recent trading shows that any kind of news on the regulatory front can move Facebook and other internet stocks. And with the 2020 elections less than a year away, Facebook, Google, and Twitter (NYSE:TWTR) likely will be in the headlines, and in candidates’ statements, much more often than they would like.

User Growth and Facebook Stock

One potential irony surrounding FB stock is that the most widely-discussed risk hasn’t played out. For years, skeptics  have worried that Facebook’s user growth was going to slow. Reports of teenage users fleeing the platform to escape their parents have persisted for years. Snap Inc (NYSE:SNAP) platform Snapchat was highlighted as a potentially legitimate competitor.

The Cambridge Analytica revelations supposedly turned off users. Conservatives in the West see bias on the platform; liberals decry the spread of “fake news” on FB. For years now, it’s seemed like multiple demographics were on the verge of exiting Facebook for good, and, for some time, that exodus was seen as a key risk to the stock.

It simply hasn’t happened. Facebook’s daily active users (DAUs) increased 9% year-over-year in Q3, to a stunning 1.62 billion. Facebook wrote in its Q3 earnings press release that an estimated 2.2 billion people use at least one of the company’s four services (Facebook, Instagram, WhatsApp, and Messenger) each day. That’s nearly 40% of the world’s adult population; excluding China, its daily penetration  rate is almost 50%.

That said, slowing user growth could be a risk going forward, particularly if the trend is combined with higher spending. In the West, Facebook’s DAU numbers have stagnated. The daily active user base in the U.S. and Canada increased just 2% year-over-year in Q3; DAU growth in Europe was just 3.5% YoY. Elsewhere, the platform’s reach is expanding, but a ceiling might loom.

Competitive fears do seem markedly lower. Snapchat’s user growth has started to rise again, but its DAU base is barely one-eighth that of Facebook. Twitter has evolved into a different tyoe of platform. Still, lower user growth will lead to lower revenue growth. It’s possible that at least some of those who were skeptical about  Facebook stock weren’t wrong, but just early.

The Case for FB Stock

With FB stock back at $200, the bull/bear argument comes down to the risks outlined above. If Facebook stays on a relatively “normal” path, with its revenue and spending growth  decelerating as the company matures, Facebook stock will likely outperform the market. The company has too much cash and generates too much cash to be trading at a market-level valuation. At the moment, from a financial perspective, FB  is one of the best businesses in the world, with operating margins near 40% and revenue growth above 20%.

The key qualifier there, however, is “at the moment.” The world changes quickly, and the volatility of social media stocks shows the industry isn’t immune to changes. Regulators can be fickle. Customers can be unpredictable. I still believe that  Facebook stock is worth buying, despite these risks. But the risks are real — and the owners of FB stock should keep that in mind.

As of this writing, Vince Martin has no positions in any securities mentioned.

Article printed from InvestorPlace Media,

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