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Facebook (FB) - Thesis

Rating: Buy
Current Price: $86.73
Price Target: $ 142.50

Thesis:
Facebook’s opportunities for continued advertising revenue growth are enormous.  Rather than maximizing these opportunities as quickly as possible, Facebook CEO Mark Zuckerberg is focused on continuing to improve the user experience which he believes is ultimately better for the company’s long-term success.  As Facebook continues to improve and integrate the Facebook application, WhatsApp, Messenger, Instagram, and new innovations, the monetization opportunities via advertising make this company worth far more than its current stock price suggests.

Valuation:
Using a Discounted Cash Flow (DCF) valuation model, Facebook’s is worth $142.50 per share.  The model assumes FCF will grow 30% in 2015 to $4.7 billion, and then grow at 27.2% for the next five years before reverting to a more market normal growth rate of 3% beyond 2020.  This five year expected growth rate (27.2%) is consistent with the average estimate of over 40 professional analysts according to Yahoo!Finance.

 

Facebook only needs to grow at about 12% for the next five years to be worth its current market price, and based on the advertising revenue growth opportunities available, Facebook is easily worth considerably more than its current stock price suggests.

Sources of Growth:
According to Facebook’s Chief Financial Officer, David Wehner, the company has three strategic priorities.  First, is to capitalize on the shift to mobile (see Q1’15 conference call).  This has been the highest priority since the company’s initial public offering (IPO) in 2012.  Thus far, the company has allayed fears that they would not be able to profitably convert to the small screens of mobile devices, but there is more opportunity ahead.  The company is still in the early stages of mobile advertising, and has foregone enormous short-term revenue opportunities in favor of building this business prudently for long-term success.  For example, according to the company’s annual report:

“We prioritize user growth and engagement and the user experience over short-term financial results.  We frequently make product decisions that may reduce our short-term revenue or profitability if we believe that the decisions are consistent with our mission and benefit the aggregate user experience and will thereby improve our financial performance over the long term. For example, from time to time we may change the size, frequency, or relative prominence of ads in order to improve ad quality and overall user experience. Similarly, from time to time we update our News Feed ranking algorithm to deliver the most relevant content to our users, which may adversely affect the distribution of content of marketers and developers and could reduce their incentive to invest in their development and marketing efforts on Facebook.”

The bottom line here is that Facebook is trying to build for the long-term and there is huge room for growth.

Facebook’s second strategic priority is to grow advertising revenue.  This goal is noticeably second, not first, because the company recognizes the long-term importance of putting users (not advertisers) first.  During Facebook’s most recent Q1 conference call, Chief Operating Officer Sheryl Sandberg repeatedly pointed out Facebook only has a small portion of companies’ advertising revenue, and this is a truly enormous growth opportunity.

Facebook’s third strategic priority is making their applications more relevant.  This is important because it helps Facebook retain, grow and improve users, which ultimately sets up the company for long-term success.  Facebook’s other applications include WhatsApp, Instagram, Messenger, and other initiatives designed to benefit users.  Facebook recently acquired WhatsApp and Instagram, and the company hasn’t even scratched the surface yet in terms of monetizing these businesses.

Worth noting, Facebook continues to spend a large amount of money on research and development.  This supports the notion that the firm is building for long-term success by serving users rather than simply trying to monetize everything as quickly as possible so the inside owners (e.g. Mark Zuckerberg) can “cash out.”

Risks:
Stagnant or Declining User Base:  Facebook’s number one risk is its ability to retain users.  According to the company’s annual report:

“If we fail to retain existing users or add new users, or if our users decrease their level of engagement with our products, our revenue, financial results, and business may be significantly harmed.”

In other words, if people stop using Facebook, then the advertisers go away and Facebook isn’t able to make any money.  Facebook combats this risk by focusing on user experience across everything they do.  They forgo revenues to improve user experience, they constantly innovate and introduce new features and applications through a large research and development budget and by acquiring businesses (e.g. Instagram, WhatsApp) that pose a threat and/or create integration benefits.  When invetors ask CEO Mark Zuckerberg questions, his go to response always seems to be that the company is just really focused on improving the user experience.

Corporate Governance:

Facebook’s corporate governance structure introduces a variety of risks for shareholders.  For some background, Facebook founder and CEO, Mark Zuckerberg, is the largest shareholder, he has virtually complete control over the company via voting rights (there are multiple share classes, and Zuckerberg own the class with the real voting rights), and Facebook’s board is comprised of insiders and friends.  This allows Zuckerberg to take actions that are not necessarily in the best interest of shareholders, and he has already demonstrated a penchant for taking questionable actions.

For example, Zuckerberg has made some very big acquisitions (WhatsApp, Instagram); these types of acquisitions are often a symptom of a company with more cash than it needs, and rather that returning it to shareholders it is spent on the types of acquisitions which have historically destroyed value for shareholders.  Facebook may be young enough with enough growth opportunity that these acquisitions may bunk the norm and actually add value in the long-term, but they may also be the beginning of a bad habit for Zuckerberg; additional acquisitions could prove quite destructive to shareholders as often is the case.

As another example, Facebook’s board could inappropriately increase the number of shares outstanding which would be dilutive to existing shareholders.  Facebook has historically used shares to pay for acquisitions (e.g. Oculus) and to reward executives with stock options.  These types of share issuances are often not in the best interest of existing shareholders.

Mark Zuckerberg has done an exceptional job growing Facebook, but the company is still early in its public company lifecycle.  For this reason, Facebook is able to do things now that may be totally unacceptable in the future (e.g. big acquisitions, dilutive stock issuances). Inevitably, Facebook will eventually focus less on growth (because Facebook’s untapped markets will continue to decrease) and focus more on increasing the value of the business (because that will become the more profitable priority).  And as this shift occurs, Facebook’s current corporate governance will become more of a risk.

Conclusion:

Facebook continues to have significant growth and monetization opportunities ahead.  Despite some questionable corporate governance for this young public company, and despite the possible risk of a stagnating user base, Facebook is still easily worth more than it's current stock price suggests.  We own shares of Facebook, and we value the company at $142.50 per share.

 

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