The coronavirus pandemic has led many investors to look at the technology giants that have driven much of the market returns in recent years. Facebook Inc. (NASDAQ:FB) is a prime example. Many investors are bullish on FB at these depressed share price levels due to the company’s fortress balance sheet and clear ability to withstand the crisis. Others point to the clear tailwinds the company has from stay-at-home trends increasing in the new era of social distancing. This is all true. FB is going to be much more resilient than many large cap companies in this slowdown. However, I believe many in the market may be underestimating how much FB’s underlying business model can be affected by this economic slowdown.
FB has been a phenomenal growth story over the past decade. Impressive double-digit annual revenue growth and gross margin expansion from the 75% range in 2010 to the 80%+ range in the last few years has done wonders for the company’s stock price. The company is simply a cash machine.
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Source: FB Q4 2019 Earnings Presentation
Now that the 11-year bull market run is over, though, what will be the company’s source of revenue growth? FB has enormous leverage to the macro economy. If this recession were U.S.-specific, one could point to the company’s global revenue growth as an area of strength for the company. However, COVID-19 has caused economic chaos all over the world and I believe FB’s revenue stream is about to be attacked from all sides. Important to note here: FB’s revenue and average revenue per user (ARPU) in the U.S., Canada, and Europe are known to be higher due to the maturity and size of the online and mobile advertising markets in these regions compared to the rest of the world. In 2019, for example, FB’s 2019 ARPU in its U.S. and Canada region was >11x than in Asia-Pacific for the company.
FB’s primary source of revenue is obviously advertising revenue. From the company’s 2019 10-K:
“We generate substantially all of our revenue from advertising. The loss of marketers, or reduction in spending by marketers, could seriously harm our business.
Substantially all of our revenue is currently generated from third parties advertising on Facebook and Instagram. As is common in the industry, our marketers do not have long-term advertising commitments with us. Many of our marketers spend only a relatively small portion of their overall advertising budget with us. Marketers will not continue to do business with us, or they will reduce the budgets they are willing to commit to us, if we do not deliver ads in an effective manner, or if they do not believe that their investment in advertising with us will generate a competitive return relative to other alternatives. We have recently implemented, and we will continue to implement, changes to our user data practices. Some of these changes reduce our ability to effectively target ads, which has to some extent adversely affected, and will continue to adversely affect, our advertising business. If we are unable to provide marketers with a suitable return on investment, the pricing of our ads may not increase, or may decline, in which case our revenue and financial results may be harmed.”
The last thing major advertising buyers want to associate with their brands is the novel coronavirus, which has been the source of recent chaos for much of the world. Seeing a Coca-Cola (NYSE:KO) ad next to endless news feed stories about COVID-19, for example, is not very appealing to viewers. Logically, I would expect a great deal of slowdown in advertising revenues for FB as a result of this type of thinking at major corporations as well as significant budgetary pullbacks due to the economic recession. Even before the coronavirus chaos hit the world, the company was projecting “low-to-mid single-digit [deceleration]” for Q1 2020:
“We expect our year-over-year total reported revenue growth rate in Q1 to decelerate by a low-to-mid single digit percentage point as compared to our Q4 growth rate. Factors driving this deceleration include the maturity of our business, as well as the increasing impact from global privacy regulation and other ad targeting related headwinds. While we have experienced some modest impact from these headwinds to date, the majority of the impact lies in front of us. Turning now to expenses. We anticipate our 2020 total expenses will be in the range of $54-$59 billion, unchanged from our prior outlook. Our 2020 capital expenditures outlook is also unchanged at $17-$19 billion, driven by investments in data centers, servers, office facilities and our network infrastructure.”
The name of the game for many of these large companies that traditionally advertise on online channels is survival. While many major buyers of advertising are blue chip companies that will survive this recession due to fortress balance sheets, others have more credit risk than is probably good for them in light of the sudden economic stop. Online advertising, especially of the highly targeted sort that tends to take place on Facebook, tends to be relatively expensive.
The Wall Street consensus seems to have incorporated this view to some extent, with Morgan Stanley (MS) cutting price targets on some internet companies due to weaker anticipated advertising spending. This included some companies such as Alphabet (NASDAQ:GOOG) (GOOGL), Snap (SNAP), Twitter (TWTR), and Yelp (NYSE:YELP). Morgan Stanley also cut its price target on FB from $270 to $185, but maintained its Overweight rating on the company. I am not sure Facebook will see greater resistance in ad spending cuts compared to Snap and Twitter.
Meanwhile, the unfavorable indicators continue to mount. Last week, TWTR withdrew its Q1 revenue and profit guidance amid this bleak outlook for online advertising revenue. Another survey of nearly 400 marketing decision makers found that 24% have paused all advertising expenditure for the first and second quarters of 2020. 74% of those media planners surveyed in this report believe the coronavirus will have a greater impact on U.S. ad spend than did the 2008 financial crisis. Many sporting events have also been cancelled or postponed, including the NCAA March Madness tournament, professional sports seasons in the U.S. and around the globe, and the 2020 Tokyo Olympics (now to be held in 2021). The knock-on effects of event cancellations in sports and other areas will no doubt impact FB’s advertising revenue stream as well.
It is difficult to quantify the impact all of this will have on FB’s topline. One sell-side analyst team believed FB and GOOG would lose more than $44 billion in worldwide advertising revenue for full year 2020. I think there is too much uncertainty around the potential impact to the next several quarters for Facebook to take a long position in the company today until there is greater visibility to the duration and severity of this current crisis. While FB is enjoying significant increases in user engagement during this crisis, the impact to financials from this is unclear.
“Facebook’s total usage has increased during the pandemic, with message volume up more than 50% over the last month in countries hit hardest by the virus, but “We don’t monetize many of the services where we’re seeing increased engagement,” Facebook’s Alex Schultz, VP of analytics, and Jay Parikh, VP of engineering wrote.
In sum, I think $30 billion in operating income is a decently conservative estimate for what FB should be able to do in 2020, even in a down year. At over $465 billion in market capitalization, 15.5x EBIT is obviously cheap on a relative basis to the company’s median valuation over the past bull run, but it still feels a bit rich to me given the uncertainties discussed here. I would keep an eye on FB into the coming weeks and start to get more excited about a long position if the stock drops to the 10x EBIT range.
Despite the economic outlook, Facebook has pledged no layoffs during the current economic crisis and rather is keeping with its aggressive hiring strategy on the product and engineering side. The company has moved quickly in the current work-from-home shift, launching a desktop-based version of its popular Messenger app as a response to doubled usage of audio/video desktop browser calling. For what it’s worth, I find Zoom Video’s (ZM) product to be better than Messenger’s video chat solutions, especially for calls with multiple people. Perhaps FB will find a way to monetize this further, but I am not sure.
On a valuation basis, many are looking to the FAANG stocks as well as Microsoft (NASDAQ:MSFT) as becoming cheap during this downturn. I would point to their elevated valuations in absolute terms as an indication that there is plenty of room for them to get even cheaper. While these stocks may be the cheapest they have been in quite some time, it’s important to keep in perspective that we are coming off the greatest bull market in American stock market history, and that earnings for the foreseeable future for some of these companies, like FB, could be significantly lower than many think.
Obviously, this is an election year, and FB’s reaction to developments over the coming months could be in the headlines. I disagree with another recent contributor on this site who claims FB has a major business problem with fake accounts. If the public perception around FB’s reaction to various manipulations changes in the coming months, however, this could affect the stock price.
Another risk for the bear case on FB is the company’s fortress balance sheet. If the company uses their significant cash on hand to increase share buybacks, this could put buying pressure on the per-share price in the near term as well. I am not sure this would be the best use of cash for FB and time will tell whether such a move would represent a good investment for the company. Note the figures presented in the chart below do not include FB’s marketable securities. As of the end of 2019, FB had almost $55 billion in cash and cash equivalents plus marketable securities, or ~$18.50 on a per share basis. The company had a $10 billion share buyback authorized at the end of 2019, and I would keep an eye on this as a prospective investor.
Keep an eye on FB for the near term, but do not “load the boat” aggressively in a portfolio yet as the stock could get significantly cheaper if the pandemic concerns persist for the medium term. Good luck to all.