Facebook: megacaps can grow too

Facebook as a business owns the facebook.com website along with some other social media properties like Instagram and WhatsApp.

The main revenue driver is the facebook.com website. Within facebook.com, the most important revenue source is the news feed.

The news feed is a list of articles that is customized to each user that shows the activities of their friends. Sprinkled within that news feed are ads that are also tuned to the user's likes.

The numbers

2016 Revenue: 28B

2016 Net Income: 10B

Net Margin: 35%

2017 Estimated Revenue: 36B

2017 Estimated Net Income: 17B

Net Margin: 47%

This is an extremely capital-light business. 2016 property and equipment was only 9B. They have 0 long-term debt.

The fundamentals behind the numbers

Net Income is a function of the following variables:

MAU = monthly active users

ARPU = average revenue per (monthly active) user

Net Income = MAU x ARPU x net margin

MAU is about 2B.

Worldwide ARPU is about $18 currently. In the US ARPU is close to $75.

Net Margin is about 47%, which is outstanding.

In the base case, in 5 years:

MAU goes up to 3B, i.e. ~8% CAGR

ARPU goes up by 5% CAGR to $23 (global GDP goes up 2%; 3% is secular shift from traditional to digital ad spend)

Net Margin expands due to operating leverage by 1% CAGR.

Valuation comes down from 25x to 20x, i.e. -4% CAGR

Share dilution of about 3% CAGR

In this scenario, the net income will increase by 14% CAGR. Due to valuation decrease and share dilution, shareholder return may only be 7%.

In a realistic scenario, I think ARPU will go up more than 5% CAGR. To me, 10% or so CAGR seems realistic so the final ARPU would be $28 in 2023. This may be because of higher ad load, or more tuned ads. Also, the valuation may not shrink (and if it shrinks, I suspect it will be because the benchmark valuation also shrinks). In this "realistic scenario" the earnings CAGR would be 19% and the shareholder return will be 12%.

In optimistic scenarios, worldwide ARPU can go up to $50 or more. While this can happen, it is unlikely due to more users joining from geographical locations where ARPUs are much lower than worldwide ARPU. Here are the 2017 approximate ARPU figures by geography:

US&Canada: $75

Europe: $24

Asia-Pacific: $8

Rest of World: $6

Side Note: There is quite a disparity between US and Europe, which cannot be explained by difference in GDP per capita alone. Europe / US GDP per capita = 65% while Europe / US FB ARPU = 32%. Perhaps this difference is cultural (Europeans may have fewer friends, or are less interested in friends' activities). It would be interesting if Facebook provided some insights into these trends in their annual reports.

The next billion users to be added will surely come from Asia-Pacific and Rest of the World. US MAU growth rate is ~5.7% while Asia-Pacific is ~26% and Rest of World is ~15%.

The drivers behind the fundamentals

We can dream up any ARPU or MAU figures, but ultimately these will be as a result of happy users engaging with the facebook.com platform. The platform must provide meaning and value to users' lives in order for users to keep spending time on it.

Ultimately, users want platforms to stay in touch with friends and family. So that will likely not change in the future. The relevant question to me is what platform they will use to stay in touch with friends and family. While there are many choices (Snapchat, Facebook, Instagram, Google+, etc.), I think facebook.com will remain the platform of choice because of network effects. Users will want to stay there because their friends, photos, comments and other digital memories are there (likes, stickers, etc.). Starting a new social network is not easy (think of Google+) because your friends aren't already there.

How does one estimate future ARPU? I think the key factors involved are:

1. average time spent per user per year
2. average "engagement" (think of this as how much the user enjoys looking at the posts on their feed): are users skimming through the feed, or are they looking at it with concentration
3. number of ads shown in the news feed (though this knob has quickly diminishing returns)
4. quality/relevance of ads shown in the news feed (ads should be tuned to the user's tastes)
5. how much the advertiser is willing to pay for an ad

(1) and (2) depend on the content of the news feed which is user-created. Facebook only has indirect control over those and can provide tools to improve on this (like auto tagging, filters, etc.). Facebook has direct control over (3) and (4) and especially (4) is likely to increase a lot in the future due to advancements in machine learning. Plastering too many ads by increasing (3) can actually cause (1) and (2) to go down, so that knob may be saturated. Growth in (5) can be attributed to two components: GDP growth and advertisers moving their budget from TV/newspapers to facebook.

At the minimum ARPU will grow inline with GDP + secular trend of ad budgets moving from offline to online.

Other factors to consider

Other positive or negative factors to consider are:

1. Buybacks may increase in the future. Current buyback is rather insignificant at $6B which is ~1% of market cap.
2. Company is run by the CEO who is an owner-operator. I like that he sacrifices short-term results for long-term results.
3. WhatsApp is totally unmonetized right now. This may take a long time to monetize though.
4. Management may get distracted with money-losing acquisitions or ventures. I thought paying $20B for WhatsApp was a very high price but if they can have an ARPU of $2 there (with 50% net margin), they paid 20x earnings which seems reasonable.
5. Longevity in the technology business is rare.

Bottom Line

FB is currently a great company and the price of the stock also seems reasonable at 28x forward earnings (where the S&P500 is trading at 19x).

My estimate of forward S&P500 returns is around 6% CAGR and FB should be able to beat this by 5% CAGR as long as user engagement doesn't drop.