Introduction

We review Facebook’s (FB) Q3 2020 results, released after markets closed yesterday. Shares were up 4.9% during the day but fell 2.7% in after-market trading. Since we initiated coverage on FB with a Buy rating in March 2019, shares have gained 60%, nearly 3 times the gain in the S&P 500 index, and also significantly ahead of that in Alphabet (GOOG) (approx. 40%).

Buy Case Recap

Our original Buy case was based on FB being capable of growing at a 15-20% EPS CAGR after 2019, with a revenue CAGR of 15-20%, driven by growth in the number of users, the number of ads per user and revenue per ad, and margins stabilizing or even improving after 2019. Valuation at the time was attractive, being comparable with quality large caps with lower growth.

Even with the COVID-19 outbreak, we reiterated our Buy rating in May and July, taking the long-term view that earnings would recover and resume growing eventually. As of our July update, we expected EPS to be down 17% year-on-year in 2020, but to recover to 5% above the 2019 level in 2021. We assumed EPS growth would then continue, at 20% for 2022 and 15% in 2023.

FB’s Q3 2020 results exceeded our expectations and we are raising our estimates again, as we will explain below.

Q3 2020 P&L

Q3 2020 saw a sharp rebound in year-on-year ad revenue growth from Q2, to 22%, more than twice the 10% saw in both Q2 and in July, which was guided by management as the figure to expect for Q3:

The acceleration from Q2 was “largely driven” by strong advertiser demand, from the accelerated shift from offline to online commerce during COVID-19. The largest verticals were e-commerce, Retail and Consumer Packaged Goods, similar to Q2. E-commerce’s share of U.S. retail has risen by 4 ppt in Q2 alone, compared to rising by 1 ppt annually before COVID-19.

FB’s Q3 2020 ad revenue growth was driven by the number of ads (up 35% year-on-year) on a 12% higher MAU (Monthly Active Users), but with revenue per ad down 9%. Growth in the number of ads was driven by both Facebook and Instagram. The year-on-year pricing trend has in fact improved from Q2 (down 21%), though the mix shift towards lower-rate geographies and Stories ads continued to be a headwind:

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FB Components of Ad Revenue Growth (Since 2012)

Source: FB company filings.

We expect average price per ad to eventually start rising again, when newer ad surfaces like Stories become more familiar to advertisers, and when economic growth recovers from COVID-19. As shown in 2012-15, FB has a track record of first growing the number of ad impressions in new markets and then reducing them again to raise prices sharply to maximise revenues.

With strong ad revenue growth, Q3 revenues were up 21.0% year-on-year excluding currency, up 21.6% reported. Despite OpEx growing 28.3%, EBIT was up 11.9%, and EPS was up 13.4% (excluding an one-off tax benefit):

FB Results – Group Key Items (Q3 2020)

NB. FTC settlement accruals of $3bn in 19Q1 and $2bn in 19Q2 NB2. One-off $1.1bn tax expense in 19Q2 after unfavourable tax ruling on IRS vs. Altera. One-off $913m tax benefit in Q3 2020 related to election to capitalise & amortise some R&D expenses.

Source: FB company filings.

The increase in OpEx was in the low 30s ppt across all categories, except Marketing & Sales, reflecting the 32% year-on-year growth in headcount. Marketing & Sales expense was up only 11%, “a slower growth rate than prior quarters due to a slowdown in consumer marketing and hiring”.

Q3 2020 Operational Metrics

FB’s user numbers continued to increase in Q3, but with a lower growth rate than in Q2, which benefited from many countries entering lockdowns. The FB Family MAP (Monthly Active People), including all FB apps, reached 3.21bn in September, while its DAP (Daily Active People) reached 2.54bn; MAU and DAU (Monthly Active Users), which included only Facebook and Messenger users, also continued to rise:

Facebook MAU, DAU, FB Family MAP and DAP (Since 18Q4)

Source: FB company filings.

FB’s most developed U.S. & Canada market showed a dip in MAU, DAU and also the DAU/MAU ratio in Q3, as some of the COVID benefit in Q2 dissipated. However, the region’s MAU and DAU remained significantly higher year-on-year, and its DAU/MAU ratio was still slightly higher than Q3 2019 (76.9% vs. 76.5%):

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Facebook-Only MAU & DAU Statistics – U.S. & Canada (Since 2017)

NB. Figures here are for Facebook and Messenger only, and exclude Instagram & WhatsApp. Source: FB company filings.

FB’s Ad Revenue Per MAU rose in all regions, with APAC and Rest of World bouncing back from the dip in Q2. The long-term growth in ad revenue per user has continued to be a strong trend, albeit one with some seasonality and occasional currency headwinds (especially in Emerging Markets):

FB Ad Revenue Per MAU ($) (Since 2017)

Source: FB company filings.

2020 & 2021 Outlook

FB provided some forward guidance. Management now expects Q4 U.S. & Canada MAU and DAU to be “flat or slightly down” from Q3, with the benefit from COVID-19 further dissipating. However, ad revenues are expected to benefit from a strong holiday spend, with Q4 ad revenue growth year-on-year expected to be higher than the reported rate in Q3 (22%); other revenues are expected to benefit from strong Oculus Quest 2 orders to date.

2020 expenses are now expected to be $53-54bn, narrowing the from $52-55bn range previously given. On a preliminary basis, 2021 expenses are expected to be $68-73bn, implying a year-on-year growth of more than 30%.

If we assume a Q4 2020 total revenue growth rate of 22.0% year-on-year, then year-to-date results and the full-year expense outlook imply a 2020 adjusted EBIT that will be slightly (2%) up year-on-year:

FB Illustrative P&L (2020)

Source: FB company filings, Librarian Capital estimates.

The 2020 CapEx outlook was left unchanged at $16bn (vs. 2019’s $15.7bn). CapEx is expected to be higher in 2021, at $21-23bn, due to investments in data centres and other infrastructure.

Management also cited a number of possible headwinds in 2021, including a reversal of e-commerce’s benefit from COVID-19, changes in device platforms (particularly the iOS 14) that may impact ad targeting, and new European Union regulations (which may affect trans-Atlantic data transfers).

Valuation

Shares ended post-market trading on 29 October at $273.40. Relative to 2019 financials, FB had a P/E of 32.0x and a Free Cash Flow (“FCF”) Yield of 1.8% (cash on the balance sheet is worth 7.0% of the market capitalisation):

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FB Net Income & Cashflows (2014-19A)

Source: FB company filings.

We continue to believe FB deserves a P/E multiple of at least 30x, as a high-quality large cap stock with above-average growth, in a “lower for longer” interest rate environment.

Illustrative Returns Calculations

We update our illustrative return forecasts with the following assumptions:

  • 2020 EPS now to be flat year-on-year (was down 17.0%), in line with the slightly-up EBIT as implied by year-to-date results and the new outlook
  • 2021 EPS to be 10% above the 2019 level (was 5% above)
  • Then EPS to grow by 20% in 2022 and 15% in 2023 (no change)
  • P/E at 30x at 2023 year-end exit, below the current 32x
  • No dividends

At the current price of $273.40, the exit price of $389.29 implies a total return of 42% (11.8% annualised) in just over 3 years, which we regard as highly attractive for a franchise of FB’s quality and its potential for further growth:

Illustrative FB Return Forecasts

Source: Librarian Capital estimates.

Conclusion

Facebook’s ad revenue growth in Q3 exceeded previous guidance, accelerating to 22% year-on-year, more than twice the Q2 figure.

Even with expenses up 28%, Q3 EBIT was up 11.9%, making up for the decline in Q2; year-to-date EBIT is now flat-ish (-1.2%) from 2019.

Operational metrics remained strong, with growing user numbers and revenue per user, albeit with some of Q2’s COVID benefit dissipating.

Ad growth in Q4 is expected to be faster than that in Q3; full-year EBIT s implied to be slightly higher than 2019, despite COVID and OpEx growth.

At $273.40, shares can deliver a total return of 42% (11.8% annualised) in just over 3 years, by 2023 year-end. We reiterate our Buy rating.

Note: A track record of my past recommendations can be found here.

Disclosure: I am/we are long FB. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.



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