Facebook's Rapid Growth Is Being Undervalued by the Market

Strong revenue growth and a cheap valuation make Facebook a very compelling opportunity.
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Facebook  (FB) - Get Report shares have been volatile over the last 12 months amidst a consistent storm of negative press and government investigations. However, its shares have still been very rewarding, appreciating close to 48% compared with 25% for the S&P 500.

Looking ahead there are strong reasons to be very bullish on the shares of Facebook, which reports Q4 earnings after the market close on Wednesday, Jan. 29. Here’s why:

Growth Rates: Stable and Strong

Facebook frequently attracts negative press -- as success often does. But if we shut off the noise and focus in on the company’s financials, a very different picture emerges:

Facebook Chart 012720

Facebook spent the whole of 2019, as well as, the latter parts of 2018 reconfiguring its business to appease numerous government agencies. Indeed, these changes dented some of its growth prospects.

Nevertheless, Facebook’s CFO Dave Wehner asserted that although Q4 2019 would be marked by mid-to-high single-digit revenue deceleration compared with the same period a year ago, that the pace of revenue deceleration would be less pronounced in 2020.

Perhaps the most astonishing aspect of the whole story is that notwithstanding Facebook’s size, it is still delivering growth rates of approximately 20%. In other words, Facebook is still far from reaching a steady mature state.

Free Cash Flow Generating Machine

To say that Facebook makes a lot of cash would be an understatement. What investors should remember is that no other company is as successful at converting its revenues into free cash flow while at the same time supporting such strong growth rates.

Put another way, whereas many large unicorn companies find themselves struggling to become profitable, not only is Facebook incredibly cash generative but even after factoring in its heavy stock-based compensation and significant growth in capex, approximately 23% of its revenues end up as clean free cash flow.

Indeed, it's not too much of a stretch to argue that Facebook is one of the best cash-producing companies in the world.

Investment Risks: Reasons to be Cautious

A skeptical reader would be right to question: if Facebook is such a strong company with such strong free cash flow, then why is so cheaply valued? Here's where we get to the heart of the thesis.

Facebook generates north of 95% of its revenues from advertising. However, if users were to leave Facebook en masse as it continues to be hit by negative press and its trustworthiness gets questioned, this would start to limit its appeal to marketers.

Furthermore, a substantial decline in user engagement with Facebook’s family of apps would directly impinge on Facebook’s ability to monetize its users. This would create a negative spiral as fewer users that are less engaged start to reduce Facebook’s average revenue per user (ARPU).

Valuation - Large Margin of Safety

Even though Facebook is a strong cash flow generating company, consider the table below:

Facebook Table 012720

The table offers a stark contrast between the likes of Snap (SNAP) - Get Report and Pinterest (PINS) - Get Report, which gather significant financial media attention as up-and-coming social media platforms. Yet the verdict is still out on whether they will be able to convert their revenues into strong and stable cash flows.

On the other hand, Twitter  (TWTR) - Get Report finds itself priced similarly to Facebook, despite the fact its ability to grow its revenues pales in comparison with that of Facebook's. Twitter’s most recent guidance for Q4 2019 points to approximately 10% growth rates, while Facebook is growing at more than twice this pace.

In addition, Twitter’s profit margins are unimpressive and highly volatile, while Facebook's are high and stable.

Takeaway

The old adage says that if it's in the headlines, it's in the share price already.

Facebook remains out of favor with investors. Yet, it is still growing at approximately 20%, while its cash flows are being valued for less than 19x. 

As noted, Facebook reports its highly anticipated Q4 2019 results and 2020 guidance this Wednesday -- stay tuned for updates. 

Facebook is a holding in Jim Cramer’s Action Alerts PLUS Charitable Trust Portfolio. Want to be alerted before Cramer buys or sells FB? Learn more now.