Going into Facebook's (FB - Get Report) earnings next Wednesday, there will be a sea of distraction. However, I urge investors to take a slightly longer-term view, of two to three years, and to see how investing today at this valuation offers investors compelling upside potential.
The Main Investment Risk?
Presently, amidst all the chatter, one risk stands out -- uncertainty over Facebook's revenue growth rate going forward.
Historically, Facebook's top-line was growing in the high 40% to low 50% range. Consequently, when its revenue growth started to slow down, as is the case with any large business when it starts to mature, Facebook's operating costs remained elevated, causing its operating margin to compress significantly. For instance, after its operating margins hitting 52% in Q4 '16 and 57% in Q4 '17, its operating margin came down to 46% in Q4 2018.
Moreover, throughout the rest of 2019, Facebook has guided investors that its operating expenses would continue to increase in the 40%-50% range, as Facebook heavily invests in infrastructure in order to best position the company for long-term sustainable growth. As a result, after this year of elevated expenses, Facebook will look to better align its expenses with its revenue growth, coming out of 2019 and into 2020.
However, during this turbulent year, Facebook's operating expenses will remain elevated and misaligned with its revenue growth rate, implying that there is a very significant danger that its operating income will come out at just over $25 billion, which would be flat with 2018.
Facebook's Long-Term Moat
CEO Mark Zuckerberg believes that Facebook's competitive advantage lies in creating meaningful experiences for its users. And right here, I believe that despite the doubters, Facebook continues to perform astonishingly well.
While many believe that Facebook is no longer as relevant today as it was in the past, the facts simply don't back up this theory. Facebook's daily active users come out to 1.52 billion as of last quarter -- up 9% compared with the same period a year ago. Additionally, the number of daily active users in the U.S. and Canada has remained flat year-over-year and has not been falling or losing relevance as naysayers have been emotionally arguing.
Facebook is working on growing its e-commerce opportunity. The game plan will be to allow brands to surface more easily in front of the right consumers at the right time. However, despite investors clamoring for a new narrative and new sources of revenue growth, Instagram's e-commerce opportunity is going to continue to remain in the background for now, for a couple of reasons.
Firstly, because Facebook's e-commerce opportunity as a whole is still very early in the developmental stage, and will not be a meaningful contributor to revenue any time soon.
Secondly, because Facebook's long-term prospects are fundamentally an advertising-driven business. And seeing as how Facebook is able to convert earnings to cash at such a high rate, Facebook feels under no pressure to change what's already working terrifically well for the company.
Specifically, investors can see that even after factoring in employee's large stock-based compensation packages, nearly 20% of Facebook's revenue converts into free cash flow. This puts Facebook amongst the highest quality businesses available.
Look Towards Repurchases as A Sign Of Confidence
At the end of Q4 2018, Facebook's balance sheet carried $41 billion of cash and equivalents. Thus, given Facebook's recent announcement of its intention to deploy $9 billion for share repurchases, investors should keep an eye on how aggressive these repurchases have been during this period of Facebook's depressed valuation.
In fact, looking back over the past five years, Facebook's traded multiples have not been as depressed as they were during Q1 2020. If Facebook's management believes that 2020 will indeed see its margins returning to their former glory, then Facebook will have reflected this confidence with a meaningful capital deployment toward share repurchases during this past quarter.
If share repurchases turned out to have been any figure above $3 billion during the quarter, readers should consider that to be a strong signal of management's confidence in Facebook's medium-term prospects.
The Bottom Line
In summary, when Facebook announces its Q1 2020 earnings next Wednesday, investors should look towards not only its revenue growth rate but also how much free cash flow Facebook ultimately generated. And an important tell-tale sign will be how aggressive its share purchase program turned out to have been.