Facebook (FB) has been hit with a perfect storm of operational issues. At its core, however, the company's business is resilient and its long-term competitive advantage is unaffected. Through it all, Facebook remains extremely cash generative while at the same time remarkably undervalued.
Why Is The Stock Down?
If a picture is worth a thousand words, then the graph above cuts through all the noise on Wall Street.
For a long time, investors had been both attracted and accustomed to Facebook's compounded annual growth rate (CAGR) of sales in the mid-40%s.
When Facebook acknowledged that this level of sales growth was no longer sustainable going forward, without having major investment, investors become fearful and rushed for the exits, leaving its stock oversold.
Moreover, CFO David Wehner highlighted to investors that Facebook is forecasting its expenses to rise substantially over 2018. At the high end of the range, investors should be bracing themselves for total expenses to reach approximately $47 billion, or a 50% increase year over year.
Said another way, in the most conservative scenario operating income in FY 2019 should come out flat at around $27 billion. This news caused investors to feel despondent toward the stock. But having said that, trouble brings opportunity.
One of the Strongest Long-Term Competitive Advantages: People
There are 2.6 billion people already using one of Facebook's platforms per month. The game for Facebook is now how to increase the quality of meaningful interactions with one's family, friends and communities.
CEO Mark Zuckerberg believes that in order to increase the stickiness of its platforms, Facebook needs to guide its users away from passive consumption and toward increasing users' meaningful interactions.
Moving on, recently Zuckerberg has been reported as saying that Facebook Watch sees itself as meaningful challenger to Alphabet's (GOOGL) YouTube. In fact, Zuckerberg insists that Facebook today remains long-term focused on increasing the quality of interactions on its platforms. Then, later on, down the road there are plenty of avenues through which Facebook can successfully monetize its platforms further -- which I have no doubt they will succeed in, given the company's culture of cash generation.
One such opportunity includes developing Facebook's machine-learning capabilities to help creators to seamlessly build large audiences across all of Facebook's platforms, such as Instagram, Facebook and Messenger, and to target users with similar interests.
Some of the tests which Facebook has explored so far have resonated very well with companies looking for creative ways to reach their key potential consumers. For now, Facebook's focus is on increasing this service's awareness. Then on adoption. Then increasing its monetization.
Highly Free Cash Flow Generative
Investors often forget amid all the noise just how free cash flow generative Facebook actually is. Allow me to drive home this point.
After treating Facebook's biggest cost, its share-based compensation expense as a cash expense, Facebook is still able to churn out roughly 30% of its revenue into free cash flow. This is higher than practically any other business, even when compared against asset-light software businesses such as Microsoft (MSFT) or Alphabet. And best of all, while Facebook may be currently out of favor with investors, its valuation says the stock is an absolute steal.
Facebook currently trades for less than 25 times its cash flow per share, with minimal needs for long-term capital expenditure. Once again, any way an investor objectively appraises Facebook's growth prospects they are likely to reach the conclusion that over the medium term Facebook is likely to grow at a minimum in the mid-20%s.
What's more, we should not forget that Facebook has a rock solid financial position with slightly more than $40 billion of cash and equivalents and no debt.
Finally, and best of all, in spite of generating very strong free cash flows the past two years, which has seen this cash accumulate on its balance sheet, Facebook's share price is now lower than its been during the past 18 months.
It is difficult to imagine a scenario where Facebook's asset-light business model, with $40 billion of cash and equivalents is not undervalued. Given that Facebook has recently announced potential stock repurchases of up to an additional $9.0 billion, clearly company management also believes that Facebook is undervalued.
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