Facebook: Higher Costs, Lower Revenue, New Valuation (NASDAQ:FB)

I want to answer a simple question: What is Facebook (FB) worth in 2020?

This is an absurd year. The current situation has complicated the economics of operating a digital platform. Facebook, for better or worse, operates some of the largest and most popular digital platforms ever known. So what is the impact on its financials and what is the stock worth today?

Source: White House Archives

While there’s plenty of controversy here, ranging from the political risks to the reliability of user statistics, I want to focus on two key dimensions – costs and revenue – to inform my valuation of the company.

Costs

Every aspect of Facebook’s operation is about to get more expensive in 2020.

Obviously, usage is up. Last month, messaging surged over 50% in countries that were hit hard by the virus. Video and voice calls on WhatsApp more than doubled. Influencers stuck at home are now leveraging Facebook Live more than ever before, while everyone has more time to create and share content as they self isolate. This surge in activity could be sustained for the duration of the lockdown, which is completely unknowable at this stage. Server and procession costs, of course, will rise in tandem.

Meanwhile, Facebook has clearly said it isn’t planning layoffs. In fact, the company plans to hire 10,000 additional staff this year in its product and engineering teams. The median Facebook employee is already better paid than most of Silicon Valley. The company plans to release annual bonuses early and add an extra $1,000 on top to compensate its full-time employees. However, that $45 million bonus is a drop in the bucket for a company as large as Facebook. As is the $100 million relief fund for small- and medium-sized businesses it announced recently.

Altogether, Facebook reported $46.7 billion in operational costs in 2019. Those expenses are split into four categories. Here’s how those four categories could shape up in 2020:

Costs

2019*

2020 estimate*

Reason

General + Admin

10.47

15

Hiring more staff and bonuses

Marketing

9.88

6

Team can cut back on marketing since usage is up regardless

R&D

13.6

14

Steady to shore up liquidity

Cost of Sales

12.77

20

Up due to 50% higher usage

Total

47.12

55

*$B

Effectively, Facebook’s costs could rise by about 17% under these conditions. The company also reported $15.65 billion in CapEx in 2019. Assuming the company might have to expand its server farms and storage capabilities, I’ll add another $1 billion to this.

Revenue

A 17% rise in costs isn’t really a crisis for a fully-funded company like Facebook. However, I believe the real threat lies in its top line.

Not only is the company completely reliant on advertising revenue, but it is also completely reliant on regions that are the epicenters of the COVID-19 crisis. In its latest quarter, Facebook derived 48% of its revenue from the US and Canada. 24% was generated in Europe.

As I write this, COVID-19 cases across Europe seem to be plateauing. Even severely hit countries such as Italy and Spain are starting to flatten the curve. I believe Canada, where I live, could flatten the curve by the end of April as well.

However, numbers in the United States seem to be on a similar, if not worse, trajectory. States like Florida ordered a “shelter in place” mandate only recently. 10% of the US population is still under no such order. Meanwhile, Donald Trump has instituted a taskforce to see if the economy could be reopened sooner.

These factors lead me to unfortunately conclude that the lockdown (and ensuing economic crisis) in the U.S. will be deeper and longer than anywhere else on the planet. That’s terrible for families that will lose loved ones and businesses that will have to shutter forever. It’s also bad for Facebook’s sales.

Here’s an extract from Facebook’s recent blog post that outlines the issue:

“We don’t monetize many of the services where we’re seeing increased engagement, and we’ve seen a weakening in our ads business in countries taking aggressive actions to reduce the spread of COVID-19.”

Beyond ads? The company does sell hardware such as the Portal and extract fees from payments on its platform. However, these sales account for low single digits of overall revenue. Although sales of Facebook’s portal could rise since more people need teleconferencing now, I can’t see how payment fees will rise in a quarter where unemployment and small business failure are skyrocketing. In short, Facebook’s non-ad business is negligible enough to overlook for this assessment.

How much the company could earn in 2020 is anyone’s guess, but Fitch Ratings recently published a note estimating how 2020 and 2021 ad spend could shape up. Economic activity has dropped to nearly 0. So, the cutback in digital ad spending could be wider. Here’s what Fitch says:

We expect overall advertising spending to contract in the mid-to-high single-digits range during 2020 and in the low-to-mid-single digits during 2021.

With that in mind, here’s my take:

Sales

2019*

2020 estimate*

Decline in annual revenue

North America

34.1

28.9

15%

Europe

17.1

15.4

10%

Asia

12.67

12

5%

RoW

6.7

6.4

5%

Total

70.7

62.66

12%

*$B

A 12% decline in total annual revenue for a multi-billion-dollar company is immense. For any other company, this would have been lethal. However, Facebook has enjoyed more than a decade of near-invincible growth and profitability and now sits on a literal and metaphorical treasure chest of cash and data.

At the end of 2019, FB had $54.86 billion in cash and cash equivalents. Another $35.7 billion in marketable securities and $9.5 billion in accounts receivable. All three will certainly be impaired in 2020; however, the company has enough resources to survive more than a few brutal years like this.

Valuation

A 12% decline in revenue and 17% surge in costs squeeze the margin nearly out of existence. It seems one of the most lucrative companies in the world now faces a plummet in profits in 2020 and a gradual recovery in the years after.

Facebook’s survival isn’t in doubt. However, its valuation is now substantially different. Here’s how cash flow could shape up in the next three years and what that means for the company’s intrinsic value today:

2019

2020

2021

2022

Cash from ops

36.3

7.5

14

25

(CapEx)

15

20

15

15

(Financing)

0.55

.6

.6

.6

Free Cash Flow

20.75

-13.05

-1.6

9.4

Assuming normalcy won’t be achieved until 2022, it seems fair to run a discounted cash flow analysis based on 2022’s free cash flow and discount it back to today.

With a 6% discount rate, 10% growth for 10 years and 2% terminal growth rate after 2032, the company’s intrinsic value works out to $341 million or $119.6 per share (30% lower than the current market price).

A Stronger future

Of course, I trust Zuckerberg to have a card up his sleeve. The company is already poised for a pivot away from its reliance on advertising in the developed world. It’s seeking out a 10% stake in India’s Reliance Jio which should give it access to the largest wireless subscriber base in Asia’s second-most populous country.

It’s also planning to launch an e-commerce platform through Instagram which could be worth billions. Payments on WhatsApp alone would drastically change Facebook’s revenue model. In a few years, Facebook will be a more robust and more valuable company. For now, let’s wait for a pullback.

Conclusion

Facebook’s bottom line could take a hit this year, and that means investors need to readjust their assessment of its value. I believe a double-digit decline in revenue could be likely. Meanwhile, costs have expanded due to higher usage.

Based on these estimates, Facebook’s stock should be worth 30% less than what it is trading at today. This pullback could occur when Facebook reports earnings and offers its own (likely revised) guidance for the years ahead.

This idea was first discussed (in much greater detail) with members of my private investing community, Betting on Tomorrow. To get an exclusive “first look” at my best ideas, subscribe today >>

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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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