Time to Look at Facebook

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After conducting a sensitivity analysis based on the various ways that Facebook may be affected, we are sticking with our wide economic moat rating and $198 fair value estimate. While many downside scenarios are in play, we believe that a good portion of any potential downside is priced into the shares today. Facebook’s shares have sunk 18% since March 16 and are now trading at 0.77 times our fair value estimate.

The Cambridge Analytica scandal reignited the discussion about the safety of private user data, and now the FTC is examining the procedures and technology through which Facebook attempts to protect such data every day. This is not the first time the FTC has looked into Facebook and its handling of data. In 2011, the FTC filed a complaint against the company, stating that data in the social graph that the Facebook platform and its users help create had become accessible to third-party app developers. This is similar to what may have taken place when University of Cambridge professor Aleksandr Kogan used an app to conduct a survey, indirectly allowing the professor and Cambridge Analytica to get their hands on around 50 million Facebook users’ information. The FTC and Facebook reached a settlement in 2011 that basically ordered the company to not only take further steps to protect user data from third parties, but also make it easier for users to refuse to allow access to their private data.

Such data breach issues can affect Facebook’s top- and bottom-line growth and valuation in a couple of ways. First, the doubts that this news has created could lead to a gradual long-term defection of Facebook users. We think the main effect would be on users in the U.S. and Europe, markets for which we have modeled mere 3% and 6% average monthly user growth per year through 2022, respectively. The user count in those markets has been growing at around 6% per year during the past five years. If we assume no growth and a net 1% decline in the monthly users in those regions during our explicit forecast period of five years and hold average revenue per user constant, this could lower Facebook’s five-year revenue compound annual growth rate to 18.5% from our current assumption of 22%. The lower top-line growth is likely to reduce our fair value estimate by 11%, to $177 per share. A 5% decline in monthly users would result in a 16% revenue CAGR and would reduce our fair value estimate to $161 per share. Both of these possible valuations still represent upside to the current price.

We note that Facebook also has another attractive and fast-growing property, Instagram. While Facebook doesn’t break out Instagram revenue, based on our research and some data from eMarketer, we estimate that Instagram generated around 11% of Facebook’s total revenue last year. Also, Instagram has been successful in bringing more users, as its user count has increased at a 41% CAGR the past three years, according to eMarketer data. Snap SNAP and Twitter TWTR remain as alternatives for Facebook users. However, given that Instagram has a different brand name and completely separate app from Facebook, we think its popularity will remain intact, making it a more likely destination for former Facebook users. With this in mind, we think the impact of the Facebook platform’s user defection can be discounted only slightly by assuming that some Facebook-only users will jump on Instagram. Assuming a 0.8% decline per year in U.S. and Europe users, Facebook’s five-year average revenue growth would be around 19%, and our fair value estimate could drop to $178 per share. A 4% decline in those markets’ Facebook users would result in 17% average annual revenue growth and a $164 fair value estimate. Again, both of these possible valuations represent upside to the current price.

Second, if the U.S. government takes more regulatory actions, which the announced FTC investigation may indicate, Facebook’s ability to collect and share necessary data with advertisers could be affected. If that were to happen, the return on investment for what were previously pretty accurate user-targeted ads would decline, which would also reduce advertisers’ demand for Facebook’s ad inventory. We don’t think advertisers would instantly abandon Facebook and the world’s largest user platform. However, in such a case, they may begin to slowly allocate their Facebook ad dollars to other digital platforms or more-traditional marketing channels such as television.

Lower demand from advertisers would probably reduce ad prices and the average revenue per user that Facebook generates. In this scenario, we again focus on the U.S. and Europe markets, which generated 2017 advertising ARPU of $21.26 and $6.98, respectively, compared with the company’s overall ARPU of $5.18. ARPU has been increasing at around 50% per year in the U.S. and 41% in Europe during the past five years, and we model 13% and 11% compound annual growth rates for those markets’ ARPU for the next five years.

If we assume no growth in ARPU and no change to our base-case user growth assumptions, our revenue CAGR dips to 17%, which takes our fair value estimate down to $168 per share. To drive our fair value estimate far below recent share prices, we would probably need to see advertisers flee much faster. If ARPU were to dip around 5% per year in those markets, we would potentially lower our five-year revenue CAGR forecast to 9% and valuation to $120 per share. While we concede that risks can always be worse, we believe that many downside scenarios are already priced into Facebook’s shares today.