Facebook (FB) may have looked down and out over the last year and a half, but there’s more opportunity now in Facebook’s future than just a few short quarters ago. Expenses have peaked as headcount growth has been meaningfully reined in throughout 2019. Operating margins did not suffer outside of the one-time charges in 2019. But that’s only half the story. The best part is the market is pricing Facebook for continued deterioration masked as maturity while valuations across the board are at historic lows.

Facebook is moving past its stormy story and the market has yet to let you know.

With expenses slowing and very slow deceleration of revenue growth, it’s setting Facebook up to accelerate bottom-line growth in the next year to two years. Combined with the lack of market enthusiasm for shares, this will revive valuations off the floor and drive share returns through accelerating growth and multiple expansion.

(Image source)

To fully understand where Facebook is coming from and where it’s going let’s start by backing out the one-time numbers from 2019. Then, we need to look at the trajectory of expenses – are expenses continuing to grow and accelerate, or has the business reached a peak in ramped up expenses amid all of the privacy and security implementations? If it’s the latter, the market hasn’t yet priced in the leaning out of expenses and the turnaround in margins.

Starting With Q4 Earnings

Scanning the expenses section of Q4’s report, it’s easy to spot the 87% increase in G&A expenses. But 30% of the G&A expenses for the quarter were a $550M one-time charge for a settlement in connection with the Illinois Biometric Information Privacy Act litigation. Backing this expense out, G&A grew a more palatable 31% year-over-year. Then, if you zoom back out, overall expenses increased 28% instead of 34%. A little steeper than the near-25% revenue growth for the quarter, but as I alluded to above, it’s about the expense trajectory.

The year ended on the same foot it started on – one-time expenses due to settlements and legal charges, none of which reflecting ongoing costs. Therefore, we must remove this noise and look at the expense growth of Facebook on a holistic, long-term scale to understand if the company has reached the peak of expenses.

The Whole 2019

Q1 started with a $3.0B charge due to an expected settlement with the FTC. This was the low end of the expected settlement range and, by accounting practices, was required to be taken in anticipation of the settlement. Then in Q2, another charge was taken, but this time for $2.0B related to the same settlement since a finalized number totaling $5.0B was reached. These numbers on a GAAP front made the business appear to be plunging at first glance. These numbers showed expenses totaling $46.71B, growing at 51% over 2018’s $30.93B. That’s a problem when you put it up against yearly revenue growth of 27%.

But, let’s back out 2019’s one-time legal charges. Expenses are then $41.16B, or growth of 33% over 2018. That seems quite a bit more palatable. Sure it’s higher than the 27% revenue growth, but Facebook knew it would need to run expenses a little higher to put in place new mechanisms and functionality to heighten the security and privacy of its platforms. I also should note throughout 2019 management brought down its expense outlook and wound up lower than the low end of the range for 2019 during Q4 2018’s earnings call when the CFO said “…we continue to expect 2019 total expenses will grow approximately 40% to 50% compared to 2018.” This was before any settlements were factored in, so we can easily make a one-to-one comparison to where expenses wound up after the year excluding the settlements – and that was 33%. Well below the 40% to 50% range given a year earlier.

Where’s 2020 Headed?

Why do I mention Facebook’s expense guidance for last year? I say it because Facebook has far and wide been a conservatively-run company when it comes to expectations and guidance. This has been evident with revenue guidance, something I pointed out very clearly last summer. Facebook runs a very conservative ship – underpromise on revenue and come in higher, and overpromise on expenses and come in lower.

This is why I see a clear opportunity to buy against the market’s bearish reaction when Facebook said expenses would grow 31% to 43% for 2020. This is well below last year’s guidance of 40% to 50%, which – to reiterate – came in officially at 33%.

But why should we believe Facebook will continue in this manner of setting a higher expense bar than it will really deliver? There are a few factors, but headcount has been a good barometer in so far as giving us an idea of where more recent expenses have come – expenses related to the headline buzzwords like security and privacy.

Facebook, for the most part, has been a very, very lean company with some of the highest revenue per employee in all of the tech industry. It’s outdone only by Netflix’s (NFLX) $2.57M per employee.

ChartData by YCharts

Facebook’s revenue per employee only began to dip when headcount started to meaningfully rise in 2017 and 2018 – directly correlated to the increased need for additional oversight of content and data. But let’s look at the growth and trajectory of headcount over the last few years to understand if expenses can honestly begin slowing down.

(Chart is author’s)

After normal growth in 2017, headcount growth exploded to nearly 46% in 2017 and remained in the low 40s in 2018. However, 2019 has shown the slowest headcount growth of the last four years. It’s clear the growth needed to work on reviewing content and data has slowed dramatically. Of course, I expect headcount to continue to grow as the company continues to implement more functionality and continues to add users, but to see headcount growth slow to this level tells me the height of the transition toward a more secure Facebook is behind us.

With an expectation for lower expense growth in 2020 and the trajectory of the company’s headline expenses already slowing meaningfully, I see Facebook as turning the corner on expenses and compression of operating margins.

ChartData by YCharts

After smoothing out the dip in operating margin for 2019 related to the fines and court rulings, Facebook has been hovering near historical averages, moderating in the mid-to-low 40s. As the company has maintained software-like gross margins, its strength remains intact. The company is not in dire straights as some would have you think. Expenses have come down much quicker than revenue growth is slowing, meaning the company is getting its feet under it once again and will be able to leverage a higher EPS growth rate than the recent year-and-a-half.

Valuation Wise, We’re At A Bottom

The market hasn’t been oblivious to Facebook’s higher expenses and headline risk. Therefore, it’s no surprise Facebook’s valuation on a sales or free cash flow metric is near its historic lows.

ChartData by YCharts

The company continues to invest in new products and new features in its apps and has shown progress with Instagram Feed and Instagram Stories over the last year. I expect this progress to continue in these products along with new ones, so I have extrapolated out the growth of “net cash provided by operating activities” to grow the same as it did in 2019.

(Source: Facebook’s 2019 10-K Filing)

This results in net cash provided by operating activities for 2020 of $45.03B and using the midpoint of its capex guidance of $18B and continuing principal payments on finance leases of $550M, I arrive at free cash flow for the coming year of $26.48B, or growth of 28%. With a slight price to free cash flow multiple expansion from today’s 28.48 to 29.5 – given because the company has maintained its growth – the market cap would be $781B or $274 per share on a constant share count basis – a 35.6% return on shares this year from the current $202 area. This is my bull case.

If the company hits more headline trouble this year along with sentiment-driven multiple contraction – the bearish picture in the last two years – and FCF barely grows while the multiple returns to the lows set in late 2018 of 21, the stock would be valued at $193, a return of -4.5% for the year. This is my bear case.

Should the company increase free cash flow only a modest amount – to $23B, or 11% FCF growth – with no multiple changes from the current 28.48, the stock would be valued at $230, a return of 14% for the year. This is my base case.

The risk-reward is about even if you look at it from a base case and bear case scenario. Looking at the stock from a bull case to bear case, the reward far outweighs the risk. Facebook can outperform this year even on the 22% yearly revenue growth and 29% expense growth rate I used in my model above. Facebook will not likely increase free cash flow only a measly 11%, but more probabilistically 18-20% which gives us a “realism return” of $245 (for no multiple changes) to $254 (for the slight increase in FCF multiple), or a 21.3-25.7% stock return from $202.

Facebook Is On The Other Side Of Peak Pessimism

Facebook’s stock has been beaten and battered over the last year or so due to headline worries that it will see expenses continue to rise and revenue growth slow severely. It turns out expenses are decelerating after peaking in 2018 as headcount growth tapers off dramatically while capex will not increase faster than revenue growth (19% at the capex guidance midpoint). All the while, the stock meanders at valuation lows with operating margins stabilizing and free cash flow continuing to grow at a rate faster than revenue.

The stock will rebound as expense guidance tightens toward the lower end of the range while the company outperforms on a revenue basis. After a rough year with FTC fines and court rulings, the company can resume growth and continue printing money and buying shares.

Oh, right, I never calculated the buyback into a single number in my model above – after the company decreasing the diluted share count over 1.5% last year alone. With a new authorization in place for another $10B, the company can purchase close to $15B between the old and new authorization, good for 2.5% of shares at current prices. There’s a buffer built in.

On a very conservative base case, it matches the bearish case. On a similar bull-to-bear comparison, the bull case outperforms using only a slight expansion of the multiples. Facebook has shown it can fight the battles thrown its way without hindering execution. Expenses are not accelerating but being reigned in and decelerating. The reward outweighs the risk by the numbers.

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Disclosure: I am/we are long FB. 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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