Facebook (FB) reported a strong quarter, pacing ahead of expectations both for financial results and user engagement. Sales grew 51% from last year despite the widely expected decrease in ad load growth. Disciplined cost control limited expense growth to only 40%, below expectations. Facebook, Messenger, Instagram, and Whatsapp each continued to accelerate user growth above expectations. FB has been a nice winner for Northlake, and we continue to see upside given the relatively inexpensive valuation and the explosive growth trajectory.
One concern in the past for FB has been that expenses would grow more than expected as the company invested in innovation. Recent quarters have shown FB management’s discipline, as illustrated by the reiterated guidance of 40-50% expense growth this year. Last year, FB narrowed the top end of that range throughout the year, and the 40% expense growth seen in the first quarter leaves us hopeful that a similar pattern could repeat in 2017.
Another concern developed after FB warned investors that ad load growth was expected to decline in 2017. The reduced ad loads are intended to improve user experience while FB attempts to increase video views and drive customers to become accustomed to coming to FB to find premium video (and premium video ads). This is reminiscent of Mark Zuckerberg’s focus on user experience before monetization on the original Facebook website. We are curious to see how the video initiatives at FB develop over the coming quarters, and believe success could lead to further shifting of TV advertising budgets to FB. As an offset to the slower ad load growth, we expect that FB has meaningful upside to current ad prices driven by their unique targeting and measuring capabilities.
The recent IPO of Snapchat (SNAP) spurred several concerns about FB’s future. However, we were comforted to see that Instagram’s stories feature grew to have more users than SNAP extremely quickly. This illustrates FB’s ability to innovate (or copy) to fend off competition by leveraging its various brands.
In summary, FB remains on a strong growth path with disciplined spending while maintaining innovation. Each of the core apps continue to perform well and drive user engagement. FB’s video initiatives appear promising so far. Further upside is expected over time as FB monetizes Messenger and Whatsapp. In the near-term, we believe FB could trade at 30x 2017 EPS of $5.28, or $158, potentially moving toward $200 as investors become comfortable with 2018 EPS of $6.50 or higher.
FB is widely held by clients of Northlake Capital Management, LLC, including in Steve Birenberg’s personal accounts. Steve is sole proprietor of Northlake, a registered investment advisor. Northlake’s regulatory filings can be found at www.sec.gov. FB is a net long position in the Entermedia Funds. Steve is portfolio manager and managing partner of Entermedia, long/short equity hedge funds focused on media, entertainment, leisure, communications, and related technologies.