Facebook (FB) reported very strong 3Q17 results with both sales and earnings substantially better than expected, largely driven by lower than expected expenses for the second straight quarter. The company has now spent less than their initial annual expense guidance for the past two years, demonstrating operational discipline even while investing for growth. FB noted that 2018 would be another year of substantial investments in growth initiatives including premium video content, artificial intelligence and machine learning, virtual and augmented reality, and global internet connectivity. FB also announced plans for new investments in security related to increased scrutiny around the 2016 election. In total, FB expects expenses to grow between 45-60% in 2018 compared to expense growth of 35-40% in 2017 and initial 2017 guidance for expense growth of 40-50%. We believe FB wanted to create some flexibility due to the ongoing uncertainty around security expenses, but will remain disciplined and expense growth will end 2018 toward the bottom end of the new target range.
FB year-over-year sales growth accelerated from the previous quarter, up 47% compared to 45% in 2Q17. Analysts currently expect sales growth to gradually slow toward 20% over the next several years. Slowing sales growth combined with rising costs could create a headwind to FB shares. However, Northlake believes that disciplined investments in growth initiatives such as premium video content and new computing platforms can allow FB to grow faster than currently expected. Additionally, FB has opportunities to increase monetization on all of their existing applications. The primary Facebook platform should be able to support increased ad prices due to the company’s dominant competitive position and unmatched ad measurement capabilities based on customer data. Instagram is still early on in the effort to maximize advertising contributions by increasing price and volume of ads. Untapped potential in Facebook Messenger and WhatsApp also should also lead to upside revisions to earnings estimates.
Northlake expects FB to push above $200, roughly equivalent to 25x 2019 EPS of $8.13 with potential upside to earnings estimates as growth initiatives start to meaningfully contribute. Slowing revenue and earnings growth combined with increasing expenses could pose a challenge in the near term, but we believe the recently demonstrated expense discipline will continue to provide another source of upside surprises for investors. FB has a dominant competitive position and several untapped opportunities. A relatively undemanding valuation given the company’s growth prospects should prove rewarding for investors.
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.