After a tough stretch beginning with last August’s shocking guidance reduction, Facebook (FB) appears mostly out of the woods as far as the bear case goes.  User growth at the core Facebook app has held up well in the U.S. and Europe despite the near constant controversies related to privacy.  More importantly, advertisers appear to have stuck by the platform.  At the same time, Instagram has completely avoided the privacy issues, gained users, and developed new products – Stories and ecommerce – that are driving advertiser counts and spending.  FB does not breakdown data between the Facebook and Instagram apps but the overall revenue growth has held up better than expected and expenses to fight back against the privacy issues have not been as large as originally guided or feared.

Northlake had hoped this would be the case and held onto client positions in FB.  This has turned out to be a good choice with the stock up 39% this year before rising another 6% so far today following last night’s earnings report.  The recovery in the shares and the financial metrics has occurred faster than we anticipated.  Fortunately, the 1Q19 performance and improved guidance for 2019 expense growth support the huge stock gains and offer incremental upside.  It now looks like FB could earn $9.50-$10.50 per share next year, 10-15% higher than we originally expected.  Higher estimates and a higher multiple based on the company weathering the storm support a target in the $225 range based on at low to mid-20s P-E.

Key to the improved outlook is that so far revenue deceleration due to flattening user growth in the U.S. and Europe and the transition from high-CPM Facebook ads to low-CPM Instagram Stories ads has been less than expected.  FB still appears able to grow the corporate top line in the range of 30% whereas guidance assumed a deceleration to the low 20% range.  We have often thought of Facebook as a modern day digital broadcast network in that TV has proven so valuable for advertisers that it can continue to grow ad revenue even against massive ratings declines.  FB is a little different in that its resilient ad revenue growth is driven by expanding impressions and high ROI rather than just ever higher prices.  However, the idea that that FB’s properties are indispensable to a massive group of small and mid-sized businesses is similar to the unreplaceable reach that large, TV endemic advertisers find in broadcast TV.

Just as important to the near-term outlook for FB is the less than guided spending to attack the privacy issues.  Management had suggested operating expenses cold rise 40-50% in 2019.  Northlake expected the high end with only a modest deceleration in 2020.  Following two consecutive quarters of spending at or below guidance – up just 34% in 1Q19 – management lowered guidance to 37-45% expense growth in 2019.  This supports analyst estimates for a sharp deceleration to low 20% growth in 2020 and offers the prospect that operating margins can expand moderately in 2020.  The combination of higher than expected revenue growth and lower than expected operating expense growth supports the P-E multiple for FB shares.

The company and stock are not completely out of the woods.  New regulation and continued privacy surprises can still hurt user growth and damage advertiser confidence.  Mark Zuckerberg has outlined a dramatic shift for FB toward privacy-based social networks and messaging.  Questions remain as to how that foots with the company’s advertiser-driven revenue model.  For now, the stock should be most responsive to the financial metrics for 2019 and 2020.  For that reason, Northlake plans to hold client positions in FB shares.

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.