Facebook (FB) reported a stronger than expected 2Q20 driven by large increases in engagement across its family of properties.  Social apps like Facebook and Instagram have seen a huge boost in usage during the pandemic as people stuck at home looked for social interaction.  Higher engagement led to more ads being delivered, which overcame a sharp decline in ad prices as advertisers initially pulled back when the economy shutdown.  These trends were consistent across Facebook’s global reach.

FB also benefited due to the company’s importance to direct response and e-commerce advertisers.  FB advertising has a well-accepted high return on investment for this group of advertisers that largely have been beneficiaries of stay at home and work from home trends.  Think of sellers with mostly an e-commerce reach or sellers of apps such as video games.  FB has never had a huge presence in brand advertising that is dominated by the giant corporations you see on TV such as Procter and Gamble and Coca Cola.  Management noted in this quarter’s conference call that the top 100 advertisers represent just 16% of total advertising revenue.  This share has fallen steadily as the other 9 million advertisers on FB continue to grow.  This data is the reason why the widely publicized boycott of FB among large brand advertisers is not expected to have much impact on the company’s revenue growth.

FB exited the third quarter with advertising revenues growing about 10% and management forecasted this level of growth for the third quarter.  Overall advertising is still declining due to the global recession putting FB’s growth in a very favorable light.  The company is continuing to invest in what it views as a still very large total addressable market, so costs grew faster than expenses and margins contracted.  However, better than expected revenue growth allowed earnings to beat expectations.

Looking ahead, the 10% growth forecast appears conservative.  Management is assuming that pandemic driven engagement and daily active users flatten out as economies around the world are now more open.  In addition, Apple is implementing more restrictive data sharing that could reduce return on investment for advertisers that rely on the data for targeting.  Investors generally believe FB can navigate these issues.  It seems too soon for engagement to flatten given a renewed rise in virus cases in much of the world and prior tightening of privacy restrictions have actually served to help the internet giants including Facebook and Google.

Analysts expect FB to earn $8 per share in 2020, up from $6.43 in 2019.  In 2021, the current consensus estimate is just over $10 with 2022 currently estimated at $12.65. From 2019 to 2022, growth is estimated to compound at 25%.  This is rapid growth for a company the size of Facebook in a growth starved world economy further pressured by ongoing impacts from the pandemic.  FB has a long history of exceeding analyst estimates. 

After a big post-earnings pop, FB shares trade at 25 times 2021 earnings.  Northlake believes this is a fairly full valuation.  Looking further ahead, as investors will do, the P-E is 20 times 2022 earnings.  On the assumption that current estimates will prove low, we could shares the move modestly higher over the balance of 2020.  Thus, we expect to hold core positions for Northlake clients, understanding that the rich valuation leaves room for a sharp correction should large cap growth stocks lose favor.  We are also wary of the possibility of new government regulation attempts that seem likely before the election. As we did recently with Activison Blizzard, we may make marginal sales of Facebook in coming months to manage position size and risk.

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.