Relative Strength Into the Back Half of 2020

Laveta Brigham

Last week, Facebook Inc. (NASDAQ:FB) reported results for the second quarter of fiscal 2020. For the quarter, revenue increased 11% to $18.7 billion, another meaningful sequential deceleration (revenues were up 25% in the fourth quarter and up 18% in the first quarter). As noted on the call, this result reflects […]

Last week, Facebook Inc. (NASDAQ:FB) reported results for the second quarter of fiscal 2020.

For the quarter, revenue increased 11% to $18.7 billion, another meaningful sequential deceleration (revenues were up 25% in the fourth quarter and up 18% in the first quarter). As noted on the call, this result reflects the impact of decreases in advertising revenue as a result of the pandemic (most notably ad rates), offset by a meaningful increase in user engagement. Daily active users (DAUs) and monthly active users (MAUs) increased double digits in the quarter, with higher engagement across the company’s services as people around the world sheltered in place. As shown below, despite lingering fears over the past few years that users would turn away from Facebook (blue app), its growth has continued unabated.

There are 2.47 billion people (de-duplicated) around the world who use at least one of the company’s services (Facebook, Instagram, Messenger or WhatsApp) on a daily basis – with more than 100 million people joining that group in the past 90 days.

With help from higher engagement across feed and stories, ad impressions increased by more than 40% in the quarter, offset by a 21% decline in ad pricing. The decline in pricing reflects a demand side shock as small and large advertisers alike pulled back, particularly in April. Average revenue per user was flat from a year ago, with a 10% increase in the U.S. and Canada largely offset by a decline in Rest of World (as noted on the conference call, this reflects foreign currency headwinds, less exposure to online verticals like e-commerce and gaming and a less clear economic benefit from government stimulus than what was seen in developed markets).

A big part of the Facebook story (from an investment perspective) continues to be the outsized growth of expenses. Operating costs increased by 24% in the second quarter (adjusted for the Federal Trade Commission settlement in second-quarter 2019); while that was an 11 point deceleration from the pace of expense growth in the first quarter, it still outpaced revenue growth by a wide margin, resulting in another quarter of operating margin compression. As shown below, Facebook’s operating margins in the first half of 2020 were more than 1,500 basis points below the result in 2017.

The company’s updated 2020 guidance doesn’t alleviate these concerns: they expect $52 billion to $55 billion in operating expenses for the year, implying an increase of in the high-20s (%) at the midpoint. By comparison, revenues will likely grow by about 10% for the year – suggesting meaningful margin compression, along with a decline in earnings per share for 2020.

Moving past the income statement, I continue to be disappointed by the company’s approach to capital allocation (I know I’m a broken record, but this could have a material impact on per share intrinsic value over the long run). Note that Facebook entered 2020 with more than $50 billion in net cash. When the stock price fell precipitously in March, along with the broader market, management continued to approach repurchases with caution ($1.3 billion of repurchases in the first quarter). They acted similarly in the second quarter, repurchasing $1.4 billion worth of stock.

I’ve received pushback from fellow Facebook investors who believe the reason why the company has been cautious is that they want the financial flexibility to pursue inorganic opportunities (mergers and acquisitions or minority investments in other companies). And to their credit, we saw that recently, when Facebook invested nearly $6 billion in Jio Platforms Ltd.

The problem is that these investments do not happen with enough frequency or at a large enough size to have a meaningful impact on the balance sheet. Importantly, I do not think there’s much the company can do about that either: attempts to do a large deal in an arena anywhere close to the core business would likely face significant regulatory risk in both the U.S. and Europe.

The net result to date is that Facebook’s net cash balance, after accounting for the Jio Platforms investments (paid for in early July), is not much different today than it was at the start of the year. Simply put, if Facebook is unable to make a meaningful dent in its cash balance in this environment – after making a sizable outside investment and having the opportunity to repurchase shares at a price roughly one-third below its highs – it’s not clear to me what could change that outcome. Said differently, it seems likely that tens of billions of dollars in cash will sit stranded on the balance sheet for years to come (the company continues to generate prodigious amounts of free cash flow as well). This is obviously a good problem to have – but investors valuing the company’s cash as akin to money in their own pocket are mistaken.


Facebook’s revenue growth has slowed over the past six months, but they’ve fared much better than the broader advertising market. This reflects rising engagement among billions of users, as well as the company’s large exposure to direct response advertising (as Chief Financial Officer Dave Wehner noted on the first quarter conference call, “it’s really driven our business for many years”). As Ben Thompson of Stratechery noted in April, direct response advertisers – by definition – must continue to spend money, regardless of the macroeconomic environment: “Direct response advertisers depend on advertisements for revenue directly (because ads lead directly to conversion); to stop advertising is to stop doing business entirely.”

In summary, while the stock has appreciated by more than 20% since the start of the year, I still believe Facebook is a reasonable investment. For that reason, I continue to own the stock.

Disclosure: Long Facebook.

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