- Facebook's strength in fundamentals combined with heightened value accretion from FB Messenger and WhatsApp create a compelling thesis.
- Bank of America recently released a report on combined value accretion and long-term sales accretion from the two apps.
- I have created a model to arrive at similar conclusions to other sell side analysts.
Facebook (NASDAQ:FB) remains one of my best investment ideas, and while I can acknowledge that stock returns weren’t exactly phenomenal for growth/momentum names this year, I believe the upside from adjacent applications to core Facebook in conjunction with healthier profit margins will lead the stock higher.
Unlike Twitter (NYSE:TWTR), the company has remained relevant in the minds of users. FB has implemented various ad technologies, platform improvements to sustain relevance in the minds of users and reduced its dependence on the core app to drive growth. However, I also want to acknowledge that there are risks to the stock as it does trade at a heightened valuation (90.9x earnings) when compared to peers.
Despite valuation risk and dependence on continued success in upcoming quarterly earnings, the company is poised to sustain growth due to various open field opportunities via messenger applications, Instagram and VR adoption. I believe these near term drivers to sales/earnings reassert my conviction in my investment thesis. Furthermore, the broad resurgence in equities creates opportunities to buy some of the faster growing companies, as risk appetite for more speculative names has returned.
Near term catalysts to Facebook include the F8 Conference on April 12th and 13th, earnings announcement on April 27th and preliminary sales figures for Oculus Rift.
Recent research from the sell side suggests further momentum in other Facebook products. In a report released on March 31st 2016 by Bank of America Merrill Lynch, the analysts attempt to quantify the immediate upside from WhatsApp and Facebook Messenger:
We assume $5.00 revenue per user per year for Messenger and $4.00 per user per year for WhatsApp (WhatsApp has more emerging market users). Using valuation in the following table, we get a $17bn potential valuation for Messenger and a $18bn for WhatsApp.
Bank of America Merrill Lynch goes onto estimate that WhatsApp will generate $6 billion and FB Messenger will generate $5 billion. This is driven by the fact that WhatsApp is more of a global messenger application with different revenue contribution and has the potential to build into a larger user pool when compared to Messenger. FB Messenger will be monetized first, so the build-up of average revenue per user drives ARPU assumptions above WhatsApp. However, given enough time WhatsApp’s ARPU metric will compare favourably to the core FB application.
Needless to say, I have different assumptions on the messenger applications but agree with a lot of Bank of America’s research with regards to the upside potential of these applications. While monetization has yet to materialize in the case of WhatsApp, the company’s management team has indicated that they will pursue monetization once MAUs exceed 1 billion.
Well, we’re at that key inflection point above 1 billion, so investors should look for further news along this avenue. Personally, I’m anticipating a fairly quick ramp-up to revenue, but I’m also realistic on how it will affect the company’s valuation in the immediate near term.
As we all know, Facebook tends to be slow and methodical before monetizing any of its core applications. There’s the potential to lose engagement in the process, so factors like ad load and integration with other apps to drive value-add purchases will create a long lead time to meaningful sales.
I anticipate that FB Messenger will contribute $1.46 billion revenue in FY’16 when based on initial ARPU rates for historical ad/product introductions on core Facebook/Instagram. Needless to say, the ramp up in sales may take longer, but my estimate on initial year sales still comes across as reasonable. I don’t anticipate Facebook to break-out the separate contribution of revenue from FB Messenger for several more years, so these estimates will become difficult to compare.
In the initial stages, peer to peer payment services and app integration (sort of like an app market place) has been the main sources of revenue for FB Messenger. I don't anticipate the app to get cluttered with ads, but then again I could be proven wrong.
I’m anticipating the company’s ARPU growth to sustain at 17.1% upon establishing its initial year of revenue in-line with Facebook’s historical growth from 2007 to 2015. I anticipate the business to be valued at $4.985 billion in 2016 (22.71x earnings) when separated, but since a sum of the parts analysis makes little sense for a company trading at 90x EPS, I view this analysis as a means to arrive at a tangible estimate for the separate unit if it were to be sold or spun-off into a separate entity (which is highly unlikely). When consolidated, the combined growth of Facebook core, Messenger, WhatsApp and Instagram would drive my value estimate much higher.
In the case of WhatsApp, there isn't any meaningful source of revenue after FB removed annual subscriptions. Even so, when compared to other messenger apps like KaoKao and Line that have much higher ARPU, it seems probable that monetization will occur. I’m anticipating similar ARPU growth trends to FB’s historical revenue ramp. I’m anticipating a higher rate of user growth for WhatsApp when compared to FB Messenger as its better positioned globally to ramp at a higher user attach rate. That being the case, I also value the business much higher as it’s more valuable due to better growth dynamics/monetization potential. Clearly, my current intrinsic value estimate of $8.37 billion seems low, but then again this separate valuation is meant to be more illustrative in nature assuming the business was spun into a separate entity or sold to another entity.
Clearly, Facebook paid a much higher premium than what I value the separate unit at. At the time, there wasn’t value accretion of the purchase and much of the investor base was divided on the subject. However, I fully anticipate that when combining Facebook’s network of applications, the consolidated valuation would be much higher than when separated. Furthermore, the business as a stand alone unit will be worth more given enough time. In a future article I plan to consolidate the relative growth trajectory of Facebook’s business units inclusive of Oculus to arrive at a fair estimate for the entire business across a multi-year time frame.
As it currently stands, I still believe there’s further upside to Facebook’s current valuation. I reiterate my high conviction buy recommendation and $163.21 price target.