Three reasons to invest in Facebook

facebook-fbWhen our firm looks for companies worthy of investment, our experience is that the best predictor of future success isn’t a sell-side “axe” or Wall Street pundit. Rather, the best predictor of future success is present success.

Right now, in the spring of 2014, Facebook (FB) is undeniably succeeding. In late April, it reported an outstanding March quarter, with 72% year-on-year revenue growth and mobile-ad revenue comprising 59% of total ad revenue, up from essentially 0% two years ago.

So, when we rebalanced our firm’s model-technology portfolio in mid May, we initiated a position in Facebook. There are three reasons why.

Facebook is the operating system for people’s lives

Facebook’s rise to over 1.2 billion registered users heralds an important change from the traditional view of technology companies. We’re accustomed to thinking of our lives as, well, our lives, with various technologies and devices coming along to “enhance” or “improve” our lives.

But Facebook isn’t really on the periphery. It’s central to the lives of hundreds of millions of people. To many Americans, Facebook is perceived as a kind of bulletin board, helpful in arranging gatherings and posting information about recent events in users’ lives.

But more than 80% of Facebook’s average monthly users live outside the U.S. Their perception of Facebook (and the Internet in general) is vastly different than it is for Americans. Thanks to efforts like Facebook Zero and Facebook for SIM, hundreds of millions of users have been able to access Facebook at low or no cost, even with the simplest of mobile handsets.

Now as the company layers on storefronts (a la eBay and Alibaba) and money transfer and payment services, the Social Network is integrating itself more completely into users’ lives. So for a whole lot of people, Facebook is the Internet, giving it an enormous commercial advantage.

Facebook continues to overcome mistakes

Whether the idea for Facebook came from Mark Zuckerberg or the Winklevoss twins or from a fortune cookie, the company has grown into a powerful business model. And that’s in spite of (not because of) a variety of missteps:

  • The over-sharing inherent in Facebook’s ill-fatedBeacon project , launched in 2007 which revealed users’ purchases to their Facebook friends
  • The “everyone” policy change in 2009 that had theunintended consequence of allowing everyone on the web to view status updates and other sensitive information
  • Facebook’s botched IPO in 2012
  • The “shadow contact” screw-up in 2013 that revealed it was possible, using Facebook’s Find Your Friends tool, to mine personal data about users that users had never revealed to Facebook directly — only to their Facebook friends

And now that the company is actually succeeding on mobile and releasing useful products on purpose, like the Facebook Audience Network and the Website Custom Audiences targeting tool for advertisers, success seems more durable and likely.

Facebook is phenomenally profitable

If you look at a basic financial analysis of Facebook you notice something very unusual. The company’s forward price-to-sales ratio is 12. This is would represent a premium valuation for a high-profile, fast-growing, yet unprofitable company.

But Facebook is profitable, and its forward price-to-earnings ratio is 38. This latter figure is not very high, especially when you consider that in its March 2014 quarter, its year-over-year revenue growth was 72%.

Consider for a moment the relationship between price/sales and price/earnings — dividing the former by the latter represents the company’s net margin, i.e., earnings divided by sales. In this case, 12/38 = 31.5%. And indeed, that’s roughly the expected 2015 consensus net profit margin for JP Morgan (34.0%), Wedbush Morgan (28.6%) and the 40 or so analysts covering the stock. By comparison, the average publicly traded technology company has a net profit margin of about 10%.

And these aren’t just accounting profits either. In Facebook’s March 2014 quarter, it generated $900 million in free cash flow, representing a 36% FCF margin.

So when you combine Facebook’s premium growth with its premium profitability, you can see why it deserves a premium valuation.

In the past year, Facebook has made several acquisitions that seemed, well, insane.

First, they bought Instagram for $1 billion in April 2012. Then, this past February, they shocked the world by offering to pay $19 billion (including $4 billion in cash) for messaging-app vendor WhatsApp, which was largely unknown by most investors. In March, it contracted to buy the virtual-reality firm Oculus. The price, a reported $2 billion, seems positively sober compared with what it offered to pay for the prior two.

But realize two things. First, if the equity markets decide your currency (i.e., your shares) is worth more than that of your competitors, you are actually wise to spend it if it improves your competitive position. Second, the impact of these acquisitions mostly affects Facebook’s balance sheet, rather than its income statement, given the ultra-low headcounts at all three of these acquisitions.

With incredible cash flow and a huge and growing share of the advertising market, Facebook is a compelling investment, one we “like” a lot.

DISCLAIMER: The investments discussed are held in client accounts as of May 31, 2013. These investments may or may not be currently held in client accounts. The reader should not assume that any investments identified were or will be profitable or that any investment recommendations or investment decisions we make in the future will be profitable. The opinions and views expressed herein are of the portfolio manager and may differ from other managers, or the firm as a whole. Past performance is no guarantee of future results.