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Facebook Stock Is a Deal After Avoiding a Coronavirus Earnings Disaster

By Nicholas Rossolillo – May 5, 2020 at 9:02AM

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It's less about this year’s profit margins and more about the massive cash hoard getting deployed for the future.

Contrary to mounting fears, Facebook (META 0.07%) ended up doing pretty well to kick off the first quarter of 2020. With the world getting upended by the coronavirus and the subsequent economic clampdown, the social media king reported surging average daily use and an 11% year-over-year increase in monthly active people on one of its services (Facebook, Instagram, WhatsApp, and Messenger) to 2.99 billion.

Of course, advertising takes a hit during a recession, and 98.3% of Facebook's $17.7 billion in revenue in Q1 were of the ad variety (the balance, mostly from Oculus virtual reality products, growing 80% from a year ago to $297 million). No surprise, then, that the ad revenue grew "only" 17%, suffering from a steep drop in spending in March.

CFO David Wehner reported last week that sales have since stabilized through the first three weeks of April and are on par with where they were a year ago. Still, Q2 and full-year 2020 guidance was pulled given the fast-changing and uncertain situation -- save for an operating expense outlay of $52 billion to $56 billion, up 16% at the midpoint from 2019. Operating expenses were already elevated as Facebook made security changes to its platform, so it's safe to assume profit margins are going to head in reverse for the balance of the year.

That's quite OK with me. Profit foregone now in lieu of more later always makes sense for long-term business owners, and the company can afford the spending with its massive cash stockpile.

A Facebook thumbs-up "like" icon getting pressed by someone pictured in the background.

Image source: Getty Images.

An update on the here and now

While the bottom line is likely going down from here, let's catch up a bit. Facebook's free cash flow (revenue less cash operating and capital expenses) was $7.34 billion in Q1 2020, a 37% increase. That's thanks to the company managing its outflows during the elevated period of social network updates it has been embarking on, including data center investments.

In fact, over the last 12 months, Facebook's free cash flow generation has been a massive $22.7 billion -- good for a profit margin as a percentage of revenue of 32%. And price to free cash flow (market cap, or value of the company divided by free cash flow) values the stock at 25.4 times the last year's worth of results.

Cheap? By most value investors' calculations, perhaps not -- and especially not when considering the cloudy outlook for the rest of 2020. If ad sales stay subdued and operating expenses do continue to rise, free cash flow is surely going down. Plus, while Facebook recorded its record $5 billion fine to the FTC last year, the cash didn't actually leave the balance sheet until just after the conclusion of Q1. That too will eat into the bottom line. Yikes.

Mobilizing the war chest for what it does best

CEO Mark Zuckerberg addressed this problem on the earnings call. While profit margins are undeniably important, advertising-based business models are cyclical. The down cycle is now here. However, Zuckerberg and company rely heavily on the success of small businesses around the globe, and spending to support them is important. Zuckerberg expounded:

I think during a period like this there are a lot of new things that need to get built. And I think it's important that rather than slamming on the brakes now, as I think a lot of companies may, that it's important to keep on building and keep on investing in building for the new need that people have and especially to make up for some of the stuff that other companies would pull back on, and I think that in some ways that's an opportunity, in other ways, I think it's responsibility to keep on investing in the economic recovery.

And it's not as if elevated spending is going to continue forever. Rather, even as the massive tech firm it now is, Facebook still sees itself as a high-growth outfit with a huge opportunity ahead of it. Profits will eventually rebound, but now's the time to invest while others are fearful (to paraphrase Warren Buffett). Investing only when the sun is shining puts a cap on future investment returns. It's in times of duress that the foundation for serious future payoff is laid.

To that end, India's Jio is getting a $5.7 billion investment from Facebook to help get JioMart -- a small-business initiative -- rolling. India is home to Facebook and WhatsApp's largest communities. The social media conglomerate sees an opportunity to help Jio stitch together the highly fragmented economy dominated by tiny merchants via its social networks, powering commerce through payments processing, text-based ads, and social promotion.

It's but one anecdotal example of where Facebook is doling out cash to promote future returns (video communications being another example). But even in a bad year, Facebook will remain free cash flow positive. It can afford to spend. Plus there's the $60.3 billion in cash, equivalents, and short-term securities and zero debt on the balance sheet at the end of March. Yes, $5 billion of that has since gone to the FTC, but Facebook is close to the very top of the list of the most net-cash-rich organizations on the planet.

Cheap stock? Based on the last and next 12 months' worth of profit, perhaps not. But a massive war chest paired with high profit margin should not be underestimated. For those looking more than a year down the road, Facebook is a deal.

Randi Zuckerberg, a former director of market development and spokeswoman for Facebook and sister to its CEO, Mark Zuckerberg, is a member of The Motley Fool's board of directors. Nicholas Rossolillo and his clients own shares of Facebook. The Motley Fool owns shares of and recommends Facebook. The Motley Fool has a disclosure policy.

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