Fundsmith Equity Fund (FEF) revealed in its February 2018 fact sheet that it had “initiated a new position in Facebook.” Shares in the social network were the eighth largest holding in the fund at the end of the February 2018.

Facebook share price US$149 on 25 Jan 2019 close; Market Cap US$428 billion

- Fundsmith average buy in price estimated at US$180 per share; the current share price is 17% lower at US$149.

- The bulk of Facebook’s users are outside the US, Canada and Europe. However, 72.5% of Q3 revenue was from the US, Canada and Europe.

- Facebook Q3 year-on-year revenue growth was still strong at 33%. Q4 results to be announced 30 Jan.

Fundsmith Equity Fund (FEF) has taken a fairly big position on Facebook.  It was the fourth largest holding at the end of May 2018 and June 2018.

The Facebook position reduced Fundsmith Equity Fund's return by 0.7% in 2018.  The current US$149 share price is 17% below Fundsmith's estimated average entry price of US$180 (the shares traded around this level in February and early March 2018).

Fundsmith's thoughts on Facebook can be found in Terry Smith's annual letter to shareholders and the interim and annual reports that the fund issues.

Facebook share price since the start of 2018 (Fundsmith started buying in February 2018)

Source: SharePad

Fundsmith’s Facebook investment case in short

The Fundsmith interim report for 2018 revealed that Fundsmith Equity Fund spent a cool £687 million on Facebook shares in the first half of 2018. This compares to £233 million spent on the next largest purchase in the period, Reckitt Benckiser. 

Terry Smith stated in the report (published in August 2018) that:

“We acquired a holding in Facebook, viewing the furore over the use of users’ data as a typical glitch of the type which has sometimes enabled us to find a favourable valuation entry point in the past for companies such as IDEXX. We may of course be wrong, as inevitably we sometimes we bought Facebook on about the same valuation as the average S&P 500 company. Facebook has been growing at about 50% pa and whilst this growth rate must slow, it would have to fall a long way to make the shares look expensive.”

Terry Smith also alluded to Facebook being something of a contrarian call in the annual shareholder letter (published in January 2019).

I strongly suspect that most people’s judgement of Facebook is based upon their personal experience and prejudices.

Facebook historic and forecast growth

Source: SharePad

Facebook historic and forecast P/E multiples

Source: SharePad

Facebook and Fundsmith

Facebook founder and CEO Mark Zuckerberg owns the majority of voting rights in Facebook.  External shareholders, and the board of directors, therefore have little effective oversight.  This makes corporate governance and capital allocation two key risks.

An additional risk is that the use of Facebook as a social media platform could fall out of fashion. This seems unlikely given that we are "social animals".  However, people may start to use Facebook for less time each day if it is seen in a negative light.

Facebook doesn't appear to be an archetypal Fundsmith company given that it is only 15 years old while the average Fundsmith holding was founded in 1922.  Fundsmith was also somewhat aggressive in making Facebook a top-ten holding.

Facebook historic daily P/E ratio (last 12 months reported earnings)

Source: SharePad

Facebook’s valuation in terms of the historic P/E multiple (last 12 months reported earnings) has been in decline since the IPO.  Revenue growth and margin expansion have both resulted in rapid earnings growth since 2012.

When Fundsmith started buying into Facebook a year ago the historic P/E ratio was around 34X versus circa 22.4X today. The forecast P/E (12 months ahead) for Facebook currently stands at a modest 19.5X.

Fundsmith estimated in February 2018 (when it first started buying shares in Facebook) that annual revenue growth in Q3 2018 would halve to circa 20% (annual letter).  In the event, annual revenue growth in Q3 came in at 34%.

Facebook share price since the IPO in May 2012

Source: SharePad

Facebook’s July 2018 revenue growth warning

Facebook's recent share price weakness has been due to management caution on revenue growth.  CFO David Wehner stated in the  Q2 conference call on 25 July 2018:

“Our total revenue growth rate decelerated approximately 7 percentage points in Q2 compared to Q1. Our total revenue growth rates will continue to decelerate in the second half of 2018, and we expect our revenue growth rates to decline by high single digit percentages from prior quarters sequentially in both Q3 and Q4.”

Factors contributing to the deceleration included:

- A currency headwind in the second half

- Promotion of engaging experiences like Stories that have lower monetization.

- More user choices for data privacy.

In Facebook' Q3 conference call (P10)  on 30th October 2018 the company continued to warn that the pace of revenue growth will slow.  CFO David Wehner stated:

In Q4, we expect that our total revenue growth rate will decelerate by a mid-to-high single digit percentage compared to our Q3 total revenue growth rate.

Fundsmith’s investment case for Facebook

Fundsmith "tends to look for suitable investments from the numbers that they report."  The annual shareholder letter (P9-11) sets out Terry Smith's thinking on Facebook:

Facebook user numbers:

- Facebook has a virtual duopoly in online advertising with Google.

- Facebook’s user metrics suggest “ubiquity.” The platform has 1.5 billion Daily Active Users (DAU) and 2.3 billion Monthly Active Users (MAU). These numbers are despite the group having no presence in China.

- 69% of Facebook’s DAU (daily active users) and 73% of its MAU (monthly active users) are outside the United States and Europe.

- Facebook users outside the US and Europe are unlikely to care about data misuse in the US election. This is evident from the 9% increase in Q3 2018 DAU and the 10% increase in MAU.

- Facebook has yet to 'monetise' WhatsApp.

Facebook financial numbers:

- Facebook generates strong financial returns - In 2017 the return on capital was 30%, the gross margin was 87% and the operating profit margin was 50%.

- A significant increase in spending by Facebook to protect data may have “built and even bigger barrier to entry for competitors.”  Costs increased by 53% in Q3 2018.

- Facebook has grown strongly in the past – Revenue has grown at a 49% annual rate for the past 5 years. Operating profits have grown at a 106% annual rate for the past 5 years.

- Q3 2018 was resilient with 13% profit growth despite the 53% increase in costs.  The operating profit margin was 42%.

Facebook operating margin over two years

Source: Facebook

Facebook breakdown: users and revenue

Terry Smith is correct to say that the bulk of Facebook’s monthly active users are outside the US and Europe. However, the bulk of Facebook’s revenue comes from Europe, the US & Canada.

Average Revenue per User (ARPU) in the US & Canada was US$27.61 in Q3 2018 while ARPU in the Asia-Pacific region was US$2.62. US & Canada users generated 48.5% of Facebook total revenue in Q3 and Europe generated 24% of revenue (source: Facebook Q3 presentation) - 72.5% of total revenue.

Accordingly, Facebook needs to remain popular in North America and Europe.

Monthly Active Users (MAU) in Europe peaked in Q1 2018 at 377 million and in Q3 2018 were 375 million.  Monthly active users in the US and Canada have seen marginal or no growth in recent quarters.

Source: Facebook

What is interesting is that revenue has nevertheless grown at a reasonable pace in the US & Canada in recent quarters.  Advertisers are willing to pay more to target the same number of users in the US & Canada.

Revenue growth has also been strong in Europe.

Accordingly, the risk of a decline in Monthly Active Users (MAU) in the West appears to be overstated.  Higher advertising rates in the West are more than offsetting a lack of user growth.

Source: Facebook

Facebook's total Average Revenue per User (ARPU)  increased 20% from US$5 in Q3 2017 to US$6 in Q3 2018.  This was driven by a 30% jump in ARPU in the US & Canada to US$27.61.

In Europe there was a 29% jump in ARPU over the same period to US$6.85 in Q3 2018.  The negative headlines about Facebook have been accompanies by advertisers paying more to be on the platform in the West.

Growth in ARPU was more modest in Asia-Pacific where there was an 18% increase in Q3 on a year ago to US$2.67.  In the Rest of World block there was a 14.5% increase in ARUP in Q3 2018 on a year ago to US$1.82.

Source: Facebook

Facebook’s current valuation

The January shareholder letter stated that Facebook is on an historic P/E of 19.7X…“about the same as the S&P 500.” Shares in Facebook traded as low as US$132 in January and are now trading 13% higher than the low at US$149.

The current forecast P/E for 2018 is 19.8X with this declining to 19.5X in 2019 and 17.1X in 2020. Net cash is expected to be 10.9% of the current market value at the end of 2018 and 15.9% at the end of 2020.

Facebook key ratios (fiscal year to 31 December)

Source: SharePad

Facebook diluted earnings per share

Source: Facebook

Fund Hunter comment

Fundsmith’s Facebook purchase was a surprise and has been controversial decision. While the financial metrics indicate quality the voting rights situation is a concern.

Another risk is the current dependence on users in the US, Europe and Canada. If these users start to desert Facebook it would be a problem. Increasing Average Revenue per User (ARPU), though, may more than offset any user decline in the US and Europe.

The longer-term outlook is supported by growth in developing markets in terms of both Monthly Active Users and Average Revenue Per User.  Facebook's targeted advertising is likely to remain extremely popular with advertisers.

In hindsight, the owner of Google (Alphabet) may have been a better way for Fundsmith to buy into the online advertising.  However, Facebook has a very sticky user base and a powerful competitive barrier to entry due to network effects i.e. Google tried to compete in social networking and failed.

In summary, the two key pillars of Facebook's investment case are increasing users in emerging markets and strengthening Average Revenue per User (ARPU), not least in the West.  Both factors should more than offset a decline in Monthly Active Users (MAU) in the West.

Appendix:

1. To better understand Facebook I would recommend the book "The Four: The Hidden DNA of Amazon, Apple, Facebook and Google."