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Thursday, July 4, 2013 - 14:30

5 Reasons Why Facebook Is Still A Buy

Thursday, July 04, 2013 2:30 PM

If you're like millions of investors, you've decided against investing in Facebook (Nasdaq: FB).

The company's hotly-anticipated IPO in the spring of 2012 was a bust, and over subsequent quarters, shares have been adrift at sea. Indeed, as the S&P 500 has tacked on additional robust gains this year, shares of Facebook have quietly sunk below the 100-day moving average.

Of course, like many other investors, you've tucked this stock away into the back of your mind, planning on giving it a fresh look when the current phase of malaise has passed.

Well, the time has come to give this broken IPO a fresh look. And when you do, you'll find a business model that is finally ripening, with many arrows in its quiver. Facebook's 2013 sales and profit trends may not seem overly impressive, but the seeds are now in place for a much better 2014 and 2015.

Here are five key reasons why shares of Facebook should finally hold great appeal.

A Global Freight Train
At first glance, Facebook would seem to be a purely American phenomenon. The company's U.S user base of 207 million (as of May) is larger than its next four markets combined (Brazil, Indonesia, Mexico and the U.K). Yet the U.S.-centric nature of this business model is really a matter of timing, as the social-media network was launched here first and is only now showing solid growth in other less-penetrated markets.

For example, two-thirds of all Americans now have a Facebook account, according to investment firm Jefferies & Co. Across Europe, that figure stands at 50% in Europe, while in Japan and other key markets in Asia, that figure is closer to 25%. Notably, Facebook's penetration is rising at a faster rate outside the U.S. as the rest of the world plays catch-up. Simply focusing on the 600 million registered users in Facebook's 10 largest markets gives you a sense of the size of this company's captive audience. Those 10 markets account for half of the company's total user base.

Learning To Monetize
The biggest concern around Facebook's IPO was an unproven ability to profit from that customer base. Management has been pilloried for moving slowly on that front, preferring to "build the base" before profiting from it.

Yet thanks to sharp rises in ad placements, revenue is finally starting to take off. Look for 30% revenue growth this year (to above $6.5 billion) and 25% annualized growth in coming years, setting the stage for $10 billion in revenue by 2015.

Aggressively Pursuing New Platforms
Investors may mistakenly think that Facebook is losing its grip on the young consumer. Even if that's the case, management is adeptly building (or buying) complementary user platforms to retain consumer interest. For example, the $1 billion purchase of Instagram in April 2012 now looks like a masterstroke, as some Facebook users now simply spend more time on Instagram instead. In the quarter that ended in March, the number of global Facebook users rose 5% sequentially, compared with a 25% increase in Instagram users.

In addition to Instagram, "Facebook has rolled out a series of mobile apps fundamentally niche mini-social networks) over the past 12 months," noted analysts at BMO Capital Markets. "These include the Messenger, Camera, and Poke apps. We see these offerings not as an attempt to create the next blockbuster platform, but rather as specialized offerings for users focused on particular activities as opposed to the 'social utility' that is offered by Facebook." BMO 's analysts raised their rating on the stock to "outperform" from "market perform" in late May, with a $33 price target.

Other growth initiatives include:

  • Custom Audiences: Allows marketers to reach target audiences based on their own custom databases, whether a list of client email addresses, phone numbers or Facebook IDs.
  • Partner Categories: Enables marketers to leverage third-party data to deliver targeted ads.
  • Facebook Exchange (FBX): Provides for real-time-bidding for coveted ad slots.
  • Facebook Offers: This has a chance to exceed Groupon's deals platform, thanks to Facebook's massive reach.
  • Facebook gifts: Will allow users to send gifts for birthdays, anniversaries and other events.
  • Premium Services: This has been briefly mentioned by management with few details thus far.

As Google (Nasdaq: GOOG) will tell you, not all of these initiatives will succeed, but those that do should help sustain solid long-term revenue growth.

A Premier Player In Mobile Video
Sometime in the current quarter, look for Facebook to start serving video ads on its core site and on Instagram. And look for that effort to have a huge effect on the income statement, as ad rates are far higher than static image-and-text ads.

Facebook is expected to take a "Super Bowl commercial" approach, selling coveted 24-hour slots, with hundreds of thousands of ads served, for a price between $1 million and $4 million. Details remain a bit sketchy, but when the service is rolled out, look for solid revenue forecasts from analysts.

For instance, analysts at Jefferies predict "video ads could be Facebook's next billion-dollar business." That outlook was a key reason why Jefferies upgraded shares from "hold" to "buy" in late May with a $32 price target.

Not As Expensive As You Think
Until now, Facebook has been seen as a "story stock" without a robust income statement to drive valuations. That is an issue that dogged Amazon.com (Nasdaq: AMZN), Google and others as they patiently built out their businesses.

Yet Facebook's operating metrics are extremely strong. Margins on EBITDA (earnings before interest, taxes, depreciation and amortization) exceeded 55% in each of the past five quarters and should stay above 50% for the foreseeable future, even as the company heavily invests in headcount for new growth initiatives.

Equally important, shares trade for around 12 times consensus 2014 EBITDA, on an enterprise value basis (according to FactSet Research). Facebook's EBITDA is expected to grow at a 24% annual pace through 2016, according to Merrill Lynch, faster than most of its rivals .

Also, free cash flow was a bit disappointing in 2012 at just $379 million. However, free cash flow is expected to hit $2 billion by next year and approach $3 billion by 2015, according to consensus forecasts. For comparison, Google didn't reach $3 billion in free cash flow until 2010 -- six years after its IPO.

Risks to Consider: Facebook is entering prime time in terms of monetizing its user base, and any problems on that front will push shares to fresh lows.

Action to Take --> Thanks to the imminent launch of video ads, shares of Facebook may be reaching an inflection point. Though second-quarter results (which are due July 23) are unlikely to surprise on the upside, management's forward view should be quite bullish, leading many investors to give this moribund stock a fresh look.

P.S. -- If Facebook continues to improve its bottom line, it could join Google in a special class of securities we call "Forever" stocks. These are world-dominating companies that pay investors a fat dividend, dig a deep moat around their business to fend off competitors and buy back massive amounts of stock, boosting the value for the rest of the shares. They're solid enough stocks to buy, forget about and hold "Forever." To learn more about these stocks -- including some of their names and ticker symbols -- click here.

David Sterman does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.