Facebook’s (FB) share price is taking a beating after the company posted better-than-expected third-quarter results. Savvy investors know that the future is all that matters, and once a quarter is complete, the only thing that matters is what the company says about its outlook. What Facebook said about the remainder of 2014 and 2015 wasn’t great with respect to spending guidance. Wise investors, however, will look to 2016 and beyond to assess the firm’s earnings potential.
Facebook’s third-quarter results were fine. In fact, they were excellent. Revenue for the third quarter totaled $3.2 billion, a near-60% increase from last year’s quarter. Mobile advertising revenue represented nearly two thirds of advertising revenue during the period, up from about half during the third quarter of 2013. The firm was able to leverage revenue growth into a 90% increase in GAAP income from operations, to $1.4 billion.
Facebook’s non-GAAP operating margin was 44% for the third quarter, up an impressive 7 percentage points from the year-ago period. This is phenomenal improvement and represents an enormous level of profitability. At the end of the quarter, cash and cash equivalents stood at $14.25 billion, as Facebook posted $766 million in free cash flow during the period. The firm’s third-quarter earnings slide deck can be accessed here.
Shares are under pressure as the market is worried about excessive spending guidance. Facebook expects 2014 GAAP costs/expenses to rise 45%-50%, up from a prior outlook of 30%-35% growth. The company also expects to spend quite a bit during 2015. In fact, management is looking for non-GAAP spending to increase an incredible 50%-70% on a year-over-year basis in 2015. This means that, unlike the leverage we saw this quarter (where operating income expanded at a much faster rate than revenue), income will likely grow at a much slower pace than revenue in 2015. That is, unless such spending translates into significant revenue growth opportunities.
The stock market is (and has always been) very much near-term oriented, and it should not be surprising that investors are disappointed by the spending outlook over the next 12-18 months. Still, investors should be reasonable. Facebook’s stock has more than quadrupled since its September 2012 bottom, and unlike Twitter’s (TWTR), Facebook’s growth will be profitable growth. Facebook is investing in “everything from the core service to ad tech to new products (source).” Instagram and virtual reality headset maker Oculus will also see considerable investments. By comparison, Twitter has yet to turn a profit on a GAAP basis, and only turned marginally profitable on a non-GAAP basis this quarter.
We like Facebook infinitely more than Twitter, but we’re not compelled to rush out to scoop up shares of Facebook at the moment. The market has a way of reading too much into short-term events, and we think this could provide an entry point on shares in coming months. We’re staying patient. Our fair value estimate of shares remains $100.