As we get closer to finishing out 2019, let’s take a look at two of the big winners in our Best Ideas Newsletter portfolio this year: Facebook and Alphabet. What a comeback Facebook has made since the summer of 2018! On the basis of our fair value estimate, we expect the company to surpass new highs. Alphabet just hit an all-time high last month, too!
By Callum Turcan
Image Shown: Shares of Facebook Inc have skyrocketed over the past year as the market shrugged off near-term political/regulatory headwinds and looked out towards the future, with an eye towards Facebook’s strong free cash flow growth trajectory and pristine balance sheet.
Facebook Inc (FB) is a company we’ve been pounding the table on for a while now as we view its stellar free cash flow profile, promising growth trajectory, and pristine balance sheet as far more important (to the intrinsic value of the company’s equity) than near-term political/regulatory headwinds. As you can see in the graphic below, Facebook’s monthly active user (‘MAU’) base has continued to grow at a decent clip over the past several quarters due to its international user base continuously getting larger. Please note that Facebook’s MAUs in the US and Canada grew modestly from the third quarter of 2017 to the third quarter of 2019, implying domestic political hurdles are having less of an impact on its operations than one might expect given the mature nature of these markets.
Image Shown: Facebook’s user base continues to grow with an eye towards its expanding international footprint. Image Source: Facebook – Third Quarter 2019 Earnings IR Presentation
At the end of September 2019, Facebook had $16.0 billion in cash and cash equivalents along with $36.3 billion in marketable securities on the books. Even better, Facebook had no debt at the end of this period. During the first nine months of 2019, Facebook generated $16.2 billion in free cash flow while spending $2.9 billion on share buybacks (share repurchases were down sharply year-over-year). Given the strength of its balance sheet and free cash flow profile, Facebook could easily launch an aggressive share buyback plan and/or initiate a common dividend while maintaining its ability to invest in the business as needed.
Going forward, Facebook’s financial performance will be augmented by rising average revenue per user (‘ARPU’). While the digital advertising market is significantly more lucrative in North America than anywhere else, even Europe, there’s an enormous amount of room for growth in the Asia-Pacific region as more and more generations enter the global middle class from the first time. Facebook’s ARPU on a global basis rose from $6.09 in the third quarter of 2018 to $7.26 in the third quarter of 2019, aided by growth across the board (in Europe, North America, Asia-Pacific, and other regions).
Image Shown: Rising ARPU will allow Facebook to generate larger cash flow streams from its existing and future user base, supporting its promising free cash flow growth outlook. Image Source: Facebook – Third Quarter 2019 Earnings IR Presentation
Our fair value estimate sits at $234 per share of Facebook, implying substantial upside from where shares of FB are trading at as of this writing. In the graphic below, from our 16-page Stock Report (which can be accessed here), we highlight the valuation assumptions we used when modelling out Facebook’s future financial performance. Please note the relatively strong free cash flow to the firm growth rate during the mid-cycle period (“Phase II”), underpinned by Facebook’s growing user base and rising ARPU as the global digital advertising market offers long-term upside.
Image Shown: The midpoint of our fair value range estimate sits at $234 per share of FB, and we see room for substantial upside ahead.
Facebook is a top holding in our Best Ideas Newsletter portfolio, and we expect that will continue to be the case for some time. Should the US Congress attempt to break up domestic tech giants, that could counterintuitively cause shares of FB to rise as the market begins to evaluate the company on a sum-of-the-parts basis.
Alphabet
Image Shown: Shares of Alphabet Inc Class C have resumed their upward climb since stumbling briefly during the middle of this year, and we remain very optimistic on the company’s long-term outlook.
Alphabet Inc (GOOG) (GOOGL) is another prime example of a US tech giant that’s come under political/regulatory fire yet still managed to produce solid results. We include Alphabet Class C shares as a top holding in our Best Ideas Newsletter portfolio, and our fair value estimate sits at $1,440 per share of GOOG. Should Alphabet continue to outperform, shares of GOOG could test the high end of our fair value range estimate, which sits at $1,800 per share.
In the graphic below, from our 16-page Stock Report (which can be accessed here), we highlight the valuation assumptions we use when modelling Alphabet’s future financial performance. As is the case with Facebook, we expect strong free-cash-flow-to-the-firm growth rates during Alphabet’s mid-cycle period due to the tech giant’s exposure to promising secular growth tailwinds; for Alphabet, that includes the global digital advertising market, autonomous and semi-autonomous driving services, and cloud computing offerings.
Image Shown: We see meaningful upside at Alphabet going forward due to its promising free cash flow growth trajectory.
At the end of September 2019, Alphabet was sitting on $16.0 billion in cash and cash equivalents and $105.1 billion in marketable securities versus $4.1 billion in total debt. Its $117.1 billion net cash position provides a nice boost to its intrinsic value and should allow for Alphabet to continue repurchasing a material amount of its stock. During the first three quarters of 2019, Alphabet generated $22.6 billion in free cash flow while allocating $12.3 billion towards share repurchases. Material share repurchases are a good use of capital, in our viewm seeing as how shares of GOOG have been trading at a significant discount to the midpoint of our fair value range estimate for most of 2019.
In the graphic below, please note that Alphabet’s ‘Other Bets’ segment continues to produce large operating losses. Here we would like to highlight what might arise should the US Congress decide to try and break up a firm like Alphabet. We think that in the event Alphabet gets broken up into several different companies, the management teams of those firms would likely allocate substantially less towards “moonshot” investments as the smaller companies focus on their core operations. While one may argue that these types of investments with very long-term time horizons are the kinds of investments that can occasionally yield some big winners (Alphabet’s Waymo is clearly at the top of that list), we see room for potential operating expense reductions without sacrificing a significant chunk of that upside (with an eye towards pet projects, defined here as any venture that’s vastly outside of Alphabet’s core operational focus with no clear way to become profitable within the next decade).
Image Shown: Alphabet’s ‘Other Bets’ segment continues to produce large operating losses and minimal revenues. Image Source: Alphabet – Third Quarter 2019 Earnings Press Release
On December 3, Alphabet announced some big management changes. Sundar Pichai will be taking over as CEO of both Alphabet and Google as co-founders Larry Page and Sergey Brin have decided to step down from their roles as CEO and President of Alphabet, respectively. Mr. Pichai was already CEO of Google but will now have an even greater role as leader of the whole enterprise. Shares of GOOG spiked over 2% on December 4 during normal trading hours, which we view as a sign that the market is factoring in how Alphabet may change its capital allocation priorities going forward.
That may include a greater focus on profitability, per-share earnings growth, and putting Alphabet’s huge cash pile to work. While a common dividend may still be a way off, Alphabet could repurchase a material amount of its stock and rationalize its ‘Other Bets’ spending levels in a bid to increase the intrinsic value of shares of GOOG over time. Going forward, we see growth at Google, YouTube, Google Maps, and Waymo underpinning Alphabet’s impressive growth outlook with its ‘Other Bets’ segment largely offering incremental upside.
Concluding Thoughts
Facebook and Alphabet remain two of our favorite companies out there. We see top quality secular growth plays trading at a nice discount to their intrinsic value as one of the best ways to navigate rising geopolitical tensions around the world. As we get ready to head into 2020, Facebook and Alphabet are very well positioned to handle domestic political/regulatory headwinds, and the market appears to be warming up to both companyies’ free cash flow growth prospects once again. Members interested in seeing our other favorite capital appreciation ideas should check out our Best Ideas Newsletter portfolio here—->>>>
Computer Hardware Industry – AAPL BB HPQ IBM TDC
Internet Content & Services Industry – GOOG GOOGL BIDU FB JD TECHY TWTR
Related: BKNG
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Callum Turcan does not own shares in any of the securities mentioned above. Shares of Alphabet Inc (GOOG) (GOOGL) Class C, Booking Holdings Inc (BKNG), Facebook Inc (FB), and Apple Inc (AAPL) are all included in Valuentum’s simulated Best Ideas Newsletter portfolio. Shares of Apple Inc are also included in Valuentum’s simulated Dividend Growth Newsletter portfolio. Some of the other companies written about in this article may be included in Valuentum’s simulated newsletter portfolios. Contact Valuentum for more information about its editorial policies.