New Constructs Initiates Facebook (FB) Coverage At Neutral

Last week, Facebook FB filed its second annual report as a publicly traded company, which allows us to initiate coverage. The company’s strong return on invested capital (ROIC) and profit growth offset the stock’s expensive valuation (~$70/share) to earn our Neutral rating.

For comparison, 31 out of 33 analysts have a “Buy” or “Strong Buy” rating on FB. This strong positive bias from Wall Street does not surprise me given the huge profits they can gain from winning investment banking business with Facebook.

Fundamentals

Facebook grew after-tax profits (NOPAT) by 61% last year, from $1.1 to $1.8 billion. The company also expanded its NOPAT margin to 23% and increased its ROIC to 29%, better than Google GOOG at 28%.

LinkedIn LNKD, a key competitor, saw its ROIC drop from 8% to 4% in 2013 and has slim NOPAT margins of just 3%. Even though LNKD is a much smaller company than FB, both companies grew revenue by about the same percentage last year. FB is executing much better than LNKD in terms of profitability.

Where are all of these profits coming from, when Facebook sells few paid services? Ad revenue of course. Facebook drew $7 billion of its $7.9 billion in revenue from its advertising fees, with the other $900 million coming from its “Payments” segment. The other big player in this space is Google, which derives between 92-93% of its revenue from advertising. In the ad space, Facebook is going-toe-to-toe with Google and winning in terms of ROIC (29% v 28%) and NOPAT margins (23% vs. 19%). Despite some signs that teens are losing interest in Facebook, it appears that advertisers are not.

In the wake of FB’s difficult IPO, the question was whether the company could properly monetize its rapidly growing mobile user base. By all accounts, FB has succeeded. According to its 2013 10-K, FB earned 53% of its advertising revenue from mobile in the fourth quarter, compared to 23% the year before. FB’s ability to adapt to the changing behaviors of its users is a big point in its favor.

Significant Adjustments: Diligence = Protection

Unique to our coverage of Facebook (and al 3000+ stock we cover) is our application of several adjustments to  GAAP metrics to uncover a more accurate view of the company’s true profits (read more about our adjustments process here). Significant adjustments to NOPAT include the removal of a one-time lease abandonment expense totaling $117 million and an equipment write off totaling $56 million.

On the invested capital side, we removed $11.2 billion in excess cash and added $837 million in off-balance sheet operating leases to calculate the true amount of capital invested in this business.

Valuation and Outlook

Despite strong fundamentals, Facebook only earns our Neutral rating due to its expensive valuation. The company ended trading last week at ~$69/share. To justify this price, Facebook would need to grow NOPAT by 22% compounded annually for the next 10 years.

While the company’s 61% growth from 2012-2013 exceeds this annualized expectation, it remains to be seen if FB can keep up high growth for the long term. FB wants to control every aspect of the way people interact online, which is why it was willing to pay $19 billion for the messaging service WhatsApp. If FB can execute on this strategic vision, the potential upside is significant, even with the growth already priced into the stock.

On the other hand, if FB can’t dominate the social sphere in the same way Google managed to dominate search, it’s lofty valuation leaves significant potential downside.

Sam McBride and André Rouillard contributed to this report.

Disclosure: David Trainer, Sam McBride, and André Rouillard receive no compensation to write about any specific stock, sector, or theme.