Huge Growth Except Where it Counts

Chad is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

I wonder if analysts growth projections are wrong about Facebook (NASDAQ: FB). Though some people are inherently comfortable with the understanding that analysts may mess up their expectations for a company, most analysts are expecting Facebook to grow earnings per-share by better than 26% over the next several years. However, based on the company's recent results, I'm not convinced that the company can grow earnings at all, much less by a significant amount. In a scary comparison, Facebook primarily reminds me of some of the dot-com stocks that investors chased to ridiculous heights even though the companies were not producing real earnings growth. I recall investors looking at growth figures and everything except for earnings as a reason to purchase shares. Facebook appears destined to follow in these unfortunate footsteps unless the company can change the way it does business.

If you look at many of the popular measures that Facebook is scored on, the last quarter was fairly impressive. The company reported revenue growth of 32.29%, and monthly active users topped 1 billion people for a growth rate of 26%. The company's daily active users increased 28%, and most impressively, mobile active users jumped 61%. Facebook reported that its iOS app was much better than the previous version, and from personal use I can completely concur. The company also pointed to deep integration within iOS as a future growth driver from the popularity of Apple's iPhone and iPad lineups. The company also mentioned that it was improving its Google (NASDAQ: GOOG) Android-based Facebook app, and these improvements should solidify Facebook's future growth in mobile. No companies like Google or even Microsoft (NASDAQ: MSFT) have tried to come up with different ways to integrate social capabilities into their products, and arguably no other site has the mind share in social networking that Facebook commands. However, just because their website is used heavily and offers its users a great value, doesn't necessarily mean that big profits will follow.

Though Facebook has over 1 million active users and mobile usage is growing by leaps and bounds, what the company is not doing is increasing earnings or cash flow. Though it's impressive to see double-digit increases in the number of people using the service, if Facebook cannot turn this growth into dollars it doesn't much matter. In fact, the company's non-GAAP EPS was flat versus a year ago. If you look further, Facebook's income before taxes actually decreased by 1.06% versus last year. If you look at the amount of growth the company saw in both advertising and payments revenue, this lack of earnings growth is truly astounding. Advertising revenue increased 36% on a year-over-year basis and represents 86% of the company's total. Payments revenue increase 13% and made up the remainder of Facebook's total. If you dig into the company's financial statements, there are multiple reasons the company did not grow earnings though seemingly every other measures showed good growth.

First, the non-GAAP operating margin dropped from 51% last year to 42% this year. By point of comparison, Google manages to create positive earnings growth with an operating margin of less than 20%, and Microsoft's operating margin is about 33%. Both of these companies generate significant free cash flow and until recent hiccups have seen consistent earnings growth. This should make investors wonder: What will it take for Facebook to grow their earnings? In addition, there were two expense line items that jumped significantly and contributed to EPS being flat year-over-year. The first issue was that the company increased its R&D spending by almost 126%. Over the long term, this should be a positive if the company is spending this money wisely to increase its offerings in the future. However, the second line item that was a problem was general and administrative expenses, which increased by more than 84%. Given that revenue was up 32%, it makes you wonder why general and administrative expenses would increase by almost three times this amount. This huge increase in expenses lent to flat earnings-per-share growth, but what is really troubling is the company's operating and free cash flow statistics relative to some of their competition.

Though some investors might not read Facebook's earnings report carefully enough, operating cash flow dropped a mind-boggling 55.75% on a year-over-year basis. In addition, the company only generated $79 million in free cash flow from over $1.26 billion in revenue. This free cash flow to revenue ratio means the company converted just 6.26% of its revenue into free cash flow for shareholders. By comparison, Google turns roughly 22% of its revenue into free cash flow, and Microsoft turns just over 49% of its revenue into free cash flow. While both of these companies are certainly more mature than Facebook, you have to wonder in the future how Facebook can increase its cash generating capabilities to really benefit shareholders.

If you're a more conservative investor, either Google or Microsoft would appear to be a better selection than Facebook. Google currently maintains over 83% of desktop market share and over 89% of global mobile market share. Analysts expect Google to grow earnings by about 13.5% over the next few years, and with the shares trading at around 14 times projected earnings, they seem like a good value for the dominant player in its industry. Microsoft, on the other hand, runs about 90% of the world's PCs and pays a yield better than 3.4%. Though many have given the company up for dead, analysts are expecting earnings growth of around 9% in the next five years. With Microsoft's stock selling for just over eight times projected earnings, the shares are about as cheap as they've ever been. New introductions like the Windows Surface tablet, and updated Windows 8 operating system could make the stock attractive.

Even after the massive drop in Facebook's stock price since its IPO, the shares still trade for more than 36 times next year's earnings estimates. For a company that has not proven the ability to grow earnings, analyst projections of better than 26% growth in the next few years look questionable. While I understand that many would point to the sheer size of the user base at Facebook as offering great potential in the future, the question has to be asked: With over 1 billion users how is it that Facebook isn't making money hand over fist? Long story short, Facebook still offers many more questions than answers at the current time. Until the company can prove that it can monetize its user base to the point of earnings growth, it still seems the shares are too highly valued.

MHenage has no positions in the stocks mentioned above. The Motley Fool owns shares of Facebook, Google, and Microsoft and has the following options: long JAN 2014 $20.00 calls on Facebook. Motley Fool newsletter services recommend Facebook, Google, and Microsoft. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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