Facebook stock is cheaper now - and may even be worth buying

Since its IPO on May 18, Facebook (NASDAQ:FB) shares have fallen from their public offering price of USD 38 to about USD 21 today. And a new flood of Facebook shares  - from early investors and insiders - will be coming to market this fall, which could make the share price even softer in the short term. 

For a long time, I've been very negative on Facebook.  But I am starting to believe that we are approaching a price point in which the risks investors take on its shares could be rewarded. 

I will be making assumptions about user growth for the next 5 years, and this is a fairly long time when we talk about companies like Facebook, where 3 to 6 months can make a big difference.  But here I go. 

ARPU - the key metric for Facebook investors
Average Revenue Per User (ARPU) is a key metric for examining Facebook as an investment case. It segregates the company's overall revenue growth into revenue per user and overall user intake, which makes it simpler to understand the company's revenue growth assumptions and the possible flaws involved.

ARPU declined in the first half of 2012, as Facebook took on board more users from Asia and the rest of the non-Western world.  For now, these users simply do not generate as much revenue as their Western counterparts. Looking at the right columns of Table 1 below, you can see that US and Canadian users have an ARPU level of USD 3.2, but the figure for Asia and "Rest of World" is only around USD 0.5!  

The table also shows that Facebook's worldwide ARPU trended higher until the end of 2011, and the declined from USD 1.38 to USD 1.21.  While it's great for Facebook to be increasing its user base, in the short term revenue will not grow proportionally to the intake of users. 

Looking ahead on ARPU
Overall there are some constraints on what we can expect from each region. GDP and the levels of disposable income in the US and Canada remain much higher than in Asia and the RoW, and despite growth in emerging markets, it would be unwise to project equal levels of ARPU just five years from now.  

My somewhat arbitrary target, then, is for Facebook to have Asian and RoW APRU of roughly 40% of US and Canadian levels by 2017. Facebook's Asian and RoW users are probably middle-class or above in order to have access to a smartphone or PC, so I have estimated their income levels as slightly higher than the average citizen in their countries. 

I'm also making an educated guess when I assume that ARPU in Europe will align with that in the US and Canada by 2017. There are many similarities betweeen Europe and its North American cousins, from culture to income and GDP, but Facebook's level of ARPU is only USD 1.43 in Europe vs USD 3.20 in the US and Canada. My expectation is that this will even out over the next five years.

Finally, US and Canadian ARPU is the anchor for the above trends (Asia, RoW and Europe) as they converge.  I have implemented a growth of 1% per quarter in the the US and Canadian ARPU, i.e. not much more than nominal GDP growth, as this seems a good benchmark.

The result:  I see Facebook's worldwide ARPU at about USD 2.47 five years from now - compared to USD 1.28 at the end of Q2 2012.  

Let's look at the numbers graphically.  In Chart 1 I have plotted both the historical development and the modelled numbers. From the top (light blue) you see the US and Canadian ARPU trending higher over the period. The European (dark grey) growth in ARPU becomes relatively aggressive as it trends up to the US and Canadian level. In the lower part of the chart we have Asia and RoW (light grey). Their ARPU trends higher towards the 40% level compared to the US and Canada. Overall this leads to the worldwide rise shown in red.

New Users
In table 2 you can see the growth in Monthly Average Users (MAU) over the past three years. Asia/RoW has become a very important area for Facebook. More than 55% of its users are now from these regions.

Moving forward I have taken a conservative stance on the uptake of new users from US and Canadian and Europe, as there is less room for development in these mature markets.  If Facebook does perform better, I will be positively surprised.  

Instead, I see MAU growth coming from Asia and RoW, as we have seen over the past several quarters. I have set the increase of users to 10m per quarter, which is also conservative.  If wealth increases in Asia and RoW, the potential numbers of users will increase too. 

All in al, I have taken a fairly conservative approach to Facebook's user and revenue growth going forward, but I'm more comfortable having less aggressive assumptions underlying my base scenario.

Taken together, all these conservative assumptions imply 1175m Facebook users five years from now. This is an astounding number, and could be overtaken fast if Facebook is able to keep up the pace from the last few years.

Graphically the increase of users looks like this - see Chart 2.

I'll write more on Monday about what the effects of ARPU and MAU numbers on the valuation of Facebook's shares. But to give you a taste of where I'm going with this: revenue was in USD 1,184m in Q2 2012. Even with relatively conservative assumptions – well that is my take on them – suggest that earnings of nearly USD 3 bn are in the cards for Q4 2017. For the full year 2017, revenues based on the assumptions are in the level of USD 11bn. More on these numbers in part 2 of this story.

Is this enough to make Facebook stock a solid investment?  It's hard to say.  I think there are reasons to become less skeptical about Facebook's business model, and in Part 2 I will take a look at Facebook's potential versus the risks.

On May 18, IPO investors in Facebook could only look into an abyss of risk.  Things are different now.

See my previous Facebook articles:

1. Questions you should ask before investing in Facebook
2. What is Facebook really worth
3. Hey Facebook we need more disclosure.
4. Facebook increasing user numbers..
5. Facebook IPO - Valuation pushed to the extreme
6. Facebook - even USD25 seems a stretch...
7. Apple - iOS6 and the implications for Google, Facebook...
8. Facebook - Relief rally but did the big picture really change
9. Facebook analysts agree on price disagree on revenue, net income.
10. The first flood of shares will be unlocked August 16th.