Facebook Inc FB (NAS) QQQ

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1 Facebook Reports Strong Top- and Bottom-Line Growth; Increasing FVE to $127; Shares Fairly Valued Updated Forecasts and Estimates from 23 Sep 2016 Ali Mogharabi Equity Analyst Important Disclosure The conduct of Morningstar's analysts is governed by Morningstar's Code of Ethics, Securities Trading and Disclosure Policy, and Investment Research Integrity Policy. For information regarding conflicts of interest, please click ningstar.com/us/equity-disclosures/ The primary analyst covering this company does not own its stock. Research as of 28 Jul 2016 Estimates as of 23 Sep 2016 Pricing data through 31 Oct 2016 Rating updated as of 31 Oct 2016 Currency amounts expressed with "$" are in U.S. dollars (USD) unless otherwise denoted. Contents Investment Thesis Morningstar Analysis Analyst Note Valuation, Growth and Profitability Scenario Analysis Economic Moat Moat Trend Bulls Say/Bears Say Financial Health Enterprise Risk Management & Ownership Analyst Note Archive Additional Information Morningstar Analyst Forecasts Comparable Company Analysis Methodology for Valuing Companies Investment Thesis 28 Jul 2016 Facebook is the largest social network in the world, with more than 1.6 billion monthly active users. The growth in users and user engagement, along with the valuable data that they generate, makes Facebook attractive to advertisers in the short and long term. The combination of these valuable assets and expected continuing growth in online advertising bode well for Facebook, as the firm generates strong top-line growth, remains cash flow positive, and profitable. Facebook has helped increase users and user engagement by providing additional features and apps to keep them engaged within the Facebook ecosystem. With more Facebook user interaction among friends and family members, sharing of videos and pictures, and the continuing expansion of the social graph, we believe more data is compiled, which is then used by Facebook and its advertising clients to launch online advertising campaigns targeting specific users. Growth in Facebook s average ad revenue per user, or ARPU, indicates advertisers' willingness to pay more for Facebook-placed ads, as they expect high return on investment from the targeted ads. We believe Facebook will continue to benefit from an increase in allocation of marketing and advertising dollars toward online advertising, more specifically mobile and social network ads where Facebook is especially well positioned. The firm s Facebook app, along with Instagram, Messenger, and WhatsApp are among the world s most widely used apps on both Android and iphone smartphones. Facebook is taking steps to further monetize its various apps, such as launching interactive video ads and chatbots. As usage of messaging apps on mobile devices continues to increase, the firm will be using bots within its Messenger app to place native ads and create brand interaction for users and brand names, possibly resulting in higher ROI for advertisers. The firm is also applying artificial intelligence and virtual and augmented reality technologies to various products, which may increase Facebook user engagement even further, helping to further generate attractive revenue growth from advertisers in the future. Vital Statistics Market Cap (USD Mil) 376, Week High (USD) Week Low (USD) Week Total Return % 28.5 YTD Total Return % 25.2 Last Fiscal Year End 31 Dec Yr Forward Revenue CAGR % Yr Forward EPS CAGR % 37.1 Price/Fair Value 1.03 Valuation Summary and Forecasts Fiscal Year: (E) 2017(E) Price/Earnings EV/EBITDA EV/EBIT Free Cash Flow Yield % Dividend Yield % Financial Summary and Forecasts (USD Mil) (E) 2017(E) Revenue 12,466 17,928 26,797 35,395 Revenue YoY % EBIT 4,994 6,225 11,179 14,357 EBIT YoY % Net Income, Adjusted 4,009 5,436 10,798 13,829 Net Income YoY % Diluted EPS Diluted EPS YoY % Free Cash Flow -3,433 2,919 5,994 8,920 Free Cash Flow YoY % Historical/forecast data sources are Morningstar Estimates and may reflect adjustments. Profile Fiscal Year: Facebook is the world s largest online social network, with more than 1.6 billion monthly active users. Users engage with each other in different ways, exchanging messages, and sharing news events, photos and videos. Its ecosystem consists mainly of the Facebook app, Instagram, Messenger, WhatsApp, and many features surrounding these products. Users can access Facebook on mobile devices and via desktop. Advertising revenue represents more than 90% of the firm s total revenue, with 50% coming from the U.S. and Canada, and 25% from Europe. Page 1 of 25

2 Morningstar Analysis Facebook Reports Strong Top- and Bottom-Line Growth; Increasing FVE to $127; Shares Fairly Valued 28 Jul 2016 Facebook s second-quarter results handily beat all expectations with strong ad revenue growth and user growth. The latest results validate our wide moat rating on Facebook, as it remains the market leader in the socialnetworking space and one of the leaders in the overall online ad market. The company expects deceleration in top-line growth during the second half of 2016 and possibly in 2017, for which we had already modeled. Given the much betterthan-expected performance in the quarter and our assumption of further operating margin expansion, we have adjusted our estimates upward, resulting in a fair value estimate of $127 per share, up from $120. Facebook shares were trading slightly above our latest fair value estimate in after-hours trading. Total advertising revenue grew 63% year over year to $6.2 billion, driven by 15% and 17% growth in monthly average users, or MAUs, and daily active users, or DAUs, respectively. Geographically, such growth in ad revenue was led by 69% year-over-year growth in the U.S. and Canada region. Asia was not far behind with a 67% growth rate. Facebook s mobile users increased by 20% from a year ago, driving mobile revenue higher to represent 84% of total ad revenue. Operating margin expansion was encouraging, along with higher gross margins, while operating expenses declined as a percentage of revenue. User engagement, which we calculate as DAU/MAU, continued to show strength as it increased nearly 100 basis points from second-quarter We think the strengthening of user engagement will increase barriers to exit. In addition, user engagement is an indicator of possibly higher return on investment, or ROI, for advertisers. It appears that advertisers recognized this and were willing to pay, as the overall average revenue per user increased 39% from last year. While Facebook surpassed all expectations once again, the company noted that top-line growth at the rates that we have seen recently may not continue, as the firm faces tougher comparables from the second half of In addition, in order to maintain the correct balance of user content and ads to not turn away the users, the company will likely no longer increase ad load, beginning in the third quarter of While this may affect revenue growth, we applaud such a move, as it is indicative of management s long-term strategy: keep increasing the user base and user interaction, further strengthening the network effect. In the meantime, the company continues to invest in livestreaming video content to attract more users and increase time spent on its ecosystem. This likely will help compile more user data through higher user interaction and engagement, which could result in sales of additional ad inventory at higher prices. Valuation, Growth and Profitability 28 Jul 2016 Our fair value estimate for Facebook is $127 per share, representing a fiscal 2017 enterprise value/ebitda multiple of 21. We have modeled strong top-line growth and margin expansion through Our projections represent a five-year compounded annual growth rate of 29% for total revenue and a five-year average operating margin of 43%. Facebook s revenue growth will be driven primarily by growth in online advertising and increasing allocation of online ad dollars toward mobile and social network ads. We expect 51% and 30% year-over-year total revenue growth for fiscal 2016 and fiscal 2017, representing total revenue of $26.8 billion and $35.4 billion, respectively. We have modeled lower gross margin after 2016 mainly due to higher future sales of Facebook s Oculus Rift hardware. We look for lower growth in operating expenses, combined with strong top-line growth to more than offset the decline in gross margin and expect ongoing operating leverage. Our fair value uncertainty rating for Facebook is high, based upon uncertainty around future advertising growth rates, which Page 2 of 25

3 resulting in much lower advertising revenue earned for Facebook. In this bearish scenario, we model a 14% five-year CAGR. In addition, Facebook would likely have to abandon its walled garden strategy, which could result in downward ad pricing pressure. While Facebook would have to increase research and development spending to enhance its offerings and spur revenue growth, we believe the firm also will be run a bit more tightly, limiting growth in sales and marketing and general and administrative expenses. For this reason, the five-year average operating margin in our bear-case model is 36%, which essentially accounts for no further operating leverage for the firm, as this average would be only 130 basis points higher than Facebook s operating margin in fiscal is virtually the company s sole source of revenue today. Scenario Analysis Rapid growth in online advertising, driven further by usage of more mobile devices and increasing revenue from video and chatbot ads, represent the main assumptions in our bull-case scenario, in which Facebook s total revenue would grow at a 35% five-year CAGR. In such a scenario, we also expect significant growth in revenue generated from Facebook s VR products. With higher top-line growth, Facebook would be well positioned to recognize more operating leverage mainly from much lower growth in sales and marketing and general and administrative expenses. We have assumed an average annual operating margin of 45% for the next five years in the bull-case scenario. For this scenario, our fair value estimate for Facebook is $172 per share. In a bear-case scenario, we estimate that Facebook would have a fair value of $63 per share. Such a scenario would take place if more non-facebook disruptive social-networking technologies, such as Snapchat, attract users and lead to slower growth in Facebook user base and user interaction, Economic Moat We assign Facebook a wide moat rating based on network effects around its massive user base and intangible assets consisting of a vast collection of data that users have shared on its various sites and apps. Given its ability to profitably monetize its network via advertising, we think it is more likely than not that Facebook will generate excess returns on capital over the next 20 years. Now that Facebook has emerged as the clear-cut social media leader, we believe that the company s offerings, consisting mainly of Facebook, Instagram, Messenger, and WhatsApp, have further strengthened network effects for the firm, where all of these platforms become more valuable to its users as people both join the networks and use these services. These network effects serve to both create barriers to success for new social network upstarts, as well as barriers to exit for existing users who might leave behind friends, contacts, pictures, memories, and more by departing to alternate platforms. Launched in February 2004, Facebook initially targeted college students and expanded via s and word of mouth. With more requirements in order to register on the Page 3 of 25

4 site, we think that most users felt safer to engage with other users from their schools and from other schools, than they did on other early social network websites like MySpace. In addition, the flexibility of choosing which other users would have access to one's profile attracted more users and increased user engagement, which resulted in users spending more time on Facebook and, in turn, an early establishment of a network effect. At the end of first-quarter 2016, Facebook had nearly 1.6 billion monthly active users. Today, we see that Facebook, Instagram, Messenger, and the different features and apps surrounding them have increased user engagement on various devices. Facebook also is slowly becoming an entertainment hub, which helps increase engagement and user time spent on Facebook. The users are posting more videos and using the Live Video app to provide a live video feed from where they are at a certain point in time. Additional apps created by developers on the Facebook platform also help maintain users within the Facebook ecosystem. On average, users are on Facebook and its different apps approximately 50 minutes per day (compared with 40 minutes in 2014) posting photos, exchanging messages, making comments, uploading content, liking or disliking other content, and more. This demonstrates the value of the platform to users, and its network effect for the firm. Outside of network effects, we also believe that Facebook has developed additional intangible assets. Unlike any other online platform in the world, Facebook has accumulated data about each individual with a Facebook and/or an Instagram account. Facebook has its users demographic information. It knows what and who they like and dislike. It knows what topics and/or news events are of interest to them. In addition, without the need for cookies enabled on desktop or mobile browsers, and based on the Facebook Login, the firm knows its users browsing history on many non-facebook sites or apps. With access to such data and to billions of photos and videos uploaded by its users, Facebook continues to enhance the social network by offering even more relevant content to its users. This virtuous cycle further increases the value of its data asset, which only Facebook and its advertising partners can monetize. In our opinion, with this type of information about each one of its more than 1.6 billion monthly active users, Facebook provides unique and attractive advertising opportunities for advertisers and businesses, which will allow the firm to generate excess returns on capital over time. Facebook monetizes such information only by using it to increase the effectiveness of its advertisers ads. The company does not sell the data to ad-tech companies nor to other third parties. The value of such data and advertisers willingness to use it is demonstrated by the 25% average annual growth of Facebook s average ad revenue per user, or ARPU, during the past five years, which we view as indicative of the price that advertisers pay Facebook for ad placement. During the same period, Facebook s monthly average users have grown 21% annually. Facebook s large and growing user base and the rich data that it generates help advertisers post more effective target ads, in terms of brand awareness, resulting in high return on investment, or ROI. With higher ROI, more advertisers jump onboard allowing Facebook to further monetize the network. The company continues to take steps to improve the monetization of its network. Through its Audience Network (launched in 2014), Facebook allows advertisers to target its users anywhere within the Facebook ecosystem, whether they are on mobile apps, mobile sites, reading Instant Articles, or watching videos. The company also recently enhanced the Audience Network so that advertisers can show the same ads to non-facebook users. Page 4 of 25

5 Morningstar Analysis In our view, Facebook will also continue to grow its user base in the expanding mobile market, positively affecting the network effect as it becomes more valuable to advertisers, which will result in more ad revenue growth. The main driver behind growth in online advertising has been growth in the mobile ad market. Facebook is well positioned, as its users are accessing Facebook and its apps more via mobile devices. Facebook s monthly mobile active users have been increasing more than 42% annually during the past five years. While smartphone users in the U.S. spend more time on social-networking applications, and more time on Facebook than any other social-networking application, users around the world spend more time on messaging apps; through bots, Facebook views this as a monetizing opportunity. The firm is using bots within its Messenger app to place native ads and create brand interaction for users and brand names. The chatbots provide users opportunities to visit or revisit a site (remarketing), open an app, and/or make a purchase right away. Other features, such as sending money and receiving money, in addition to ordering Uber pickups, have already been added to Facebook s Messenger. By working with advertisers, Facebook is also adding a similar click-and-buy feature to video ads, where viewers can click on a product they like within the video and get more information about it or purchase it. In the long run, we believe these strategies can further strengthen Facebook s network effect, driven by growth in user base (mainly mobile) and user time spent on the platform, and businesses having more options on how to market their brands and products. its owned platforms may cause some friction for users. Facebook users today would lose data, such as posts, pictures, video clips, contact information, their nearly one hour per day interaction with other users, and much more. Even though many users access more than one social network per day, it does not appear to be at the cost of declining users or user engagements within the Facebook ecosystem. The Facebook Login may also supply modest switching costs, as users may otherwise need to spend more time registering on websites. Moat Trend While Facebook continues to battle Alphabet for the bigger piece of the growing online ad market, we do not see long-term threats to Facebook s sources of economic moat--intangible assets, network effect, and switching costs--that would preclude us from assigning a stable rating for the company s moat trend. The company s network effect continues to strengthen as more users sign up to Facebook and its other apps, and as usage time and user engagement continue growing. This leads to the generation and collection of more user data, continuing the virtuous cycle. Facebook has continued to take steps to remain competitive in the online ad market and to maintain its position as the number-one social network in the world. Its recent extension of the Audience Network will allow it to challenge Alphabet s Google more effectively when targeting non-facebook users. The firm is also going at Alphabet via the launch of its interactive video ads, which Google s YouTube already has. While not a primary source of moat, we also think that Facebook benefits from modest customer switching costs. Although it is easy for customers to sign up and use alternative platforms like Snapchat, departing Facebook and At the same time, Facebook is focusing more on the fastest-growing portion of the online ad market, the mobile ad market. It is implementing more chatbot ads through its Messenger app. The firm faces increasing competition in Page 5 of 25

6 Morningstar Analysis chatbot-like advertising. They include Alphabet s Google, Snapchat, and China s WeChat. While content on Snapchat s Discover does not resemble native advertising, Snapchat does receive fees (based on views) from media publishers wanting their content on the social network company s messenger app. Similar to native ads in Facebook s News Feeds, businesses pay Snapchat to be included in its Stories for Snapchat friends to see and possibly click on. Facebook s recently announced plan to shut down its ad exchange, FBX, is another indication of the company s increasing focus on the mobile ad market. On the pricing front, it appears that advertisers are willing to pay more to advertise on Facebook when compared with what Google is receiving. While Facebook s ARPU has been growing, Google s cost per click has been declining. However, Google s lower CPC has been more than offset by higher volume of ads. Going forward, as Facebook attempts to target non-facebook users with its ads. We believe that advertisers likely will keep paying more for ads targeting Facebook users. However, as the company likely will go head-to-head against Google outside of the Facebook ecosystem, advertisers will pay lower prices for ads targeting non-facebook users. places they like to travel to, what types of fashion they like, and more. Facebook s intangible assets around virtual reality could be expanding, via the 2014 $2 billion acquisition of Oculus. The company launched its first VR headset, Oculus Rift, powered by the Oculus VR operating system in early Facebook is also licensing the Oculus OS to Samsung, which makes the Gear VR headsets to be used with its smartphones. The firm is initially targeting the hardcore gamer market with its VR technology, from which we estimate the top four players--facebook, Sony, HTC, and Samsung--can generate nearly $12 billion combined revenue by In the future, we expect Facebook to also focus on augmented reality, which can be used in various industrial and professional apps. The launch of Oculus Rift will likely attract more users, mainly hardcore gamers, to the Facebook ecosystem. Over time, we expect other types of content to attract more users to Facebook s virtual and augmented reality products, further expanding the company s overall social network user base. Finally, Facebook is also using artificial intelligence and virtual and augmented reality technologies, which could generate attractive returns in the future. With regards to AI, Facebook s Moments app is using facial-recognition AI technology-based suggested tags to ease the process of sharing photos on its users ios and Android powered smartphones. Such technology may also increase the value of Facebook s data assets, as information extracted from photos not only provides more color regarding with whom Facebook users interact and are likely to interact, but it could also provide more clarity about the activities in which the users like to participate, different Page 6 of 25

7 Bulls Say/Bears Say Bulls Say 3 With more users and usage time than any other social network, Facebook provides the largest audience and the most valuable data for social network online advertising. 3 Facebook s ad revenue per user is growing, demonstrating the value that advertisers see in working with the firm. 3 The application of AI technology to Facebook s various offerings, along with the launch of VR products such as the Oculus Rift, will increase user engagement, driving further growth in advertising revenue. Bears Say 3 Facebook is currently a one-trick pony and will be affected severely if online advertising no longer grows or if more advertising dollars shift to others like Google or Snapchat. 3 Despite rapid user growth, many of Facebook s customers may also belong to other social networks, such as Snapchat, so the firm will continually have to fight to capture a user s time and engagement with Facebook s properties. 3 Regulations could emerge that limit the application and collection of user and usage data, which could minimize the value of Facebook s aggregated data. Page 7 of 25

8 Five Year Adjusted Cash Flow Forecast (USD Mil) 2016(E) 2017(E) 2018(E) 2019(E) 2020(E) Cash and Equivalents (beginning of period) 18,434 28,925 42,156 59,466 81,133 Adjusted Available Cash Flow 13,902 13,341 17,420 21,866 25,752 Total Cash Available before Debt Service 32,336 42,266 59,576 81, ,885 Principal Payments Interest Payments Other Cash Obligations and Commitments Total Cash Obligations and Commitments Cumulative Annual Cash Flow Cushion Cash Flow Cushion Possible Liquidity Need Adjusted Cash Flow Summary % of USD Millions Commitments Beginning Cash Balance 18,434 1,771.9 Sum of 5-Year Adjusted Free Cash Flow 92,281 8,870.3 Sum of Cash and 5-Year Cash Generation 110,715 10,642.2 Revolver Availability Asset Adjusted Borrowings (Repayment) Sum of Cash, 5-Year Cash Generation, Revolver and Adjustments 110,715 10,642.2 Sum of 5-Year Cash Commitments -1,040 Financial Health In an industry where continuing investments are required to remain competitive and maintain market leadership, we believe Facebook is well positioned in terms of access to capital. Facebook has a very strong balance sheet with more than $20 billion in cash, cash equivalents, and marketable securities, and no debt. The firm generated $8.6 billion cash from operations in 2015, up 58% from While such a growth rate will not be maintained, we believe average growth in cash during the next five years will outpace growth in revenue, owing to operating leverage from slower-growing operating expenses. Facebook s strong operational and financial health is demonstrated by the 26% average free cash flow to equity/revenue, or FCFE/sales, during the past five years. We project average annual FCFE/sales to increase to 35% through 2020, as a result of top-line growth and operating margin expansion. We do not expect Facebook to issue a dividend as the firm remains in a rapid growth phase. The firm may use some portion of its cash, as it remains active on the merger and acquisition front. Enterprise Risk In terms of risks, we believe that while barriers to exit for the more than 1.6 billion users may be increasing, the risk of another disruptive and innovative technology coming on to the scene and luring users away from Facebook and its apps remains. We do not expect competition in the form of a substitute for Facebook, as most consumers are users of more than one social network. However, given the fixed number of hours per day, an increase usage and engagement on one social network could come at a cost to other social networks, reducing user engagement and the potential return on investment for advertisers. Decline in ads would hurt Facebook s top and bottom line, reducing return on invested capital and the firm s fair value. Furthermore, even with Facebook s dominant position in the social network market, its high dependence on continuing growth of online Page 8 of 25

9 advertising could heighten the negative impact of a downturn in online ad spending on the company, resulting in a much lower fair value estimate.the risk remains that limitations could be imposed by regulatory agencies around the world on what user and usage data Facebook can compile and how the data can be utilized. In addition, some governments may simply forbid access to Facebook, which could result in lower user growth and user interaction. Page 9 of 25

10 Management & Ownership Management Activity Name Position Shares Held Report Date* InsiderActivity MS. SHERYL K. Director 4,007, Oct ,376,441 SANDBERG MR. JAN KOUM Director 2,576, Nov ,442,674 MR. MICHAEL 679, Oct ,500 SCHROEPFER CHRISTOPHER K. COX 397, Oct ,496 MR. DAVID B. FISCHER 159, Oct ,371 JAS ATHWAL 110, Aug ,433 MR. REED HASTINGS Director 83, May 2016 COLIN STRETCH 82, Oct ,614 *Represents the date on which the owner s name, position, and common shares held were reported by the holder or issuer. Fund Ownership Top Owners % of Shares Held % of Fund Assets Change (k) Portfolio Date Fidelity Contrafund Fund Sep 2016 Vanguard Total Stock Mkt Idx , Sep 2016 Vanguard 500 Index Fund Sep 2016 Vanguard Institutional Index Fund Sep 2016 SPDR S&P 500 ETF Oct 2016 Concentrated Holders Biondo Focus Fund Aug 2016 Fidelity Advisor World Equity Growth Fd Nov 2015 TongYang Global IPO New Stock Master Eq Jul 2016 The Investment House Growth Aug 2016 Morgan Stanley Inst Opportunity Port Jun 2016 Institutional Transactions % of Shares Held % of Fund Assets Shares Bought/ Sold (k) Top 5 Buyers Portfolio Date Government Pension Fund of Norway - Global , Dec 2013 Capital World Investors , Jun 2016 D. E. Shaw & Co LP , Jun 2016 UBS Asset Mgmt Americas Inc , Jun 2016 Arrowstreet Capital Limited Partnership , Jun 2016 Top 5 Sellers Royal London Asset Management Ltd , Jun 2016 MFS Investment Management KK , Sep 2016 Fidelity Management and Research Company , Jun 2016 Jennison Associates LLC , Jun 2016 J.P. Morgan Investment Management Inc , Jun 2016 Management 28 Jul 2016 We assign a stewardship rating of Standard to Facebook s management. Through various acquisitions, such as WhatsApp and Instagram, the firm s management team--and more specifically, its founder and current CEO Mark Zuckerberg--have demonstrated their focus on long-term return on investments, which we view as a positive. With the large amount of cash and cash equivalents, along with no debt, the company is well positioned to make additional investments in the form of acquisitions or more research and development. We expect the firm to continue to make decisions regarding capital allocation that are beneficial for its social network users and its shareholders. We also applaud management s walled garden strategy as it continues to protect the firm s most valuable asset, its user and usage data. Sheryl Sandberg is another member of the company s management team and serves as Facebook s COO, having joined Facebook in Prior to that, she was Google s VP of Global Online Sales and Operations for nearly seven years. Our main knock on Facebook s management is its use of multiple class structures that may limit the voice of minority shareholders. Facebook is proposing a Class C capital stock offering in the form of stock dividend for current Class A and Class B shareholders, mainly to preserve Zuckerberg s more than 53% voting interest. Class C shares will not have any voting rights and it appears that they will be used mainly as share-based compensation at the firm. If such plan is approved by shareholders, it may result in significant conflict of interest depending on Zuckerberg s future strategies and whether they generate exceptional returns for shareholders, as they have in the past. Page 10 of 25

11 Analyst Notes Facebook Reports Strong Top- and Bottom-Line Growth; Increasing FVE to $127; Shares Fairly Valued 28 Jul 2016 Facebook s second-quarter results handily beat all expectations with strong ad revenue growth and user growth. The latest results validate our wide moat rating on Facebook, as it remains the market leader in the socialnetworking space and one of the leaders in the overall online ad market. The company expects deceleration in top-line growth during the second half of 2016 and possibly in 2017, for which we had already modeled. Given the much betterthan-expected performance in the quarter and our assumption of further operating margin expansion, we have adjusted our estimates upward, resulting in a fair value estimate of $127 per share, up from $120. Facebook shares were trading slightly above our latest fair value estimate in after-hours trading. Total advertising revenue grew 63% year over year to $6.2 billion, driven by 15% and 17% growth in monthly average users, or MAUs, and daily active users, or DAUs, respectively. Geographically, such growth in ad revenue was led by 69% year-over-year growth in the U.S. and Canada region. Asia was not far behind with a 67% growth rate. Facebook s mobile users increased by 20% from a year ago, driving mobile revenue higher to represent 84% of total ad revenue. Operating margin expansion was encouraging, along with higher gross margins, while operating expenses declined as a percentage of revenue. While Facebook surpassed all expectations once again, the company noted that top-line growth at the rates that we have seen recently may not continue, as the firm faces tougher comparables from the second half of In addition, in order to maintain the correct balance of user content and ads to not turn away the users, the company will likely no longer increase ad load, beginning in the third quarter of While this may affect revenue growth, we applaud such a move, as it is indicative of management s long-term strategy: keep increasing the user base and user interaction, further strengthening the network effect. In the meantime, the company continues to invest in livestreaming video content to attract more users and increase time spent on its ecosystem. This likely will help compile more user data through higher user interaction and engagement, which could result in sales of additional ad inventory at higher prices. Relaunching Coverage of Facebook With Wide Economic Moat, Stable Trend, and FVE of $ Jun 2016 We are relaunching coverage of Facebook with a wide economic moat rating and a fair value estimate of $120. Facebook s wide moat is based on network effects around its large user base and intangible assets consisting of a vast collection of data that users share on its various apps. While we remain confident in Facebook s wide moat and stable moat trend, we recommend a wider margin of safety before investing. User engagement, which we calculate as DAU/MAU, continued to show strength as it increased nearly 100 basis points from second-quarter We think the strengthening of user engagement will increase barriers to exit. In addition, user engagement is an indicator of possibly higher return on investment, or ROI, for advertisers. It appears that advertisers recognized this and were willing to pay, as the overall average revenue per user increased 39% from last year. Facebook is the largest social network in the world, with more than 1.6 billion monthly active users. The growth in users and user engagement, along with the valuable data that they generate, makes Facebook attractive to advertisers. The combination of these valuable assets and expected continuing growth in online advertising bodes well for Facebook, as the firm generates strong top-line growth, remains cash flow positive, and profitable. Page 11 of 25

12 Analyst Notes Facebook has helped increase users and user interaction by providing additional features and apps to keep them engaged within the its ecosystem. With more Facebook user engagement, more data is compiled and used by Facebook and its advertising clients to launch online advertising campaigns targeting specific users. We believe Facebook will continue to benefit from an increase in allocation of marketing and advertising dollars towards online advertising, more specifically mobile and social network ads where Facebook is well positioned. The firm s Facebook app, along with Instagram, Messenger, and WhatsApp are among the world s most widely used apps on both Android and iphone smartphones. Facebook is taking steps to further monetize its various apps such as launching interactive video ads and chatbots. The firm is also applying artificial intelligence and virtual and augmented reality technologies to various products, which may increase Facebook user engagement even further, helping to further generate attractive revenue growth from advertisers in the future. Page 12 of 25

13 Morningstar Analyst Forecasts Financial Summary and Forecasts Fiscal Year Ends in December Forecast 3-Year Hist. CAGR Year Proj. CAGR Growth (% YoY) Revenue EBIT EBITDA Net Income Diluted EPS Earnings Before Interest, after Tax -6, Free Cash Flow Profitability 3-Year Hist. Avg Year Proj. Avg Operating Margin % EBITDA Margin % Net Margin % Free Cash Flow Margin % ROIC % Adjusted ROIC % Return on Assets % Return on Equity % Leverage 3-Year Hist. Avg Year Proj. Avg Debt/Capital Total Debt/EBITDA EBITDA/Interest Expense Valuation Summary and Forecasts (E) 2017(E) Price/Fair Value Price/Earnings EV/EBITDA EV/EBIT Free Cash Flow Yield % Dividend Yield % Key Valuation Drivers Cost of Equity % 9.0 Pre-Tax Cost of Debt % 5.5 Weighted Average Cost of Capital % 9.0 Long-Run Tax Rate % 22.0 Stage II EBI Growth Rate % 7.9 Stage II Investment Rate % 31.0 Perpetuity Year 20 Additional estimates and scenarios available for download at Discounted Cash Flow Valuation USD Mil Firm Value (%) Per Share Value Present Value Stage I 45, Present Value Stage II 135, Present Value Stage III 146, Total Firm Value 328, Cash and Equivalents 18, Debt Preferred Stock Other Adjustments 4, Equity Value 350, Projected Diluted Shares 2,937 Fair Value per Share (USD) The data in the table above represent base-case forecasts in the company s reporting currency as of the beginning of the current year. Our fair value estimate may differ from the equity value per share shown above due to our time value of money adjustment and in cases where probability-weighted scenario analysis is performed. Page 13 of 25

14 Morningstar Analyst Forecasts Income Statement (USD Mil) Fiscal Year Ends in December Forecast Revenue 7,872 12,466 17,928 26,797 35,395 Cost of Goods Sold 1,875 2,153 2,867 3,913 5,570 Gross Profit 5,997 10,313 15,061 22,885 29,825 Selling, General & Administrative Expenses 1,778 2,653 4,020 5,499 7,433 Research & Development 1,415 2,666 4,816 6,206 8,035 Other Operating Expense (Income) Depreciation & Amortization (if reported separately) Operating Income (ex charges) 2,804 4,994 6,225 11,179 14,357 Restructuring & Other Cash Charges Impairment Charges (if reported separately) Other Non-Cash (Income)/Charges Operating Income (incl charges) 2,804 4,994 6,225 11,179 14,357 Interest Expense Interest Income Pre-Tax Income 2,754 4,910 6,182 11,271 14,435 Income Tax Expense 1,254 1,970 2,506 2,940 3,753 Other After-Tax Cash Gains (Losses) Other After-Tax Non-Cash Gains (Losses) (Minority Interest) (Preferred Dividends) Net Income 1,500 2,940 3,676 8,331 10,682 Weighted Average Diluted Shares Outstanding 2,517 2,664 2,853 2,904 2,904 Diluted Earnings Per Share Adjusted Net Income 1,993 4,009 5,436 10,798 13,829 Diluted Earnings Per Share (Adjusted) Dividends Per Common Share EBITDA 3,815 6,237 8,170 13,405 17,075 Adjusted EBITDA 3,815 6,237 8,170 13,405 17,075 Page 14 of 25

15 Morningstar Analyst Forecasts Balance Sheet (USD Mil) Fiscal Year Ends in December Forecast Cash and Equivalents 11,449 11,199 18,434 28,925 42,156 Investments Accounts Receivable 1,109 1,678 2,559 4,020 5,309 Inventory Deferred Tax Assets (Current) Other Short Term Assets ,392 Current Assets 13,070 13,670 21,652 33,923 48,858 Net Property Plant, and Equipment 2,882 3,967 5,687 8,698 11,265 Goodwill ,981 18,026 18,063 18,063 Other Intangibles 883 3,929 3,246 2,508 1,825 Deferred Tax Assets (Long-Term) Other Long-Term Operating Assets ,148 1,492 Long-Term Non-Operating Assets Total Assets 17,895 40,184 49,407 64,340 81,502 Accounts Payable Short-Term Debt Deferred Tax Liabilities (Current) Other Short-Term Liabilities 1,013 1,248 1,729 2,322 3,152 Current Liabilities 1,100 1,424 1,925 2,596 3,542 Long-Term Debt Deferred Tax Liabilities (Long-Term) Other Long-Term Operating Liabilities 1,325 2,664 3,264 4,766 6,048 Long-Term Non-Operating Liabilities Total Liabilities 2,425 4,088 5,189 7,362 9,589 Preferred Stock Common Stock Additional Paid-in Capital 12,297 30,225 34,886 39,234 43,487 Retained Earnings (Deficit) 3,159 6,099 9,787 18,118 28,800 (Treasury Stock) Other Equity Shareholder's Equity 15,470 36,096 44,218 56,978 71,913 Minority Interest Total Equity 15,470 36,096 44,218 56,978 71,913 Page 15 of 25

16 Morningstar Analyst Forecasts Cash Flow (USD Mil) Fiscal Year Ends in December Forecast Net Income 1,500 2,940 3,688 8,331 10,682 Depreciation ,215 1,488 2,034 Amortization Stock-Based Compensation 906 1,786 2,960 3,338 4,254 Impairment of Goodwill -17 Impairment of Other Intangibles Deferred Taxes Other Non-Cash Adjustments (Increase) Decrease in Accounts Receivable ,461-1,290 (Increase) Decrease in Inventory Change in Other Short-Term Assets Increase (Decrease) in Accounts Payable Change in Other Short-Term Liabilities , Cash From Operations 4,222 5,457 8,599 12,768 16,895 (Capital Expenditures) -1,362-1,831-2,523-4,499-4,601 Net (Acquisitions), Asset Sales, and Disposals , Net Sales (Purchases) of Investments ,241-6,700 Other Investing Cash Flows , Cash From Investing -2,624-5,913-9,434-3,368-3,664 Common Stock Issuance (or Repurchase) ,348 4,254 Common Stock (Dividends) Short-Term Debt Issuance (or Retirement) Long-Term Debt Issuance (or Retirement) -1,500 Other Financing Cash Flows 218 1,626 1,602-3,338-4,254 Cash From Financing ,571 1,582 1,010 Exchange Rates, Discontinued Ops, etc. (net) Net Change in Cash ,491 13,231 Page 16 of 25

17 Comparable Company Analysis These companies are chosen by the analyst and the data are shown by nearest calendar year in descending market capitalization order. Valuation Analysis Company/Ticker Price/Earnings EV/EBITDA Price/Free Cash Flow Price/Book Price/Sales Price/Fair Value (E) 2017(E) (E) 2017(E) (E) 2017(E) (E) 2017(E) (E) 2017(E) Alphabet Inc GOOGL USA Yahoo! Inc YHOO USA NM NM Groupon Inc GRPN USA Average Facebook Inc FB US Returns Analysis ROIC % Adjusted ROIC % Return on Equity % Return on Assets % Dividend Yield % Last Historical Year Company/Ticker Total Assets (Mil) (E) 2017(E) (E) 2017(E) (E) 2017(E) (E) 2017(E) (E) 2017(E) Alphabet Inc GOOGL USA 147,461 USD Yahoo! Inc YHOO USA 45,204 USD Groupon Inc GRPN USA 1,796 USD Average Facebook Inc FB US 49,407 USD Growth Analysis Revenue Growth % EBIT Growth % EPS Growth % Free Cash Flow Growth % Dividend/Share Growth % Last Historical Year Company/Ticker Revenue (Mil) (E) 2017(E) (E) 2017(E) (E) 2017(E) (E) 2017(E) (E) 2017(E) Alphabet Inc GOOGL USA 74,989 USD Yahoo! Inc YHOO USA 4,968 USD Groupon Inc GRPN USA 3,120 USD Average Facebook Inc FB US 17,928 USD Page 17 of 25

18 Comparable Company Analysis These companies are chosen by the analyst and the data are shown by nearest calendar year in descending market capitalization order. Profitability Analysis Gross Margin % EBITDA Margin % Operating Margin % Net Margin % Free Cash Flow Margin % Last Historical Year Company/Ticker Net Income (Mil) (E) 2017(E) (E) 2017(E) (E) 2017(E) (E) 2017(E) (E) 2017(E) Alphabet Inc GOOGL USA 21,307 USD Yahoo! Inc YHOO USA 274 USD Groupon Inc GRPN USA 36 USD Average Facebook Inc FB US 5,436 USD Leverage Analysis Debt/Equity % Debt/Total Cap % EBITDA/Interest Exp. Total Debt/EBITDA Assets/Equity Last Historical Year Company/Ticker Total Debt (Mil) (E) 2017(E) (E) 2017(E) (E) 2017(E) (E) 2017(E) (E) 2017(E) Alphabet Inc GOOGL USA 5,220 USD Yahoo! Inc YHOO USA 1,233 USD Groupon Inc GRPN USA USD Average Facebook Inc FB US USD Liquidity Analysis Company/Ticker Cash per Share Current Ratio Quick Ratio Cash/Short-Term Debt Payout Ratio % Market Cap (Mil) (E) 2017(E) (E) 2017(E) (E) 2017(E) (E) 2017(E) (E) 2017(E) Alphabet Inc GOOGL USA 556,623 USD Yahoo! Inc YHOO USA 39,547 USD Groupon Inc GRPN USA 2,289 USD Average Facebook Inc FB US 376,159 USD Page 18 of 25

19 Research Methodology for Valuing Companies Overview At the heart of our valuation system is a detailed projection of a company s future cash flows, resulting from our analysts research. Analysts create custom industry and company assumptions to feed income statement, balance sheet, and capital investment assumptions into our globally standardized, proprietary discounted cash flow, or DCF, modeling templates. We use scenario analysis, in-depth competitive advantage analysis, and a variety of other analytical tools to augment this process. Moreover, we think analyzing valuation through discounted cash flows presents a better lens for viewing cyclical companies, high-growth firms, businesses with finite lives (e.g., mines), or companies expected to generate negative earnings over the next few years. That said, we don t dismiss multiples altogether but rather use them as supporting cross-checks for our DCF-based fair value estimates. We also acknowledge that DCF models offer their own challenges (including a potential proliferation of estimated inputs and the possibility that the method may miss short-term market-price movements), but we believe these negatives are mitigated by deep analysis and our long-term approach. Morningstar, Inc. and its affiliates ( Morningstar, we, our ) believes that a company s intrinsic worth results from the future cash flows it can generate. The Morningstar Rating for stocks identifies stocks trading at a discount or premium to their intrinsic worth or fair value estimate, in Morningstar terminology. Five-star stocks sell for the biggest risk-adjusted discount to their fair values, whereas 1-star stocks trade at premiums to their intrinsic worth. Four key components drive the Morningstar rating: (1) our assessment of the firm s economic moat, (2) our estimate of the stock s fair value, (3) our uncertainty around that fair value estimate Morningstar Research Methodology for Valuing Companies Economic Moat Financial Health Stewardship Uncertainty Moat Trend Morningstar Fair Value and (4) the current market price. This process ultimately culminates in our single-point star rating. 1. Economic Moat The concept of an economic moat plays a vital role not only in our qualitative assessment of a firm s long-term investment potential, but also in the actual calculation of our fair value estimates. An economic moat is a structural feature that allows a firm to sustain excess profits over a long period of time. We define economic profits as returns on invested capital (or ROIC) over and above our estimate of a firm s cost of capital, or weighted average cost of capital (or WACC). Without a moat, profits are more susceptible to competition. We have identified five sources of economic moats: intangible assets, switching costs, network effect, cost advantage, and efficient scale. Companies with a narrow moat are those we believe are more likely than not to achieve normalized excess returns for at least the next 10 years. Wide-moat companies are those in which we have very high confidence that excess returns will remain for 10 years, with excess returns more likely than not to remain for at least 20 years. The longer a firm generates economic profits, the higher its intrinsic value. We believe lowquality, no-moat companies will see their normalized returns gravitate toward the firm s cost of capital more quickly than companies with moats. To assess the sustainability of excess profits, analysts perform ongoing assessments of the moat trend. A firm s moat trend is positive in cases where we think its sources of competitive advantage are growing stronger; stable where we don t anticipate changes to competitive advantages over the next several years; or negative when we see signs of deterioration. 2. Estimated Fair Value Combining our analysts financial forecasts with the firm s economic moat helps us assess how long returns on invested capital are likely to exceed the firm s cost of Margin of Safety Market Pricing Morningstar Rating TM For Stocks QQQQQ capital. Returns of firms with a wide economic moat rating are assumed to fade to the perpetuity period over a longer period of time than the returns of narrow-moat firms, and both will fade slower than no-moat firms, increasing our estimate of their intrinsic value. Our model is divided into three distinct stages: Stage I: Explicit Forecast In this stage, which can last five to 10 years, analysts make full financial statement forecasts, including items such as revenue, profit margins, tax rates, changes in working-capital accounts, and capital spending. Based on these projections, we calculate earnings before interest, after taxes (EBI) and the net new investment (NNI) to derive our annual free cash flow forecast. Stage II: Fade The second stage of our model is the period it will take the company s return on new invested capital the return on capital of the next dollar invested ( RONIC ) to decline (or rise) to its cost of capital. During the Stage II period, we use a formula to approximate cash flows in lieu of explicitly modeling the income statement, balance sheet, and cash flow statement as we do in Stage I. The length of the second stage depends on the strength of the company s economic moat. We forecast this period to last anywhere from one year (for companies with no economic moat) to years or more (for wide-moat companies). During this period, cash flows are forecast using four assumptions: an average growth rate for EBI over the period, a normalized investment rate, average return on new invested capital (RONIC), and the number of years until perpetuity, when excess returns cease. The investment rate and return on new invested capital decline until a perpetuity value is calculated. In the case of firms that do not earn their cost of capital, we assume marginal ROICs rise to the firm s cost of capital (usually attributable to less reinvestment), and we may truncate the second stage. Stage III: Perpetuity Once a company s marginal ROIC hits its cost of capital, we calculate a continuing value, using a standard perpetuity formula. At perpetuity, we assume that any growth or decline or investment in the business neither creates nor destroys value and that any new investment provides a return in line with estimated WACC. Because a dollar earned today is worth more than a dollar earned tomorrow, we discount our projections of cash flows in stages I, II, and III to arrive at a total All Rights Reserved. Unless otherwise provided in a separate agreement, you may use this report only in the country in which its original distributor is based. The information, data, analyses and opinions presented herein do not constitute Page 19 of 25