Is Facebook Finally A Buy After The Tech Rout?

January 27, 2019

Introduction:

 

Is Facebook (FB) finally de-risked after its self-inflicted data misuse privacy scandal and the rout in the technology sector? Facebook has been mired in privacy scandals, public relations mismanagement and a very public exodus of many high-level departures across the company. If this wasn’t bad enough, Facebook totally dropped the ball on its second quarter conference call, wiping out $119 billion in market capitalization in a single session marking the worst one day drop for any large cap company in history. This negative backdrop was met with a technology sell-off in the fourth quarter of 2018 culminating into the perfect set-up to knock the stock into bear market territory. Facebook sold-off during these two waves from $218 in July to a low of $123 in December of 2018, logging a 43% decline over this five month period. Despite the aforementioned stock implosion, Facebook remains one of the most compelling large cap growth companies posting double digit growth with P/E and PEG ratios well below its peers. Recently, JPMorgan reiterated Facebook as a “best idea” and expects the stock reach $195 and “climb the wall of worry”. Baird also came out with an outperform rating basing its target of $195 on stabilizing engagement on its Facebook platform and growth in its Instagram property. Facebook has grown its revenues by over 30% for 20 consecutive quarters with its latest quarter coming in at 33% revenue growth. As this revenue streak continues coupled with the dramatic decline in its stock and cheap valuation, I think Facebook is de-risked. The technology cohort has started to show signs of resurgence with Facebook and Netflix (NFLX) leading the pack with plenty of upside for the former.    

 

2018 Disaster:

 

Ancillary fallout emanating from its data misuse scandal involving Cambridge Analytica continued to surface throughout 2018 across the globe in various regions. Security issues affecting 50 million accounts, lawsuit alleging concealing video ad measurements and increasing EU scrutiny plagued the stock. The original mishandling user data resulted in the stock tumbling from $195 to $152 or ~20% at the time. Facebook appreciated off those data misuse lows and broke out to $220 however this scenario ended abruptly on the heels of its Q2 earnings. Facebook issued a major guide down in growth for the next few quarters tampering growth expectations in the near term. Facebook faced a challenging confluence of slowing revenue growth, margin compression and stagnant daily active users in the near to intermediate term. There was an initiative that had the backing of four large institutional investors to remove Mark Zuckerberg as Facebook’s chairman in the wake of all of these security issues.

 

Facebook has inflicted continued damage on its reputation and trust as subsequent data related issues became public. Emanating from these issues, many notable personnel have departed from the company. A total 10 high-level executives have departed the company in 2018. Jan Koum, co-founder of WhatsApp, Elliot Schrage, head of communications and public policy, Colin Stretch, Facebook's top lawyer, Alex Stamos, chief security officer, Dan Rose, vice president of partnerships, Rachel Whetstone, a top communications executive, Alex Hardiman, head of news products, Kevin Systrom and Mike Krieger, the co-founders of Instagram and finally Brendan Iribe, the former CEO and co-founder of Oculus. All these exits cap 2018 that witnessed several issues related to user privacy, data security and misinformation scandals.

 

 

Despite these headwinds, Facebook still posted accelerating revenue growth across all geographies, expanding market penetration with Instagram’s IGTV, Facebook’s Stories and monetization efforts in Messenger and WhatsApp. Facebook is still poised to grow at a double digit clip with the most recent growth rate coming in at 33% in Q3. The long term picture looks bright for Facebook and the recent sell-off in the stock and in tech cohort is a good opportunity to initiate a long position as the company contends with and addresses all the issues across its platforms. Facebook remains a premier large-cap growth stock and inexpensive relative to other large-cap growth stocks in its cohort heading into Q4 earnings.    

 

 

Figure 1 – Collection of privacy scandals negatively impacting the stock in 2018

 

Resetting Expectations During Q2 Conference Call:

 

Facebook posted the largest one-day loss in market value by any company in stock market history. Facebook shed $119 billion worth of market capitalization after dropping ~20%. No other company has ever lost greater than $100 billion in market value in a single day (Figure 2). This sell-off came on the heels of a revenue miss of $13.04 billion verses expectations of $13.16 billion and lower than expected daily active users in Europe. Key metrics suffered with data misuse and fake news issues within its platform.

Facebook warned investors that it expected revenue growth to be lower than the previous year, especially in the second half of 2018. On the conference call, CFO David Wehner stated shareholders can expect "revenue growth rates to decline by high single-digit percentages from prior quarters" for the third and fourth quarter. "We plan to grow and promote certain engaging experiences like Stories that currently have lower levels of monetization, and we are also giving people who use our services more choices around data privacy which may have an impact on our revenue growth,". Wehner also said currency fluctuations would hurt the stock in the second half of the year, after helping it for the last several quarters. Wehner went on to say that the company expects margin compression, with operating margins trending toward "mid-30s on a percentage basis," compared with second-quarter operating margins of 44 percent.

 

That margin compression is the result of expanding markets, investments in news products such as the company's long-form video format, IGTV and capital expenditures related to safety and security that total "billions of dollars," Wehner said. "We think that's the right thing to do for the business in terms of ensuring the community, safety and durability of the franchise," he said. "But they don't have obviously immediate translation into revenue dollars." Over the past few quarters, Facebook has ramped up spending on initiatives to combat fake news, ensure data integrity, implementing stringent guidelines on third party data sharing and overall transparency within its platform. Facebook had already moved to overhaul its news feed in favor of “meaningful social interactions” verses “relevant content” to improve its user experience. I think it’s safe to say that the company certainly reset expectations with regard to future growth.

 

 

Figure 2 – Biggest market cap losses among large-cap stocks in the U.S. stock market. Infographic adopted from CNBC.

Double Digit Growth Albeit Slowing Growth

 

Facebook posted revenue growth of 33% coming in at $13.73 billion while EPS grew by 11% coming in at $1.76 for Q3. Daily and monthly active users were up 9% and 10%, respectively year-over-year on a whole. Facebook ended the quarter with $41.2 billion in cash and cash equivalents. Facebook has been growing revenue by over 40% as of the last few quarters and factoring in a “decline by high single-digit percentages from prior quarters" let’s assume this growth rate settles at 25%. Facebook now trades at ~$147 per share after this sell-off and now trades at a P/E ratio of 22.5 and a PEG ratio (P/E ratio divided by growth rate) of 1.25 suggesting an annual growth rate of ~18% in EPS. EPS as of Q3 2018 was $6.64 thus factoring in a 18% premium we would theoretically arrive at $7.83 at the end of Q3 2019. Assuming Facebook continues to trade at a P/E of ~25 with an EPS of $7.55, the stock price would be ~$195 per share, conservatively by this time next year. I think Facebook is guiding too low to be conservative thus I feel investors will still enjoy ~25% revenue growth with a P/E of ~30 placing the stock price at ~$250 per share within one year.

 

Conclusion

 

The recent rout in the broader market and in particular the technology sector has exacerbated the unpinning of Facebook’s revenue growth slowdown, margin compression and daily active user stagnation. Throughout 2018, several issues related to user privacy, data security and misinformation scandals and as an extension the company has witnessed many high-level executive departures. Despite these headwinds Facebook remains a long term buy especially after this major sell-off while revenue growth remains best in-class within the large cap cohort. The broader questions of potential regulation, public backlash, additional data misuse cases and whether or not any material impact to revenue as a result remain in question. Facebook is attempting to put these issues behind the company by spending billions on initiatives to combat fake news, ensure data integrity, implementing stringent guidelines on third party data sharing and overall transparency within its platform. As trust is slowly restored and analysts back the company such as JPMorgan and Braid, the stock will appreciate Facebook looks like a compelling buy after its self-inflicted damage in conjunction with the technology sector sell-off. In my opinion, Facebook is the most compelling high-growth technology stock when compared to other companies with a similar growth profile and market capitalization.

 

Disclosure: The author trades options on Facebook. The author has no business relationship with any companies mentioned in this article. He is not a professional financial advisor or tax professional. This article reflects his own opinions. This article is not intended to be a recommendation to buy or sell any stock or ETF mentioned. Kiedrowski is an individual investor who analyzes investment strategies and disseminates analyses. Kiedrowski encourages all investors to conduct their own research and due diligence prior to investing. Please feel free to comment and provide feedback, the author values all responses. The author is the founder of stockoptionsdad.com a venue created to share investing ideas and strategies with an emphasis on options trading.

 

Originally published in partnership with INO.com

https://www.ino.com/blog/2019/01/is-facebook-finally-a-buy-after-the-tech-rout/#.XE4SaVxKjIU

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