Facebook Growth and Margin Warning Should Not Have Surprised Anyone

Shares of Facebook fell hard on Thursday after guiding investors to slower growth and falling operating margins going forward. Many FB bulls acted as this was a total shock (and obviously the stock was not reflecting the news either), but really this was bound to happen. In fact, FB had already warned that expenses would rise faster than revenue in 2018, to deal with all of the issues the company has been battling in the news lately. As a result, margin compression should not be surprising.

Evidently investors also believed that even with 2 billion active users, the company could continue to grow revenue at 40%-plus. How that is possible when 2018 revenue will top $50 billion and user growth has slowed dramatically (there are only so many connected humans on the planet) is hard to understand. Perhaps investors see Amazon growing revenue 39% this past quarter and just assume that every high flying tech company can do the same. Amazon, however, is the exception, not the rule.

Below is a summary of Facebook’s financial results, including some estimates I came up with for what 2018-2020 might look like. These are not all that different from the numbers I had been working off of for my last FB post earlier this year, but now that the company has publicly guided investors in that direction, it should be less of a speculation on my part.

As you can see, GAAP free cash flow is unlikely to get much above $7 per share, even assuming the company can grow revenue by more than 100% over the next three years. Using my preferred measure, which includes stock-based compensation as though it was being paid out in cash to employees, free cash flow might struggle to get materially past $5 per share.

The big question for investors, then, is what multiple to put on such growth. The large cap tech leaders have been getting 30-40x multiples in recent years, but it is hard to know whether slowing growth rates (as these firms get so large) will crimp those valuations.

Facebook bulls would probably argue 30x that $7 figure is more than reasonable, and therefore would suggest a rebound to $210 per share (versus the current low 170’s) is on the horizon over the next 6-12 months. Add back the company’s cash hoard and maybe $225 is doable (the stock was already at $217 two days ago!).

More cautious investors might use 25x and prefer the $5 free cash flow figure, which would mean $125 per share, or $140 including FB’s ~$40B of cash in the bank.

That leaves us with perhaps 20% downside and 30% upside depending on which camp you are in. Such a risk/reward does not exactly get me excited to build a position in the stock, but at least the shares are coming back to reality.

FB bulls are getting a good entry point and the bears have more reasons to watch from the sidelines. If I had to guess, I would give the bulls a slight edge and would not consider betting against the stock at current levels. In more specific terms, I think FB shares are more likely to see $200 again before breaking below $150 (the Cambridge Analytica bottom).

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