The Dizzying Ride That Is Wynn Resorts Stock Is Not Slowing Down

Since I first wrote about gaming and hospitality company Wynn Resorts (WYNN) three and a half years ago the stock performance has been nothing short of an intense roller coaster. For a large cap company with a relatively simple business, you are unlikely to see more volatility in the equity markets. Such wide gyrations are great for investors, especially those willing to be contrarian and buy when things look the bleakest, but the exercise can admittedly become tiring while also predictable.

Fast forward from May 2015 to today and I am still a rider on this roller coaster. Although I bought stock at low prices and sold much of it at high prices, I failed to sell everything near the top and we are now stuck in a down cycle for the shares, despite the fact that the company is doing just fine.

Below is a five-year chart of Wynn Resorts shares that shows just how dizzying the ride has been:

I was buying the stock in 2015 after the prodigious collapse from the 2014 highs and began trimming positions in late 2017 and well into 2018, but the long-term outlook (still very bright in my view) caused me to hold onto to a smaller position even as the stock reached the $200 level. And now we are left with an interesting question; what to do now?

Given the stock chart above, you would probably guess that Wynn’s business is in trouble, but you would be wrong. In fact, company EBITDA this year is likely to come in right around their previous best two years ($1.68 billion in 2013 and $1.61 billion in 2017) and could even reach $1.7 billion, a new company record. As is usually the case, the financial markets extrapolate current results and value the business based on those  near-term figures, ignoring both longer term historical track records and the future outlook a year or two down the road.

That trend is playing out now, as Wynn’s business has gotten soft in recent months and is unlikely to bounce back quickly in the near term. Never mind that their Boston property will open in June 2019 and offset weakness seen elsewhere in their property portfolio. Never mind that the company is in the process of designing new additions to their properties in both Las Vegas and Macau that will grow profits over time.

What happens when near-term stock valuations are based mostly on near-term financial results is that prices and investor reactions overshoot in both directions. When things are great, the stock reflects that and analysts have high estimates for future profits and use high valuation metrics due to those rosy outlooks. The opposite is seen as well. This week, as near-term profit expectations come down for WYNN, the multiples used to determine Wall Street price targets will also come down, undoubtedly justified in their minds “to reflect the near-term weakness of the business.”

From a valuation perspective, the value of a dollar of profit should not change based on near-term trends. The notion that WYNN should be valued at 15x EBITDA one quarter and 12x the next makes little sense, if indeed we believe that the stock should reflect the discounted present value of all future profits in perpetuity.

To illustrate this phenomenon, let’s look at Wynn’s stock price and financial results since 2013. The 2018 revenue and EBITDA figures shown are my firm’s internal estimates.

As you can see, the stock price reacts far more violently, in both directions, than the actual financial results of the business. In each and every year, the stock move is more aggressive than the year-over-year (yoy) change  in sales and profit. Interestingly, the stock today is 50% below the level of year-end 2013, even though EBITDA is roughly the same.

Generally speaking, this is why it makes sense to many of us in the industry to have a portion of one’s investment portfolio allocated to active managers; to try and take advantage of such mispricings in an inefficient marketplace.

In hindsight, it would have been nice to sell every share earlier this year and buy back each of those shares today. In actually, I am quite pleased that I bought it low and sold a portion when I did. While the roller coaster ride that is Wynn Resorts stock can be frustrating at times, there is no reason to jump off now. If my investment thesis is right (the Boston property does well and the legacy resorts in Las Vegas and Macau grow revenue and profits over the long term, despite short-term bumps along the way) then investors will surely get another chance to sell at a fair price in the future, just as they get chances to buy at attractive prices periodically.

Full Disclosure: Long shares of WYNN at the time of writing, but positions may change at any time

IBM: Damned If You Don’t, Damned If You Do

 

 

 

For years investors have been clamoring for IBM (IBM) to transform their business via acquisition, as tech infrastructure moves to the cloud and away from IBM’s legacy businesses. Despite some very small deals, the company instead opted to buyback stock and pay dividends with its prodigious free cash flow.

To put this capital allocation decision in perspective, consider that between 2010 and 2017 IBM spent $34.4 billion of dividends and repurchased $82.4 billion of stock, for a total of $116.8 billion of profits that were not reinvested in the business over and eight year period. Compare that with IBM’s current equity market value of $110 billion. Wow.

Thew result has been a stagnant business from a numbers standpoint ($15 billion of free cash flow in 2010 versus $13 billion in 2017), and a larger lead for the new age/cloud-based competition.

When we learned yesterday that IBM had agreed to buy Red Hat (RHT) for $34 billion, or $190 per share, a stunning premium of 63% compared with the prior closing price, you could have a few different reactions (or combination thereof). One, “it is about time they make a big move.” Two, “well, oh well, it’s five years too late.” Three, “great move, but why on earth pay such a steep price?”

IBM stock went down yesterday, which makes sense when taking a short term view (the deal is dilutive in the early years), but seems strange with a long term view (could IBM possibly be worth less on a per-share basis with RHT onboard?).

The way I see it is that if IBM was valued at 9x free cash flow without Red hat, it should not be worth less than that with it. But that begs the question, can RHT really make a dent in IBM’s massive business? If IBM’s valuation multiple is going to expand on the heels of this deal, RHT needs to show up in the numbers.

So let’s go through the numbers. RHT adds $3.3 billion of revenue, $650 million of EBITDA, and $775 million of free cash flow to IBM. If we assume IBM uses $10 billion of cash and borrows $24 billion at 5% to fund the $34 billion acquisition, debt costs will rise by roughly $1.2 billion pre-tax. Call it $1 billion annually after-tax. There goes the added free cash flow generation from RHT… completely negated (and more) from the added debt load.

IBM said that they would suspend share buybacks until 2022, so let’s assume they use 100% of free cash flow after dividends (roughly $6 billion per year) to repay 50% of the RHT-related debt in 2020 and 2021. At that point, perhaps the RHT business is generating $1 billion of free cash flow and debt service on the remaining $12 billion of incremental RHT debt is $500 million after-tax. The result in 2022 is a deal that is accretive to free cash flow by $500 million, or roughly 4% vs 2018 financial results ($12 billion free cash flow guidance for 2018).

Does this Red Hat deal add risk to IBM? Unlikely. Does it materially change the growth rate and underlying profits of the business? Unlikely. Does it mean IBM stock should go down? Unlikely. Could it result in a 10x or 12x free cash flow multiple longer term, vs 9x today? Perhaps.

Add in a dividend yield north of 5% and IBM stock around $120 per share seems likely to be able to put in a floor, assuming the RHT deal does not spur competing bids. Given the price being paid, it will likely not result in a surging IBM stock price, but from a risk/reward perspective, I would conclude that IBM is a meaningfully more attractive deep value/income-producing stock with RHT than it was without it.

Full Disclosure: No position in IBM at the time of writing, but holdings may change at any time

As Coastal Housing Markets Cool, 2017 IPO Redfin Is Worthy Of A Watchful Eye

For all of the business model evolutions and technology-led disruptions throughout the service economy in recent memory, the 6% realtor sales commission (a truly obscene amount for higher priced homes) for the most part has been unscathed. Tech upstarts like Redfin (RDFN) are trying to make a dent and are making progress, albeit slowly.

Public for less than 18 months after their IPO priced at $15, RDFN is using technology to save home buyers and sellers money. The company has been expanding its 1% sales commission structure rapidly, which can cut home sellers commission expense by 33% (4% vs 6%). Like Zillow (Z), RDFN also strives to offer customers ancillary services, such as mortgages.

RDFN stock had been trading pretty well, relative to the $15 issue price, up until recently:

The issue now is that RDFN was started in Seattle and focused initially on higher priced big cities for its lower sales commissions. The reason is pretty obvious; taking a 3% cut on a $200,000 home in Spokane is equivalent to taking a 1% cut on a $600,000 Seattle listing because each will take roughly the same labor hours. The idea that said Seattle seller would pay $36,000 to sell their house is a bit nutty, but that structure has largely survived in the industry.

Fortunately for RDFN, the coastal housing markets have been on fire, including double-digit annual gains in their home Seattle market for many years now. The result has been a strong revenue growth trend for the company, with 2018 revenue expected to top $475 million, versus just $125 million in 2014.

With those same markets now showing clear home price deceleration and inventory stockpiling, RDFN should see pressure on its near-term financial results, and likely similar headwinds for the publicly traded shares.

Long term, however, RDFN’s future appears bright as it continues to expand its business across the country, taking aim at the traditional 6% sales commission structure. The company’s market share reached 0.83% as of June 30th, up from 0.33% in 2014. While that figure is tiny, it shows you just how much business is out there for newer players to steal.

To be a long-term bull on RDFN, one needs to believe that over the next 10-15 years they can continue to grow market share and perhaps reach 5% penetration of a market worth tens of billions per year. The good news is that the company has enough money to try and get there. After a recent convertible debt offering, RDFN has about $300 million of net cash on their balance sheet, compared with an equity value of roughly $1.65 billion. That cash is crucial, as the company is purposely losing money now to grow quickly (cash burn has been in the $20-$30 million per year range).

It is hard to know what a normalized margin structure for RDFN could look like, and therefore assigning a fair value is not easy. With nearly $500 million in revenue and $300 million of cash, the stock does not appear materially overpriced today if one thinks they can earn 15%-20% EBITDA margins over time and therefore trade for 1.5x-2.0x annual revenue.

That said, if coastal markets continue to cool over the next few quarters, RDFN could dial back financial projections for Q4 and 2019, which would likely put pressure on the stock short-term, despite it being a long-term story for most investors. Accordingly, I think RDFN is an interesting stock to watch, especially for folks looking for growth without having to pay a huge premium for it.

Rising Interest Rate Shock: 2019 Edition

Back in February I published the table below to show investors where the S&P 500 index would likely trade if interest rates normalized (10-year bond between 3% and 5% is how I defined it):

Published 2/27/18

The point of that post was to show what the typical equity valuation multiple was during such conditions (the answer is 16x-17x and we don’t have to go back too far to find such conditions). Now that 2018 is coming to an end and earnings are likely to come in at the high end of the range shown in that table ($157 is the current consensus forecast), let’s look ahead to 2019.

I have added a gray section to the chart (see below) to include a range of profit outcomes for 2019. The current forecast is $176 but I believe there is more downside risk to that than upside, so I did not add any outcome in the $180+ area.

As you can see, the equity market today is adjusting rationally to higher rates, with a current 16.1x multiple on consensus 2019 profit projections. The big question for 2019, therefore, is not huge valuation contraction. Rather, it comes down to whether earnings can grow impressively again after a tax cut-powered 26% increase in 2018. If the current consensus forecast for earnings comes to fruition, the market does not appear to be headed for a material fall from today’s levels.

Given that the long-run historical average for annual earnings growth is just 6%, assuming that in the face of rising rates the S&P 500 can post a 12% jump in 2019 seems quite optimistic to me. Frankly, even getting that 6% long-term mean next year – resulting in  $166 of earnings – would be solid.

For perspective, at that profit level, a 16x-17x P/E would translate into 2,650-2,825 on the S&P 500, or 3% lower than current quotes at the midpoint. Add in about 2% in dividends and a flattish equity market overall seems possible over coming quarters if earnings fall to post double-digit gains next year and valuations retreat to more normal levels.

Many Gaming Related Companies Are On Sale

I have written enough about Wynn Resorts (WYNN) in recent years that much more in the way of commentary is likely unnecessary. Investors are once again getting a unique buying opportunity with the shares down a stunning 30 percent on very little news:

Even if they wind up selling their under-construction Boston property prior to opening, the haircut for shareholders would likely be less than $5 per share (a 20% gain on the $2.5B cost is just $500M). Although Macau revenue growth is slowing, the August figures are still well into the double digits.

Other leading gaming related stocks are also selling off and warrant special attention. Two notable ones are lottery and slot machine giant International Game Technology (IGT) and video game behemoth Electronic Arts (EA). 

IGT is a global leader and despite low single digit revenue growth (most markets are mature), the business is minimally cyclical and the company’s valuation seems extremely reasonable at 10 times 2019 earnings estimates and a dividend yield north of 4 percent.

EA has been riding the coattails of a transition from packaged software sales to cloud-based digital sales, and the higher gross margins such a distribution model affords. A recent profit warning, due in large part to a delay in the upcoming release Battlefield 5, has helped the stock fall about 25% from its highs. While not dirt cheap (low 20’s multiple to earnings), continued revenue growth, margin expansion (digital sales still represent less than 70% of the total, which could reach 90% over time), and a stellar balance sheet should be accretive to shareholder value over the intermediate term.

No matter your investing style, and despite the market near all-time highs, there are plenty of gaming investments worthy of consideration right now.

Would Moving To Six Month Financial Reporting Solve Anything?

News that President Trump has asked the SEC to study the potential benefits of moving from quarterly to biannual financial reporting for public companies has stoked a debate as to the merits of such a proposal.

While it is certainly true that short-term thinking, often motivated by the desire to please Wall Street, should not be a focus of management teams of public companies (I can’t stand it when I see quarterly financial press releases tout how actual results beat the average analyst forecast), I am not sure that six-month reporting would materially help solve the problem. From my perch, there are several reasons why I would not expect much to change if such a proposal was enacted:

      1. Many companies already do not spend time predicting or caring about short-term financial results, and those firms adopted such a strategy on their own. They did so because the boards and management teams of those firms decided it was the best way to run their business. Those calls fall under their job descriptions, and they take them seriously regardless of what guidance they receive from regulatory bodies.
      2. For companies that choose to give forward-looking financial guidance today, they would likely continue to do so on a six-month basis. If they tried hard to hit their quarterly numbers, sometimes doing so at the expense of longer term thinking, the same would be true when dealing with six-month financial targets. Behavior would not change, just the outward frequency of such behavior would.
      3. Reducing the frequency of financial reporting would only serve to make companies less transparent with their own shareholders. Since we are talking about public companies that are serving their shareholder base first and foremost, it should be up to the investors to voice concerns about what metrics are being prioritized at the management and board level. There is a reason activist investing has found a place in the marketplace (and the goals are not always short-term in nature, despite media claims to the contrary).
      4. Just because companies are required to file quarterly financials does not mean they need to spend much time on them, or communicating them. Jeff Bezos likes to brag to his shareholders at Amazon’s annual meetings that the company has no investor relations department and does not travel around the country to tell their story to the investment community. He does not think it is a good use of his time. Plenty of smaller firms simply file their 10-Q report every 90 days and hold no conference call to discuss their results. In essence, they spend minimal time on financial reporting (10-Q reports are not super time consuming when the same template is used every quarter and the company has to close their books every period regardless of external reporting requirements).
      5. There is an argument that less frequent financial reporting will result in more volatile stock prices when companies do publish their financials. Essentially, if things are going unexpectedly, the surprise could be twice as large if the gap between reporting periods is twice as long. For many companies, this might be true. But I am not sure of the net impact, given that it can work the opposite way too. If a company has a poor Q1 but makes it up with a strong Q2, it could be a wash when it comes time to report mid-year results, whereas quarterly reports would have resulted in surprising investors twice, in opposite directions.

     

  1. It seems the core problem people are trying to solve here is the focus on windows of just 90 days from a management and investor perspective. I firmly believe that whether a company takes a long term view, at the possible expense of short-term results, or not, that decision is a reflection of top management and the board, with input from shareholders hopefully playing a role. If that is true, then reporting frequency itself is not the core determinant of the behaviors we see. As such, we should expect companies to continue their chosen management styles and strategies, whether they have to publish financial reports every 3, 6, or even 12 months.

    From an investor standpoint, if I am going to be given information less frequently, I would want to at least believe that performance will be superior, in exchange. In this case, I do not see how six-month reporting would benefit shareholders by changing behavior at the corporate level, leading to improved revenue and earnings growth over the long term.

    If a simple financial reporting rule change would dramatically change decision making inside public companies, then the same managers who are pushing for six-month reporting should take responsibility for how they are running their companies and simply de-emphasize short term results.

  2. They can do so without rule changes at the SEC, and they can go further if they want. For instance, there is no rule that says you need to host quarterly conference calls after reporting earnings. Companies could easily host one or two calls per year if they chose to (or none for that matter), which would send a clear message to their investors and free up time (albeit not that much) to focus on the long term.

     

Canada Goose: Brings Back Memories Of Other Fashion Stock Heydays

In the spirit of fashion, let me begin this article off with a runway of sorts, even if it is a lineup of stock charts rather than models.

Here is a chart of Michael Kors (KORS)  stock since its late 2011 IPO. Notice the move from $20 to $100 by early 2014:

Here is Coach stock — now called Tapestry (TPR)– since its IPO in 2000. In this case there were two separate astronomical run-ups, neither of which could be maintained.

Abercrombie and Fitch (ANF) was scorching hot when I was in high school in the late 1990s:

And one more: UnderArmour (UAA):
There are many things these companies have in common, and not all bad actually. For instance, notice how all of these brands have survived and built sustainable multi billion dollar businesses?

But on the flip side, the stocks have been duds over long periods of time. While they have been volatile (making for plenty of trading opportunities in both directions), the reason why none of them have been good long-term buy and hold candidates is because fairly early on in their stints as public companies the brands were so popular that the stocks became massively overvalued. So even though the businesses continued to grow, the stocks turned out to be poor investments.

It has been a little while since we have seen a surging fashion brand on Wall Street (UnderArmour likely the most recent), but recent IPO Canada Goose fits the mold. Here is the chart since the 2017 IPO:

GOOS currently is valued at $6 billion USD, versus expected 2018 revenue of $420 million, for an enterprise to sales ratio of ~15x. Even with 20% growth in 2019, to $500 million (the current Wall Street analyst consensus estimate), the multiple is ~12x.

Consider what types of enterprise value-to-revenue multiples the large fashion brands currently trade for:

Tapestry 2.5x
Michael Kors 2.3x
Ralph Lauren 1.5x
Tiffany 3.9x
Nike 3.5x
UnderArmour 1.8x

There is simply no way to justify such a sky high revenue multiple for GOOS. The median revenue multiple from the group of 5 comparables above is 2.5x. So how much does GOOS need to grow over the next decade to simply justify the current stock price? The numbers come out to an 18% compounded annual growth rate from 2018 through 2028, which gets the company to roughly $2.2 billion of annual revenue:

$420M * 1.18^10 = ~$2.2 billion

Put another way, if the business grows from $420 million this year to $2.2 billion in 10 years, and the shares trade at 2.5x EV/revenue at that point in time, the stock price will go nowhere even though sales would have grown by 424%!

The only way these numbers don’t work is if GOOS has somehow figured out  a way to sell clothes for far higher profit margins than the leading fashion companies in the world, which have already amassed multi-billion dollar businesses. Betting on that outcome seems ridiculous to me.

As a result, although it can be tempting to jump on highflying recent IPOs like GOOS, thinking it could be the next big thing in fashion, it is important to realize how lofty the valuations can be. And if stock prices reflect plenty of growth already in future years, the share price will not have to follow suit.

One last example, outside of the fashion space — remember how bonkers investors went for the Shake Shack IPO back in January 2015? Take a look at how the shares have done since hitting $96 in May 2015:

And that is despite SHAK’s revenue surging 137% from $190 million in 2015 to an expected $450 million in 2018.

GOOS buyers beware.

With Aetna Buyout Set to Close Soon, CVS Health’s Flat-lined Stock Still Looks Cheap

Last October I wrote about the just-leaked CVS Health (CVS) bid for health insurance giant Aetna (AET) and tried to convey the notion that the move was about far more than just diversifying away from retail pharmacies for fear Amazon might compress margins in that industry. Interestingly, CVS’s stock price was $69.05 when I published that note, and today it closed at $69.05. So almost 10 months later and all investors have earned from the shares is the not-too-shabby 3% annual dividend.

CVS reported a solid second quarter this week and is on pace to book nearly $7 of free cash flow per share in 2018 ($6.88 in my internal model), which puts the stock at 10 times free cash flow, a price normally reserved for melting ice cube businesses. And there are plenty of people who see CVS (incorrectly) as just a bricks and mortar pharmacy company destined to be disrupted by some trillion dollar market value tech darling. Others acknowledge their huge pharmacy benefits management business (Caremark), but believe the thesis that those firms are actually robbing their commercial clients blind and helping boost drug prices, when the opposite is actually true (and hence why their clients don’t fire them). If both of those notions turn out to be correct, CVS will not be a good investment over the next 5 or 10 years, but I am taking the opposite view.

In fact, the story will get even better when the Aetna deal closes (CVS management indicated on their quarterly conference call this week that September or October is the most likely timeframe for closure). Essentially, CVS is building a healthcare services juggernaut, it seems to me anyway, and will be able to use a vertically integrated business model to offer consumers numerous options and generate efficiencies in an otherwise complex healthcare system. Bears on the company seem to fail to realize that a network of drugstores and in-store clinics, coupled with pharmacy plan management, assisting living and nursing home drug distribution, and insurance plans is an all-encompassing system that can be designed and integrated in such a way as to drive convenient usage from customers of all shapes and sizes, which in turn should bring down costs as scale is leveraged.

Now, there is no guarantee that the company will figure out the best way to harness this potential, but the goods news is that the stock is pricing in failure already at 10x free cash flow. Nothing positive is being considered by most investors and many of them figure the 3% dividend will be immaterial once Amazon announces 2-hour prescription fills delivered by drone starting in 2022 (that is merely speculation on my part — no announcements have been made). However, when you look at the breadth of CVS’s offerings it seems to me that this company is more than just a bricks and mortar retailer selling a commodity at a higher margin than Jeff Bezos would. It does not seem like something the tech giants could duplicate successfully.

As for the PBM side of the business, a lot has been made about pharmaceutical rebates and how they may be encouraging drug prices to remain high on a gross basis. The anti-Caremark thinking assumes that drug markers are giving the PBM rebates on drugs and those payments are juicing the profits of the PBM while patients pay huge out of pocket costs. CVS told investors this week, however, that they keep just $300 million of rebates annually, and pass the rest (roughly 97-98% of the total collected) back to their clients in one form or another (different clients choose different structures). That $300 million figure represents just 4% of the company’s annual free cash flow.

Put another way, in a world where PBM plans are restructured so that no rebates are kept by the plan manager, CVS’s free cash flow would drop from $6.88 to $6.59 per share. Not only is that hardly enough reason for the stock to be trading where it has been for the last year, but it is unlikely that Caremark would have to give up that $300 million at all. Rather, the PBM contracts would likely be changed to move away from rebates at all, and be underwritten in other ways such that certain folks would no longer insist rebates were the problem. Given that PBM clients are renewing their contracts in the high 90 percents every year, providers like Caremark would likely have no trouble keeping their existing business relationships, at the same underlying profit margins, even if they changed how the reimbursement of negotiated drug savings were handled.

As an investor in CVS Health, I am intrigued to see what the company can do with Aetna added to the mix. Since I don’t expect their business to begin a slow decay over the next few years, I am sticking with the shares, despite them merely treading water lately, as I firmly believe the business is far more resilient and value-providing than the bears are giving it credit for. Even at 15x annual free cash flow, still a material discount to the S&P 500 index (remember when consumer staples used to trade at a premium?), CVS stock would trade north of $100 per share. Call me crazy, but I think we will get there sometime within the next 2-3 years. Add in a 3% dividend while we wait and the upside potential is impressive, especially given how negative sentiment is today (which limits further downside to some extent).

 

The Price of “FAAAM” – 5 Tech Stocks Now Worth Over $4 Trillion

We hear a lot about the “FAANG” stocks (Facebook, Apple, Amazon, Netflix, Google/Alphabet) leading the S&P 500 higher in recent years, which is undeniably true, so I decided to take a look at a slightly modified version to see where valuations are within the group.

Below you will find data on “FAAAM” which I have coined to represent the top 5 most valuable companies in the S&P 500 today. By adding Microsoft in place of Netflix, we have a fivesome worth more than $4.1 trillion, or about 16.5% of the entire S&P 500 index ($25 trillion total value).

There are many conclusions investors can gleam from this group of tech stocks, and not everyone will agree. I will share a few of my views and feel free to chime in.

  • While not unprecedented, having such concentration within the dominant U.S. equity index means that near to intermediate returns for the market are largely correlated with large cap tech leaders. Given that none of the valuations are inexpensive, and Apple is probably the only one that looks to be no worse than fairly valued, investors relying on this group for future returns will need growth rates (in revenue and earnings) to continue at high rates for quite a while. It is hard to know whether this expectation is reasonable. For instance, will the size of these firms lead to slower growth by default, or are they dominant enough to continue to garner the lion share of the sector’s growth overall?
  • At 18x EV/EBITDA, are the valuation of this group reasonable enough to expect that the stocks, on average, can generate double-digit annualized returns over, say, the next 5-10 years? If 20% annual growth rates in the underlying businesses persist, then the valuations are not likely too high, but that is a big open question. For instance, Amazon’s revenue in 2018 is projected to reach $235 billion (current analyst consensus estimate). To keep growing at 20% per year, the company needs to find an incremental $50 billion of revenue every year, which equates to $1 billion every week! The stock is priced as though such an outcome is likely. What happens if revenue growth slows to 10%?
  • Of the five companies in “FAAAM” the only ones I would consider putting fresh money into, based on growth and valuation, would be Apple and Facebook. Apple’s run to $1 trillion this week on the heels of a strong earnings report could signal the stock is topped out in the near-term. Facebook, however, trading down lately after ratcheting down growth expectations on their latest conference call, is really the only FAAAM stock that is down materially at all. While I am not exciting to buy any names in the group at current prices, they could very well have the best mix of untapped growth opportunities and less-than-exuberant investor sentiment.

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).