Coca Cola Bottling Shares Surge 130% After Name Change: Could FinTech Be To Blame?

Hat tip to Upslope Capital for bringing this to people’s attention. It appears that do-it-yourself investors relying on tech platforms to invest need to be even more careful than some may have previously thought. Sure, having a computer decide your asset allocation could be problematic long term, but it turns out that even someone trying to buy Coca Cola stock might get into trouble if they don’t do their homework.

Whereas Coca Cola trades under the symbol KO, their largest bottler/distributor trades under the symbol COKE. The latter used to be called “Coca Cola Bottling Co Consolidated,” which made it easier to understand which stock was which (given that the “real” Coke did not trade under “COKE”). Then in January the bottler changed the company name to “Coca Cola Consolidated” and dropped the “Bottling” completely.

So what happened? COKE shares almost immediately surged more than 130%:

So much for being just a boring bottler of soft drinks… COKE shares rally from under $130 to a peak of $413 in just four months after a questionable name change.

What could possibly have prompted such a huge move in this once boring stock? Well, one theory was floated by Upslope Capital; the name change itself!

If you read through their report (linked to above at the outset), you will notice that users of the popular Robinhood investing app have gobbled up COKE stock this year, likely due to the fact that searches for “Coca Cola” bring up the name of the bottling company with the stock symbol COKE. If you were a young, amateur investor, you probably would not think twice about putting in a buy order thinking you were getting shares in the mega cap global beverage giant that counts Warren Buffett as an investor and sports a total market value of more than $200 billion (70 times bigger than the bottling company!). And then you would wind up with an investment in the far smaller bottling company. And worse, your fellow investors would be doing the same, helping to push the stock up more than 100% in a matter of months!

While the air has come out of the balloon in recent days, COKE is probably still overvalued at $316 per share. I suspect sometime over the next year the stock trade back to $200 or $250 and plenty of investors will wonder exactly how they lost so much money on such a dominant company’s stock.

While technology surely will play a role in evolving the investment process for many, the idea that hiring a human being to assist you with your savings and investment objectives is unlikely to become outdated for the majority of folks, for reasons exactly like this one. Sometimes the computers are going to be value-destructive, not value-additive as intended.

Full Disclosure: At the time of writing, I am short shares of COKE, but positions may change at any time.

Not Enough U.S. Cash Burning IPOs for You? Here Comes China’s Luckin Coffee

Just as U.S. investors are trying to make sense of the Uber (UBER) and Lyft (LYFT) IPOs, both disastrous for those buying at the offer prices, on Friday we will get a U.S. listing of Chinese-operated, Cayman Island-incorporated coffee upstart Luckin Coffee. How much should investors pay for this so-called Starbucks of China (even though its business model is not copying the Seattle-based giant)? Quite frankly, who the heck knows? If that is not a sign that one should pass for now, I don’t know what is.

Below is a summary of Luckin’s financials from the IPO prospectus, though keep in mind its operating history is short (having gone from zero to 2,370 stores between October 2017 and March 2019).

This income statement reads like a Silicon Valley cloud-computing start-up, not a Chinese bricks and mortar coffee chain

As you can see, Luckin’s stores are run at a loss, with Q1 2019 sales of $71 million dwarfed by direct store operating costs of $83 million and another $25 million of marketing expense.

Investors should not exactly be enamored with Luckin’s growth rate. After all, selling coffee at a loss is an easy way to rack up sales and there is no way that the company has a detailed, refined, and proven unit expansion plan in place given that they are opening these money-losing locations as fast as humanly possible (an average of more than 4 new stores a day since they launched 18 months ago!).

None of this says anything about the long-term odds of success for Luckin Coffee. They could very well become China’s largest coffee seller and make money doing it. There is simply no way to know at this point, so investors are left deciding whether they want to take a gamble or not. Many will given that the company will list on a U.S. exchange this week, but with no sound financial model to back up the prices being paid for the shares, there is really no fundamental case to be made for buying the stock.

All one can do is estimate what they think margins could ultimately be based on the business model, assume long-term success, and calculate an imputed price-to-sales ratio worth paying today given certain growth assumptions. That is how Uber and Lyft are likely to be valued (assuming people care to value it at all), and the same idea applies to Luckin Coffee and whatever the next cash-burning IPO waiting in the wings happens to be.

Author’s note: To give you an example, assume that Uber can ultimately earn 20% EBITDA margins over the long-term and one can justify paying 15x EV/EBITDA given their potential growth outlook. That valuation equates to an EV/sales ratio of 3x, which based on 2020 revenue projections could yield a per-share fair value in the $30 ballpark (vs today’s quote of $40). And don’t even ask me to guess what Luckin Coffee’s margins could be.

Will A Barrage Of Tech Unicorn IPOs Mark The Top?

Back in the tech bubble of the 1998-2000 era investors were left holding the bag because they paid up mightily for small, fast-growing companies that were losing money but promising dominant long-term businesses based on fast growing end markets. Paying 15 or 20 times annual revenue became the norm because earnings were negligible. Sell side analyst recommendations went something like “we recommend shares of XYZ at 15x our forward 12-month revenue estimate, as peers are trading for 20x.”

During the current bull market there was not a lot of this kind of froth in the tech sector, even though it has once again grown to be the largest in the market (31% of the S&P 500 by market value today). Companies like Apple, Facebook, Google, and Microsoft were growing nicely and had a ton of GAAP profits and free cash flow to back up the valuations. There were some exceptions like Amazon and Netflix, but it is hard to argue that they will not achieve solid profit margins at some point, and they are likely going to dominate their sectors on a global basis (exactly what those margins ultimately will be is an open question, and certainly up for debate).



Over the last year or two, cloud-based software companies are copying the Amazon/Netflix model. Given annual growth rates of 20-30%, investors are giving them a pass, despite stock-based compensation costs that are well into the double-digits as a percentage of revenue, and with sales and marketing budgets of 40-60% of revenue (whereas something more like 20-30% used to be the norm). These stocks trade at 10 times sales or more, and for that reason I cannot justify investing in most of them, but given that they are software businesses with high gross margins, these firms could make nice money today if they wanted to (cut sales and marketing to 20% of revenue and viola, your margins explode).

But as long as the public markets are valuing your stock as if you were already at peak margins and still growing 20-30% per annum, there is no reason to change your behavior. And since they can pay their employees with lots of stock, most of these companies are not burning much cash, if any, so the balance sheets are in good shape.

This week I believe we are seeing the next phase of the tech cycle with the Lyft IPO. These tech “unicorns” (firms with private market valuations of at least $1 billion) are about to flood the market with initial public offerings in 2019 as venture capitalists seek to cash out.

But something is different with these unicorns like Lyft; the income statements are gut-wrenching and look a lot more like 1999. But don’t take my word for it, here are Lyft’s results for 2016, 2017, and 2018, taken right from their IPO prospectus:

Losing $911 million on sales of $2.15 billion is no small feat, yet it is one the marketplace deemed worthy of a $25 billion valuation at Lyft’s $72 IPO price. With the stock peaking at $88 on the first day of trading and now fetching just $71 on day #4, the jury is out on whether the public market will accept these businesses at these prices.

The biggest problem, though, is not Lyft per se. It is that there are plenty more of these unicorns coming. Let’s take a look at a list of 10 unicorns that have talked about, or already started the process, to go public in the next 12 months, along with recent private market valuations:

Uber $120B

WeWork $45B

Airbnb $30B

Palantir $20B

Pinterest $12B

Instacart $8B

Slack $7B

DoorDash $7B

Houzz $4B

Postmates $2B

That’s 10 companies worth one quarter of a trillion dollars in total (more than 1% of the entire S&P 500 index) and every single one of them is losing money hand over fist. Who is going to buy all of these IPOs? What assets are going to be sold to make room for them? How many money-losing companies really should be publicly traded? Will small investors be left holding the bag this time around too? Will a deluge of cash-burning tech stocks with “good stories” mark the top of this market cycle?

I don’t know the answers to these questions, but as we look out at the rest of 2019, I do think this unicorn IPO frenzy is a material risk to market sentiment. And if Lyft traded below its offer price on day #2, what does that say about everyone else who decided not to “go first”? In the end, is Lyft really that much more than a taxi service? We’ll find out over the next few years, I guess.

If you are a do-it-yourself investor who is thinking about playing in these IPOs shortly after they debut, please tread carefully. Sure, there will likely be at least one or two big long-term winners mixed in, but I suspect many more will be quite disappointing.

Somebody mentioned on CNBC this week that Uber and Lyft feel a lot like Sirius and XM did in the satellite radio space. Once they reached scale they make good money, but they really are just media companies. And in the end, there was only room for one player so they merged to survive. I would say the same thing might be true for the food delivery services. Do I really need Amazon Restaurants, DoorDash, Uber Eats, Postmates, GrubHub, and Bite Squad to go along with apps from Domino’s, Pizza Hut, and Papa John’s? My head hurts just thinking about it.

Why I Am Selling Apple in the 180’s

While technology giant Apple (AAPL) has not been a large holding at my firm for a long time, until recently my clients did have some residual shares with a very cost basis as a result of paring back their legacy positions over time. In recent days I have been selling off those shares.

For many years Apple stock has gone through cycles whereby the valuation looks a lot like a hardware company (10-12x P/E ratio) at times when sentiment is skeptical, and a higher near-market multiple (mid teens) when investors are focused on services and other higher margin, recurring revenue streams.



Last year the shares got a boost from Warren Buffett’s purchases, sentiment was high, and the stock above $200 was sporting a market multiple. After an early January profit warning for Q4, the stock fell into the 140’s and the iPhone’s issues in emerging markets came into focus. Just two months later, the stock has regained momentum and now trades well above the level it stood before the Q4 disappointment. Why, exactly, is an interesting question.

What is clear to me is that the iPhone problem has not been resolved in the last 60 days. The device’s price continues to increase, which will serve to limit market share gains in emerging markets where household incomes are low and competing phones are close on features but priced much lower.

The notion that the iPhone will reach penetration rates globally in-line with those of its most successful regions, like North America, seems unrealistic to me. Given that the iPhone’s share in the United States remains below 50%, despite it feeling as though everyone here has one, it should not be surprising that Apple has 25% market share in China, or just 1% market share in India. And Apple’s decision to stop releasing unit sales figures for the iPhone only further reinforces the notion that material unit growth is over (iPhone unit sales actually peaked all the way back in 2015 at 231 million and have fallen more than 5% since) and revenue gains will be generated from pricing power, which will only serve to compress unit sales even more over time.

With iPhone having peaked, the next big thing for Apple was supposed to be recurring, high margin services revenue, but that thesis has played out only mildly in recent years. Services comprised 14% of Apple’s total revenue in 2018, versus 9% five years ago. In order for investors to genuinely view Apple as a subscription company, they probably need that figure to be at least 40%, and that will take many years, if it ever happens.

We will soon hear about the company’s newest services offering; a streaming video product, but that market is so crowded it is hard to see how they will be able to rival Netflix, Hulu, Prime Video, and the forthcoming Disney service. Press reports indicating that Apple CEO Tim Cook has been reading scripts and providing feedback for their shows in development should also worry investors. Should the CEO of Apple, who has no experience in the media content creation business, really be spending his time reading scripts? Doesn’t he have better things to be doing? I fear the answer right now is no, which also presents a problem in terms of future innovation breakthroughs at Apple.

We are left with a company that is seeing its largest product (the iPhone is >60% of revenue) hit a wall and has little in the way of exciting new stuff in the pipeline. I do not expect the video service to be a big winner (they should have just bought Netflix or Disney instead), they have abandoned the electric car project (which seemed like an odd match for them to begin with), and more obvious areas for them to tackle (the high-end television market) have long been rumored without any results. Why Apple hasn’t come out with a beautiful, premium priced all-in-one slim television device that integrates all video services seamlessly via voice control is beyond me. You can get one from Amazon at a bargain price, but the high end of the market remains untapped.

At the current price, Apple fetches about 16x times current year earnings estimates, versus the S&P 500 at around 17x. That valuation is high on a relative basis historically, and the company’s future growth prospects look more muted than in prior years. The iPhone’s competitive issues in emerging markets remain a problem without an easy solution (price cutting is not in Apple’s DNA), but the stock market has quickly forgotten about that and sent the stock up more than 30% from the January lows. Without material multiple expansion, or significant underlying revenue growth, it is hard to see much value in Apple’s shares in the 180’s (or extreme downside either, to be fair), and as a result, now seems to be a solid exit point.

For a replacement, I find Facebook (FB) quite interesting. Sentiment is weak, the valuation is quite attractive relative to future growth prospects (21x this year’s estimates, which are flat versus 2018 levels given the current spending cycle — which should be temporary). As a result, over the next three to five years I would be surprised if Apple outpaced Facebook in terms of stock price appreciation.

Full Disclosure: I have recently been selling client positions in Apple and replacing them with Facebook, but positions may change at any time.

Chipotle Valuation Surging to Dizzying Heights, Surpassing Amazon!

It should not be surprising that hiring a veteran restaurant executive to replace an inexperienced founder will have a material impact on the business and its stock. Chipotle Mexican Grill (CMG) is a classic example, as Steve Ells stepping aside for Brian Niccol (formerly of Taco Bell) has launched CMG’s shares into the stratosphere:

CMG’s customer traffic has rebounded (+2% in Q4 2018) after flat lining earlier in the year and material price increases (+4% in Q4 2018), which were sidestepped after the e coli incidents, have same store sales rising 6% and profits surging even faster. The current analyst consensus estimate has CMG earning $12 per share in 2019 on a mid single digit same store sales increase and 5% unit growth. Those figures would place CMG near the top of the sector.

As is often the case, the biggest issue is the magnitude of CMG’s recent stock gains. At more than $600 per share, CMG’s forward price-earnings ratio is a stunning 50x. Why a casual dining chain with 2,500 locations already should trade at such a valuation is hard to understand, unless one believes they are going to steal a lot of market share going forward from here. Many folks believe that will happen, but I am less excited.



To give readers a sense as to how nutty this CMG valuation appears to be, let’s compare it to Amazon (AMZN). I know AMZN is not a dining stock, but I find it to be an interesting comparison because they are both loved consumer brand stocks right now. Not only that, I would venture to guess that an investor poll would conclude that Amazon’s business is better than Chipotle’s and is likely to grow revenue and profits faster over the coming decade. And yet, today we can invest in Amazon at a cheaper valuation:

Looking at 2018 reported financial results, CMG trades at 31x EV/EBITDA, versus 28x for Amazon. I used EV/EBITDA to account for balance sheet items as well, but on a P/E basis the numbers are also similar: 50x for CMG and 59x for AMZN.

For those who are intrigued by Chipotle stock, I would simply point out that Amazon has long been a loved growth stock for which investors are often willing to pay sky-high valuations for. Today an argument can be made that CMG is more expensive and you would have a hard time finding people who expect CMG’s business to outperform AMZN in coming years.

If that’s true, either CMG is overvalued quite a bit, or AMZN is relatively cheap, or both. I would bet that AMZN outperforms from here. For those who like paired trades, being short CMG against an AMZN long looks interesting.

Facebook Sell-Off Hard To Ignore From A Contrarian Perspective

Shares of Facebook (FB) are dropping below $130 today as the high-flying tech sector continues a sharp correction in the market.

After such a punishing drop, it is hard for me to look away because there is a bullish fundamental story buried here, and the valuation is becoming quite undemanding.

From the business side, FB continues to offer a return on investment for small businesses that is unrivaled in the media industry. Couple that with a huge user base, that can make any successful new product launch (dating service, streaming TV, anything else they come up with later on, etc) inherently materially incremental to profits over the long term, and there are reasons to believe that the company’s business model is far from broken.

From a valuation perspective, investors are getting FB’s operations for about $113 per share (net of $14 per share of cash in the bank). With GAAP earnings of roughly¬† $7 likely for 2018, and a path to EBITDA of $30 billion in 2019, the metrics look meager on both a trailing and forward basis, despite slowing growth and falling profit margins. I understand that FB is dealing with many operational challenges, but 16x trailing twelve-month earnings? 11x next year’s EBITDA, net of cash? At a certain point, the price more than reflects those challenges. It appears we have reached that point, so I cannot help but take notice.



There is still a bear case that deserves to be considered; namely that the business is permanently impaired and that revenue cannot continue to grow double digits. Essentially, the existing business is peaking and new offerings will fall flat (the new Portal hardware device?). Without growth, a near-market multiple would roughly be appropriate.

However, if the core story remains the same; rising revenue will be met with even-faster rising expenses, resulting in lower operating margins and slower profit growth, it appears the stock already more than reflects that outcome. Put another way, if GAAP earnings don’t stop at $7 and instead go to $8 in 2019 and $9 in 2020, etc, the stock is not going to stay in the 120’s for long.

Full Disclosure: I have begun to build FB long positions in client accounts that have seen fresh cash deposits in response to the most recent market decline and those positions could very well grow over the near to intermediate term based on market conditions

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.

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).