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By David Sterman

How does a company worth $60 billion manage to completely shock investors and deliver a 25% one-day gain? That's the question being asked at traders' desks across the country after Facebook delivered a rock-solid second quarter that exceeded the most bullish of forecasts.

The answer is simple. Facebook (FB), despite its massive size, had largely been forgotten by most investors. Earlier this month, I noted how this once-hot IPO had been steadily falling this past spring, even as the rest of the market was in party mode.

Suddenly, this stock is touching 52-week highs again, and if you were savvy enough to own this stock going into the quarter, then this is no time to be a seller. After a quick move to $33, this stock may be headed toward the $40 mark by year's end.

The Great Second Quarter
Facebook's impressive second-quarter results have been discussed in many other forums, so I'll only recap the key metrics here:

  • Strong advertising revenue (up 63% from a year ago (excluding currency impacts) compared with a 41% year-over-year jump in this year's first quarter) highlights the company's rapidly increasing ability to monetize its massive user base.
  • That monetization, which surged 26% from a year ago to $1.60 per user, is now the highest in the social media landscape. That figure stood at $1.35 just three months ago.
  • Facebook's daily average users, as a percentage of monthly active users, rose to 61% in the second quarter from the previous quarter, reversing recent declines. That rebuts concerns that consumers have grown tired of daily Facebooking.
  • Mobile ad revenues of $657 million were almost 50% above consensus forecasts. The entire analyst community simply didn't see this coming.

Facebook generated more than $1 billion in quarterly EBITDA (earnings before interest, taxes, depreciation and amortization) for the first time in its history. The most bullish Wall Street analysts expected EBITDA of around $900 million.

Yet as solid as those numbers are, they don't explain why this stock still has considerable upside. In my recommendation of Facebook earlier this month, I discussed the management initiatives that are still in their infancy and not yet significantly contributing to financial results. For example, the company's purchase of Instagram -- which now has more than 130 million active users -- continues to look like a master stroke, as that division's user growth shows no signs of cooling.

Facebook management has moved slowly to monetize Instagram's user base, wisely preferring to let it grow as large as possible before shifting the platform toward ads. It's a transition that Facebook users now accept, and Instagram users will slowly be weaned into advertising in a similar fashion.

Another growth initiative to monitor: video advertising. Facebook concedes that advertisers are clamoring for more video display ad opportunities and this is likely to be a key focus for management over the next six months. (In the third point I made in my look at the stock a few weeks ago, I also highlighted many other mini-platforms that Facebook is developing.)

The other key trend is very impressive capital management. Facebook's IT team is becoming so much more adept in its hardware and software purchasing that the company was able to pursue all of its growth initiatives with just $268 million in capital spending. That's more than $100 million below consensus forecasts.

Surging revenues and controlled expenses will set the stage for Facebook to post some of the most impressive operating margin profiles of any major tech company. Merrill Lynch believes that free cash flow will exceed $2.5 billion by 2015, up from just $53 million last year. Projected EBITDA of $7.4 billion in 2015 would be roughly triple the EBITDA generated in 2012.

Wall Street Sees The Light
Wall Street analysts, who tend to move as a herd, have been suddenly boosting target prices at a feverish clip. Here's a quick sampling:

  • Merrill Lynch's target goes from $35 to $40, boosting 2014 and 2015 forward EPS and revenue targets by 20% to 40%.
  • UBS' price target was raised from $30 to $36, suggesting that "there will be upward pressure on advertiser budgets allocated to Facebook as the company improves its ability to demonstrate the (returns on investment) achievable on its platform."
  • Topeka Capital Markets sees shares rising to $40, thanks to "several well defined catalysts over the next two years including monetizing Instagram, launch of auto-play video ads ... and a bigger push into e-commerce."
  • Jefferies' target price goes from $32 to $37, predicting that Facebook will finish the year on a very strong note as current initiatives ripen.
  • JMP Securities upgraded its rating from "market perform" to "market outperform." Its new $38 price target is based on the belief that "Facebook has discovered the formula to begin significantly extracting value from its 1.16 billion global users."
  • Cantor Fitzgerald bumped its price target from $35 to $40, as "the valuation remains compelling for a company growing revenues at 40-plus percent and EBITDA margins at 55-plus percent."
  • J.P. Morgan has a Street-high $44 price target, suggesting that the just-released second-quarter results "could be thesis-changing for many."

Why should you care about these analysts' price target and views? Because Facebook is about to become a major topic of conversation among these analysts and their hedge fund clients. Analysts tend to "talk up a name" as long as its current price is a reasonable distance from its target price.

Risks to Consider
There are a few negatives to the Facebook story. First, the games category continues to underwhelm and is becoming a decreasing part of the sales mix. Second, Facebook's "Graph Search" feature, which was the product of a considerable amount of R&D spending, has not yet become a hit with consumers. And thanks to a rebounding stock price, Facebook could soon be hit by a brain drain as valuable employees cash in their stock options and migrate to smaller, pre-public tech companies where other options bounties await.

Shares of Facebook are hitting fresh 52-week highs but remain well below the IPO price. The company burned a lot of bridges with lackluster quarterly results in 2012. Yet it's increasingly clear that management now understands the need to deliver solid financial metrics both now and in the future. That said, it's the probable growth in 2014 and 2015 that should really have you focused on this stock. This week's sharp run for the stock reflects the fresh set of quarterly results -- but the next leg of share price appreciation will come from even better quarters yet to come.

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Source: Whatever You Do, Don't Sell Facebook Now