The stock market had a bit of a lackluster move last week as it was closing out most of July, and we believe that the market may begin a bit of a general pullback heading into August. All that will depend this week on a very large amount of economic data that is expected to be released. Additionally, the market will continue to have some more interesting earnings to set the stage. Even if FOMC and NFP are positive, will it give the market a lift? After seven months of rallying some correcting is due? Any miss by economic data or NFP or even at expectations could be devastating to the market.
Click to enlarge images.
The chart above shows us hitting some resistance at the 1700 level on the S&P 500. Breaking out of that level would help the market move even higher. Yet we are going to need to have a lot of confidence in the market to get out of that level. Support appears to be in the 1660-1650 area for the market right now. A retest of that level on some issues from the market would definitely be a place to comeback to for support. The Dow Jones and Nasdaq charts look quite similar.
Pending Home Sales - June
Case-Shiller 20-city Index - May
Consumer Confidence - July
ADP Employment Change - July
Chicago PMI - July
FOMC Rate Decision - July
Initial Claims - 07/27
ISM Index - July
Construction Spending - June
Nonfarm Payrolls - July
Unemployment Rate - July
It is a major week for the stock market data with NFP, FOMC rate decision, consumer confidence, housing data, and much more. The very large week will provide some definite potential for the market. The beginning of the week will be signified by pending home sales and consumer confidence. Home sales have been weak as of late and it would be good to see them get back on track. On Wednesday, we start to get employment information with ADP as well as the monthly FOMC rate decision. Expectations should not be very high for the Fed to make a major impact on the market, but the news will draw a lot of attention. On Thursday, we get the important ISM Index for July, and we wrap up the week with NFP on Friday as well as personal income and spending. NFP will be very important to the market with 175K expected. A nice beat there could get the market on track, while a miss would hurt.
Outside of the U.S., Europe and Asia have some interesting developments to watch this week. Tuesday, we get the German GfK Consumer Confidence report and Spanish GDP. On Wednesday, we get some important European unemployment data as well as the key Chinese manufacturing PMI on Thursday. Europe has started to show some green shoots, and it would be nice to see them continue with positive economic data. China could really help to get back on track with a positive PMI.
Exxon Mobil (XOM)
Procter & Gamble (PG)
Earnings are still packed this week with a lot of key companies, but with so many other crucial reports to be released this week, earnings may take a backseat. The reports that can move the market are XOM, PG, and CVX. We are interested to see how these companies are doing since they are such large economic bellwethers. How are CVX and XOM doing with supply issues and elevated prices? PG will give a great look at the consumer with consumer staples. PFE and MRK have been having some recent troubles due to margin issues, and we will see if that issue with generics is still occurring.
The Federal Reserve has been extremely important to the market this year, and FOMC rate decision is released on Wednesday. The commentary is really the important part, as the rate will stay at 0.25%. Are we any closer to taper? Are they backing off from taper? Data has been pretty solid outside of housing, but interest rates rising is an issue if taper does occur. It will be a key report to watch, and we would guess the Fed will try to do as little damage as possible and flirt with taper but not commit.
The market has a crucial week with earnings, economic data, and Fed information. The key will be the trifecta of FOMC, GDP, and NFP. The Fed needs to report they are not moving to taper, while NFP and GDP need to beat expectations for us to continue higher. We fear that the three cannot do enough to make the market rally, and this week could be the start of a lackluster period in the weakest month in the market -- August.
1. Facebook (FB)
Earnings last week were very positive for FB. The question for those not involved or currently involved is can it still go higher or is it time to book gains for a while. For the past twelve months, the key for FB has been their growth in mobile. As developed nations move away from PCs and notebooks onto mobile phones and tablets, FB needed to make sure they could make money in this change. At first, they struggled to make mobile ad revenue and did not seem to pay attention to it enough. The latest quarter, though, has confirmed that FB will be able to be successful in mobile. What we want to do today is lay out a price target model with latest results to discern the price potential in FB.
The key numbers were $333 million in net income over $157 million one year ago. The number of FB mobile users jumped 51% to 819 million year over year, and what more mobile ad revenue was now 41% of total revenue at $740 million. One year ago, the company was making nearly no money in mobile ads. The number of users are now over 1.1 billion, and the company has been able to add a lot of new users with its "Facebook for Every Phone" model that can allow non-3G and smartphone users to access FB.
Let's apply some of these numbers to a pricing model. In this model, we have assumed a growth rate of 10-15% in 2015-17. We have expected around a 37%-40% tax rate along with similar levels of growth in depreciation as operating income. The following is likely a very positive scenario where growth continues and capital expenditures are held in check, but we see this as likely to occur as the company's infrastructure is fairly set and adding each new user is cheap.
Step 1: Project operating income, taxes, depreciation, capex, and working capital for five years. Calculate cash flow available by taking operating income - taxes + depreciation - capital expenditures - working capital.
Available Cash Flow
Step 2: Calculate present value of available cash flow (PV factor of WACC * available cash flow). You can calculate WACC, but we have given this number to you. The PV factor of WACC is calculated by taking 1 / [(1 + WACC)^# of FY years away from current]. For example, 2016 would be 1 / [(1 + WACC)^4 (2016-2012). WACC for FB: 7.4%.
PV Factor of WACC
PV of Available Cash Flow
Step 3: For the fifth year, we calculate a residual calculation. Taking the fifth year available cash flow and dividing by the cap rate, which is calculated by WACC subtracting out residual growth rate, calculate this number. Companies with high levels of growth have higher residual growth, while companies with lower growth levels have lower residual growth. Cap Rate for FB: 1.4%.
Available Cash Flow
Divided by Cap Rate
Multiply by 20167PV Factor
PV of Residual Value
Step 4: Calculate Equity Value - add PV of residual value, available cash flow PVs, current cash, and subtract debt.
Sum of Available Cash Flows
PV of Residual Value
Interest Bearing Debt
Step 5: Divide equity value by shares outstanding.
In the model, we see FB worth $44 by the end of the year, so we are still looking for another 25% growth potential in shares this year. These last earnings are just the start of FB's ascent.
2. Google (GOOG)
We remain negative on Google as we have since the beginning of the year and we still believe more downside is ahead for this name. While FB is in full growth mode, GOOG looks more or less plagued by the growth of mobile and its effect on changing the landscape of Internet usage. The problem for GOOG is that the combination of successful applications and the company's increasing assets has pressured GOOG's ability to grow mobile revenue. Five years ago, GOOG was the place you would visit to look for travel reviews on "x" country or find a concert venue. Yet, the increase of specific applications with lots of followers, their own app buttons, and the ability for individuals to know that those specific companies (Zillow, LiveNation, TripAdvisor, etc.) have taken a step out of the process.
What has GOOG done? We talk about it here:
The company continues to dedicate a lot of money to new ventures that are not paying off. How do we know? The argument we are making above about increasing capex and working capital can be seen in the company's decreasing ROA and ROIC. The company has seen ROIC come down from 23.7 to just under 16 in the TTM from 2005 to present. Return on assets have also decreased in the same timeframe from 21.6 to 13.3. Both declining measures of profitability show that assets are growing much faster than profits. The decline in profits is shown in our model as well as continued strong working capital increases as those assets continue to grow. What we are getting at for GOOG is that its business has added to the business (assets) but it has not been paying off (profits).
What's the issue?
We have previously noted that Motorola is definitely going to weigh on the bottom line for some time. Google + as well we believe is a drag on the company. Motorola could turn out to be something very profitable if the company can make money off the patents in the way of exciting hardware, but that is a big question mark. Another sign that Google+ may be struggling is that the company is now funneling people to have a Google+ when they sign up for Google account. The force of people to use the product is not a positive. The company sees Google+ as a necessary defense to Facebook, who does create a threat with its social networking business.
What we are getting at is that maybe the so-called ironclad ad revenue is not so ironclad. Sure, the company is dominating search, but people are finding other ways of using its time on the Internet -- using its phones, Facebooking, and even using LinkedIn (LNKD). The move into Motorola and Google+ are definitely defensive measures as it sees FB and the move onto mobile as trends that will last, but it has not mastered these businesses the way Google has mastered search. Thus, we see the decline in profitability. We do not see that changing in the next couple years, and therefore, we are holding back our price target.
For us, the latest earnings were indicative of this issue. Cost-per-click decreased about 6% as more mobile users are now searching. Return on assets halfway through the year was 6.5%. At this time last year, ROA was 6.6%. The company continues to still not see any growth of their return on their ballooning assets. We firmly believe that this trend shows that the company has had to increase its assets in order to be able to compete with the rise of Facebook, LinkedIn, and other sites. Just look at some of the moves of Google -- Offers, +, Motorola; these are all moves to defend ad revenue after competitors like Groupon, Facebook, and Apple exploded on the scene.
The mobile makeup is changing and while GOOG is still an extremely powerful and well-run machine, the key is finding that mobile makeup that will return their ability to direct advertisers on prices like they could in the past. Until then, we say avoid.