A 105% Gain For Facebook In 3 Months - And It's Time To Take Profits

| About: Facebook (FB)

By David Sterman

We're heading into earnings season, which always yields some great trading opportunities.

The key is to evaluate current investor and analyst sentiment on a given stock, and to identify situations in which a company can deliver significant upside or downside relative to the consensus views.

In the case of social media giant Facebook (NASDAQ: FB), this strategy was laid out on a platter for investors.

Heading into the second-quarter earnings release, the social media giant was universally disliked, trading near 52-week lows. But management had only recently been telling analysts that key business trends were starting to look a lot better. Most analysts were still hesitant to stick their necks out and recommend an unpopular stock.

I laid out the bull case in early July, and shares have more than doubled -- in less than three months.

In that time, Facebook has added more than $60 billion in market value. It's hard to remember the last time such shareholder wealth was created in such a short time.

The pivot
As we head into Facebook's upcoming third-quarter report (slated for Oct. 21), the entire investment thesis has flipped. Facebook is now universally loved, highlighted by rapid-fire analyst upgrades, which paradoxically, makes this a great time to take profits.

In basic terms, there is little Facebook can do in terms of delivering upside relative to third-quarter forecasts (and the forward outlook). And the company's valuation is now in nosebleed territory.

The first issue to focus on is forward estimates. Facebook beat the second-quarter EPS (earnings per share) consensus by a nickel, earning $0.19 a share. Analysts used that result and management guidance to boost their full-year EPS outlook by 15 cents, to $0.72 a share. The 2014 EPS view was boosted by a similar amount to $0.96 a share.

Facebook is likely positioned to at least meet those revised forecasts, but the element of surprise is gone. Prior to the most recent quarter, Facebook typically topped profit forecasts by a penny or two, and if that happens, momentum investors may see the lack of huge upside as a disappointment.

The upgrade cycle
Though shares of Facebook received an initial solid pop when results were released in late July, the stock has gone on to climb steadily throughout August and September as well as formerly skeptical analysts have hopped on the upgrade bandwagon. The cycle played out yet again on Tuesday when Citigroup raised its price target from $32 to $55, leading the stock to a fresh all-time high near $50.
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Citigroup's new "buy" rating is based on a view that shouldn't be ignored: "Following several conversations with advertisers and agencies we believe the factors driving the sudden inflection and growth in (the second quarter) are sustainable and that there are a number of factors that should contribute to further growth and gains."

There's no quibbling with that view. It's why shares of Facebook were such a bargain three months ago. But what really changed? Citigroup calls the second-quarter results an "inflection point," but Facebook's now more robust growth path is simply the result of steps management had been taking in prior quarters. It's not as if the company woke up in recent days and went about its business differently.

Again, Wall Street's positive perception of Facebook is what has really changed, and now there is a real risk that analysts (and investors) are loving this stock too much. To get a sense of that, you need only look at this company's valuations.

Facebook's Lush Valuations

To be sure, Facebook appears poised for considerable growth in 2014 and 2015. But investors shouldn't extrapolate that view into perpetuity. Indeed by 2016, this business will likely be so large that robust growth is no longer feasible.

Though it's hard to pin down 2016 forecasts at this point, simply looking at 2015 projections highlights how expensive this stock is. Facebook surely deserves a market value (and enterprise value) in excess of $100 billion, but how much higher will this stock climb if free cash flow will only be in the $2 billion to $3 billion range by 2015?

It's crucial that you avoid comparing this company to Google (NASDAQ: GOOG) and Amazon.com (NASDAQ: AMZN). Those firms have also done a remarkable job of tapping into new growth niches -- but for a decade or longer. Facebook is wisely tapping into its own growth potential, but there must be limits to how much a social media site can be monetized.

In their move to upgrade their rating on Facebook, Citigroup's analysts laid out a host of future catalysts that will fuel growth in 2014 and 2015. Those catalysts are exactly the ones I laid out in my bullish recommendation three months ago. It would appear that such "catalysts" have already been incorporated into the share price, as these lofty multiples noted in the table above highlight.

Risks to consider: As an upside risk, Facebook may look to pull off other acquisitions in light of the apparent success that its Instagram deal is generating. That said, there are few large targets that could really move the needle.

Facebook is clearly riding herd with other strong gainers such as LinkedIn (NASDAQ: LNKD) and Priceline.com (NASDAQ: PCLN). LinkedIn trades for 51 times Citigroup's 2014 EBITDA (earnings before interest, taxes, depreciation and amortization) forecast, which is pretty astounding in its own right. Google, on the other hand, trades for less than 11 times projected 2014 EBITDA -- closer to reality.

Taken together, Facebook, Priceline and LinkedIn now sport a collective $200 billion market value, even as those firms are expected to generate a combined $16 billion in revenue this year. These are great companies, but as investors increasingly focus all of their funds on these winning trades, the companies are being loved too much. Facebook, in particular, looks poised for a reality check as we head into the next earnings season.

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Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.