Facebook: Uncertainty Could Cap Stock's Upside

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About: Facebook (FB)
by: D.M. Martins Research
Summary

I believe the Street could go into "wait and see" mode as we go into a more uncertain second half of 2017.

Multiples could stagnate through the next three months as top-line growth deceleration takes form.

So is FB a "sell" on revenue growth slowdown? I do not think so, but I would not be surprised to see short-term headwinds.

Last week, I talked about how Facebook's (FB) 2Q17 robust results had met a "bloated stock." In that article, I argued that, following a three-turn increase in the stock's forward P/E multiple to new 12-month highs only weeks ahead of the earnings release, shares could struggle to gain much lift in the near term.

Credit: The Telegraph

The stock indeed recovered its initial after-hours loss of -1% on Wednesday to end the following trading day up about 3% after the solid guidance disclosed during the earnings call. Although on the surface more in line with the very strong results and outlook that Facebook had posted the night before, the stock's next-day reaction was more subdued than I would have otherwise expected following such a strong print. Now that FB trades again just below the $170/share mark as shares ended this Monday down nearly -2%, I believe the Street could go into "wait and see" mode, setting aside for a moment how strongly the Menlo Park-based company has performed over the past few quarters.

FB could trade sideways on uncertainty

Think of FB's stock price in the context of projected earnings. As the table below illustrates, EPS estimates for fiscal 2017 have gone up from $4.87 to $5.23 over the past seven days, a revision that I find to be in line with the better-than-expected 2Q17 revenues and 2.5% YOY improvement in total expenses projected for the full year compared to last quarter's guidance. The net impact of better earnings projections coupled with timid stock reaction on valuation is a dip in forward P/E from about 33.9x last week to 32.5x today.

Source: Yahoo Finance

One of the key reasons why I believe multiples could stagnate or even continue to dip a bit further and the stock might trade sideways through the next three months is uncertainty. Since at least 2Q16, Facebook's management team has been warning that "ad revenue growth rates (would) come down meaningfully" this year as a result of "ad load (playing) a less significant factor driving revenue growth after mid-2017," as the company rightfully tries to preserve user experience.

I have recently read great arguments on why the ad load headwinds could be offset by positive factors, including growing ad inventory, ad load "slack" on the faster-growing Instagram platform, and newer ad units like mid-roll video. But I certainly cannot ignore Facebook's management when it says, loudly and clearly, that ad load will in fact have the impact of pushing "ad revenue growth rates [...] down meaningfully." Why would I doubt the executive team on their stated strategy and its implications when ad load is a lever that the company has full control of? In the first half of 2017, ad revenues increased 49% off an already large 1H16 base, suggesting that the "meaningful" top-line growth deceleration has not quite kicked in yet.

Facebook's talented and conservative management team has fully disclosed the timing of that revenue growth pullback: it starts in 3Q17. But it has done little, to the best of my knowledge, to give investors an idea of the magnitude of that deceleration.

Sifting through the past few earnings calls, I regret not seeing further clarification on what level of revenue growth to expect in the next quarter and beyond, and how those numbers might compare to what the Street has been projecting (currently a still-impressive 37% in the second half of the year, for a full-year total revenue growth rate of 41%). The potential cost of such lack of additional clarity into the top-line impact, in my view, is a stock that could stall.

So is FB a "sell" on revenue growth slowdown?

I do not think so. First, I believe the Street has been anticipating these headwinds for about a year now (although possibly not being able to calculate the financial impact as well), and buyers can't complain about lack of advanced notice. Second, I do not think that the long-term FB investor should worry much about how shares might perform in the next 6 to 12 months, as I believe the company is still very well positioned to maintain and even improve its market leadership position and earnings-generating abilities.

But those who currently hold FB or expect to buy the stock soon should be prepared for the possibility of some short-term headwinds, in my opinion. And if these headwinds materialize, the more bullish investor might want to take advantage of the eventual dip to accumulate shares at a (rare) discount.

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Disclosure: I/we 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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.