Top Stock Pick For 2019 - Facebook Has 32% Further Upside

Summary

• Investor fund flows relative to Facebook shares turned favorable for the stock into the turn of the year.
• The power of Facebook’s business model should reassert the case for the growth stock and draw investors back in as the company reports its earnings results each quarter.
• Facebook shares are compelling for purchase today and set for outperformance due to FB’s reasonable valuation on modest and likely understated growth expectations.
• My 12-month price target of $221 presents investors today with a 32% upside opportunity at a comfortable margin of safety.

One of my top stock picks for 2019 is Facebook (FB). The shares are already up sharply this year thanks to a shift in investor capital flows at the turn of the year and the company's subsequent reporting of stellar earnings results in February. Shareholder selling of the stock for tax loss purposes in late 2018 has been exhausted, and prior selling has been replaced by accumulation of the shares by value-seekers since the start of the new year. The shares fell in the first place, however, for a reason. A slew of negative events and news flow around the company and its operational outlook consumed investor attention. Also, broader macroeconomic concerns plagued the entire market, and especially harmed high growth stocks with exceptional price-to-earnings (P/E) sensitivity. However, with risk concerns at the forefront, investors seem to have lost focus of the reason FB shares had performed so well up until the fall of 2018. Facebook is operating one of the best business models I have ever seen or known of, providing, and greatly controlling, a service that is as pervasive (and controlled) as any service ever provided in human history. Given Facebook shares' deep retracement and its still compelling valuation against what I see as modest and understated, yet still exemplary, long-term growth expectations, I cannot help but to see great opportunity in the shares. The catalyst to get the stock to realize its potential will be its operational results, which I believe will far exceed analysts' consensus expectations for 2019. I expect the shares to remark their prior highs by this time next year and to reach approximately $221. But, if analysts are correct in their soft growth expectations for earnings this year, an outlier expectation against FB's strong earnings per share growth history (40% growth last year and 51% over the last 5 years), then new buyers of the stock at $167 per share would risk the loss of just 3% on investment in my view. This provides a solid margin of safety in an anticipated worst-case scenario. My 12-month price target sees share price appreciation marking approximately 32% over the next twelve months to the conservative level of $221. In my opinion, this type of anticipated capital appreciation is worthy of top stock status.

Data by YCharts

Facebook Stock Marked its Inflection Point and is Rising

Facebook shares are already up 28% since the start of 2019, and they are about 35% higher than they were on Christmas Eve of 2018. This year's turn in the stock has certainly benefited from the exhaustion of tax loss selling. Investors carrying a paper loss on the stock in the 2018 tax year had some incentive to take that loss up until the final day of 2018. As we have transitioned into 2019, however, all such relative pressure has come off the stock. In fact, those who sold the stock at any time in 2018 have at this point far-cleared the 30 days required by tax-relative wash sale rules and can now buy FB back for the long-term and still record capital losses for the 2018 tax year (or longer if carried forward due to excess reported capital losses).

So, with significant selling pressure off the stock, the imbalance of sellers to buyers corrected at or just prior to the turn of the year. In fact, intensified buyer interest followed and reversed the imbalance to the bid side of the trade table. Old owners and potential new owners of FB have suddenly been presented with a compelling valuation for shares of one of the most pervasive service providers mankind has ever known - more than 2 billion people globally use at least one of Facebook's services daily. The result is significant outperformance for FB shares versus the broader stock market and the Nasdaq-100, with the SPDR S&P 500 (SPY) up 11.8% and the Invesco QQQ Trust (QQQ) up 13.1% year-to-date. Those are also stellar year-to-date figures for the broader market, and I believe the result of the January Effect, which also served Facebook shares. In fact, I predicted Facebook's rebound on this premise in the article linked to in the previous sentence.

However, while I believe the broader market could come upon its first stumbling block of 2019 shortly, Facebook may be somewhat insulated because it also has a positive company specific catalyst that should serve it on an ongoing basis. The operational case for Facebook was reasserted via its most recent quarterly earnings report. The stock shot higher on the day of its report, as the company far exceeded earnings expectations.

I expect each subsequent earnings report will serve the same purpose, despite modest analyst earnings expectations for 2019. The average of 46 analysts' estimates sets the consensus expectation for Facebook's earnings per share at $7.59 this year, which is just two cents more than the company earned in 2018. I expect FB shares will get extra lift by beating the low-bar set by analysts. Further along in this report I explain why I believe analysts are incorrect in their assessment of Facebook's near-term operational outlook.

The Core of the Problem for Facebook

First, it's important to recall why Facebook's stock first fell from its 52-week high of $218.62 set in 2018. The same macroeconomic issues that plagued the entire market, including concern about the global economy, domestic monetary policy, trade policy, and more weighed on stocks broadly. The shares of stocks with extended valuations and/or those perceived that way, despite strong growth prospects, were found to be especially sensitive to investor concern. So, Facebook's shares came under especially intense pressure along with its so-called FANG peers [Amazon (AMZN), Netflix (NFLX) and Alphabet (GOOG) GOOGL)].

Data by YCharts

But there was more than just beta at work in the stock's downturn. Company specific matters played a role in FB's underperformance last year as well. What seemed like a never-ending stream of negative publicity plagued Facebook shares. The Cambridge Analytica issue, data breach & sharing concerns, and Russia's abuse of the platform were all terribly problematic for the company on a public relations basis, and for the stock on a price basis. Fundamentally, the prospect of tighter government regulation gained in probability weighting as a result, and that is a prospect that can impede growth. Also, Facebook self-imposed new expenses on its own as it sought to repair its public image, ensure user trust and meaningfully address the issues of concern. And then it seems tax loss selling built upon the macro and fundamental issues into the close of 2018. So here we are now.

Facebook's Compelling Case for Growth and Valuation

The case for Facebook's long-term revenue and earnings growth remains strong, even despite apparently saturated user counts in the U.S. and Europe for Facebook's namesake platform (Facebook.com). Second and third quarter declines in European usage resemble the company's U.S. domestic usage stall for Facebook.com, as the two developed markets are about saturated now for Facebook's namesake social media platform. The same, however, is not true for Instagram, WhatsApp and Messenger, which are still in earlier growth stages, though Facebook does not share this data publicly. More importantly, revenue growth from Facebook's namesake platform should be far from stalling in the U.S. and Europe, as Facebook continues to lever its massive user base to expand its advertising sales and service offerings.

Revenues from the European region grew 27.7% in the fourth quarter, year-to-year. U.S. & Canada revenue grew 31.9% from a much higher base level, and on a significantly smaller user count. The strength of this revenue growth from the company's most developed markets evidences just how fertile the ground remains.

While the operating environment in the European market is different than in the U.S. & Canada on a regulatory front, and with many different languages spoken and perhaps varying consumer preferences, I see the difference between the North American and European advertising dollars per user as indicative of opportunity for revenue growth in Europe. And, in the U.S., there should still be vast opportunity for growth as the company monetizes its other valuable social media and messaging platforms and continues to sell new ads, and I expect goods and services in the future, incrementally across its namesake platform. The remainder of the world market still offers vast opportunity for user growth, let alone revenue growth, though the "rest of world" market currently offers a smaller revenue per user opportunity at today's global development stage.

Region	Average Revenue Per User in Q4 2018
U.S. & Canada	$34.86
Europe	$10.98
Asia Pacific	$2.96
Rest of World	$2.11
Total Worldwide	$7.37

Click to enlarge

*Compiled by author from Q4 2018 Earnings Slide Presentation

Facebook is capitalizing upon its captive marketplace, and new opportunities therein are as vast as any marketplace is globally, only in aggregate for Facebook in my opinion. Facebook has in its total user base of well over 2 billion a huge marketplace to lever. You can think of it as a sales channel to deliver through, and a massive one at that. Every incremental dollar earned per user is $2 billion dollars to the company, so every new idea can payoff extraordinarily. This is the reason why I refer to Facebook's business model as the best I have ever come across. And I have done so since I first recommended the shares when they dipped into the low $20s after the company's initial public offering.

The Awkward Stage for Facebook

I view Facebook's recent unfortunate PR problems as "growing pains." These are the awkward years for Facebook. It's a period in which every other company remotely like it wants to become it and competes aggressively to do so. This is also the time when it comes under regulatory scrutiny and draws unwanted media attention for every misstep and mishap. Every giant company has gone through its own awkward phase of development, from General Motors (GM) to Microsoft (MSFT); and now Facebook, Amazon, Google and Netflix are in society's crosshairs. The wonderful thing is that the awkward stage has presented investors with the best opportunity to buy the stock since when I first recommended it.

FB Shares Valuation

I plan to build out a discounted free cash flow (DCF) model for this stock in the near-future, as I follow it closely and you deserve it. As I will engage in the DCF process properly (a focus of mine in graduate school and in practice on Wall Street), that will require a significant amount of time and at least one dedicated report of its own to discuss. For now, we can see clearly enough based on more basic, though professionally applied, metrics that the stock is cheap relative to growth expectations. And that is the case even as those expectations have been aggressively, and I believe erroneously, lowered.

As I finished this piece the stock was priced at roughly $167 per share and trading in a range between $160-$170. It recently surged on a strong fourth quarter earnings result, before pulling back more recently on concern about European regulatory decisions. Even so, the stock is still finding support from technicians and investment gurus, including yours truly. For long-term investors willing to hold the stock for a year or more, I see the shares well-worth purchasing now.

The stock currently trades at a P/E multiple of 22X the $7.59 in earnings per share estimated by a consensus of 46 analysts for 2019 (revised higher from $7.38 before the Q4 2018 EPS release). Analysts estimate on average that FB earnings per share will grow by just 16.4% over the next five years, despite displaying growth of 51% per annum over the last five. That provides us with a relative P/E-to-growth ratio of 1.3X (up already from 1.1X just before the company reported Q4 results). In my view, analysts' growth expectations are understated, and the company's P/E ratio is overstated on understated EPS expectations, making the true PEG ratio even lower and the stock a compelling value. Even if the stock maintains its current valuation, which I view as depressed, its share price should still advance by approximately 16% from here over the course of the next 12 months. That should exceed the market's appreciation, if we base expectations on the historical performance of stocks.

However, analysts expect Facebook to not grow its earnings this year, as they see the company's expenses rising as much as revenue. The company grew earnings by 40% in 2018 and by 51% per annum for the last five years. So, such a sudden stall in earnings growth would be greatly out of line against the company's recent past. Meanwhile, earnings per share estimates for the first quarter of 2019 ($1.63 versus $1.58 90 days ago) and for the full year ($7.59 versus $7.44 90 days ago) are on the rise. And, over the last four quarters through the fourth quarter of 2018, the company exceeded analysts' estimates by 25%, 1%, 20% and 9%, for an aggregate dollar beat of $0.84.

These soft analyst expectations are based on forecast expense structure expansion, as the company acts to deal with some of the infamous issues that have plagued its image recently. Facebook's monetization effort for Instagram and other platforms are also behind the soft expectations. However, I expect the company will continue to surprise the investment community with excellent revenue leverage and growth across platforms. I have been following Facebook since its inception, so I recall another relatively similar period of expense concern in its history. It was when Facebook was first learning how to monetize and deal with the transition of internet use to mobile from PC. It was a period that also impeded stock performance because of higher expense expectations on corporate guidance, but it only impeded the stock until Facebook reported earnings results and blew out expectations with stellar execution. Look for the same to occur this year.

If Facebook's earnings estimates are at all inclusive of regulatory penalties, treating those as recurring operating costs, then I believe the structure of any such analysts' valuation models would be inherently flawed. This is a temporary and hard to predict, though costly, phenomenon. The real risk of the recent issues to ongoing operations is to the persistency of the user base and to the rate of advertising revenues, but as of Q4 2018, we saw no reason to forecast deterioration to the user base or to advertising revenues per user.

If FB earnings grow by a relatively modest 20% in 2019 to $9.08 per share (let's call it the conservative growth scenario) and its PEG ratio remains at a fair 1.3X and its 5-year growth expectations at 16.4%, then its shares would reach a price of $194 over the next twelve months. That forecasts a return of 16% over the course of the next year. If the company's earnings grow 30% in 2019 to $9.84 per share (aggressive scenario), still short of the 40% growth seen in 2018, and its valuation expands to a PEG ratio of 1.5X on a raised 5-year growth outlook to 18%, in order to reflect startling quarterly performance and an improved outlook, then its stock price should be $266 in a year. That would mark 59% upside from current value. If the company grows its 2019 earnings by a middle-ground 25% rate to $9.46, say on expanded advertising and other sales through its various platforms, despite increased expenditures, and its PEG ratio sticks at 1.3X because of ongoing risk concerns, but its 5-year growth outlook moves up to the 18% rate it recently stood at, then its stock price would be $221 in a year. The last scenario, which I view as still conservative, would take the stock back up to its all-time high, a point where perhaps technical traders might keep it (short-term ceiling). The average of these three scenarios, and the worst-case scenario listed below, would price FB shares at approximately $211. However, I prefer a price target of $221, since I anticipate the stock should be more likely to remark its all-time high the closer it gets to it, simply on technical and psychological drivers of trading. Thus, my 12-month price target of $221 offers 32% upside from current value.

Risk for FB Shares

The risk to this outlook is that the analyst consensus is correct, and 2019 presents a year of no growth for Facebook due to overwhelming expenditures and lack of traction in advertising at Instagram and Facebook.com. In that case, if the stock maintains its 1.3X PEG ratio and consensus expectations for 2019 EPS expectations for $7.59 are realized, and if 5-year growth expectations stick at 16.4%, then the stock should be valued at $162 per share in 12 months' time. FB shares were priced at that level earlier this week and were $167 when we submitted this article. I see this providing a solid margin of safety for basically a 3% maximum expected loss on the stock if it were to fall to $162. Considering my better expectations for the company and the shares, I view Facebook as a compelling strong buy and one of my top picks for 2019.

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.