Bad news, sports fans…
I’m writing to regretfully inform you…
Menlo, we have a problem…
Regular readers (the “cult following”, as it were) know we don’t spend a lot of time here talking about individual stocks unless there’s a discernible macro narrative involved, as is the case right now with names like General Motors, Harley-Davidson and Whirlpool, whose Q2 reports are notable for what they reveal about the early impact of the Trump administration’s trade war on the U.S. corporate sector.
There are, however, some exceptions. Take the banks, for instance, whose quarterly results usually contain some clues about the broader market and also about the economy. And then there’s big cap tech, which bears special mention for one very simple reason: The sector is like Atlas, shouldering the entire burden (and then some) of the market’s 2018 returns.
What you see in that table is indicative of what Howard Marks has variously described as a “perpetual motion machine”, whereby a handful of names end up caught in a self-feeding loop, supercharged by passive investing, smart-beta flows and low turnover on the part of active managers who, with the possible exception of David Einhorn, have by now conceded the abject futility of trying to best the benchmarks that are being driven inexorably higher by this self-referential dynamic.
Simply put, FAANG is the most crowded trade on the planet and has been for months. Even lifeguards and egg “slingers” are all-in, thanks to the “sage” advice of noted financial journal USA Today.
What could go wrong? Well, a lot, as it turns out.
For instance, the President of the United States might decide to take his grudge against the media out the company run by the richest man in modern history.
Or, to take another recent example, it might turn out that setting money on fire in the interest of procuring exclusive Adam Sandler content isn’t a great business model.
Or, you could find yourself running a social network that ends up in regulators’ crosshairs thanks to all manner of data misuse and allegations of accidentally facilitating a Russian misinformation campaign and then, a couple of months later, blindside markets with the first topline miss in three years, which is what Facebook did on Wednesday.
If you follow the company, you doubtlessly know the numbers. Facebook reported revenue of $13.2 billion for the most recent quarter, a 42% gain, but short of analysts estimates. The daily active user count in June was 1.47 billion versus the 1.48 billion Wall Street was expecting.
But the real shocker came on the call, when CFO David Wehner said the following about the revenue outlook:
Turning now to the revenue outlook; our total revenue growth rate decelerated approximately 7 percentage points in Q2 compared to Q1. Our total revenue growth rates will continue to decelerate in the second half of 2018, and we expect our revenue growth rates to decline by high-single digit percentages from prior quarters sequentially in both Q3 and Q4.
There are several factors contributing to that deceleration. For example, we expect currency to be a slight headwind in the second half versus the tailwinds we have experienced over the last several quarters. We plan to grow and promote certain engaging experiences like Stories that currently have lower levels of monetization, and we are also giving people who use our services more choices around data privacy, which may have an impact on our revenue growth.
On expenses, he said this:
Turning now to expenses; we continue to expect that full-year 2018 total expenses will grow in the range of 50% to 60% compared to last year. In addition to increases in core product development and infrastructure, this growth is driven by increasing investment in areas like safety and security, AR/VR, marketing, and content acquisition. Looking beyond 2018, we anticipate that total expense growth will exceed revenue growth in 2019.
Over the next several years, we would anticipate that our operating margins will trend towards the mid-30s on a percentage basis. We expect full-year 2018 capital expenditures will be approximately $15 billion, driven by investments in data centers, servers, network infrastructure, and office facilities. We plan to continue to grow capital expenditures beyond 2018 to support global growth and our ongoing product needs.
Efforts to moderate content and investments in security are beginning to “significantly impact” the bottom line, Mark Zuckerberg warned. Here’s that quote from the call:
I also want to talk about privacy. GDPR was an important moment for our industry. We did see a decline in monthly actives in Europe, down by about 1 million people as a result. And at the same time, it was encouraging to see the vast majority of people affirm that they want us to use context, including from websites they visit, to make their ads more relevant and improve their overall product experience.
Looking ahead, we will continue to invest heavily in security and privacy because we have a responsibility to keep people safe. But, as I’ve said on past calls, we’re investing so much in security that it will significantly impact our profitability. We’re starting to see that this quarter. But, in addition to this, we also have a responsibility to keep building services that bring people closer together in new ways as well.
The shares of course crashed, falling as much as 25% after hours. If Thursday’s regular session ends up looking anything like that, it will be the worst for Facebook as a public company.
This news was accompanied by a veritable media circus. It was, frankly, laughable, albeit understandable given how sure everyone was that nothing like this could happen. Have a look, for instance, at analysts’ recommendations headed into this debacle:
Now consider this, from Goldman’s most recent hedge fund monitor, dated May 18:
Funds maintain conviction in their top positions. Hedge fund portfolio turnover remained near record lows during the volatile 1Q. The average fund carries 68% of its long portfolio in its top 10 positions, nearly an all-time high. Nine of the top 10 stocks in our VIP list last quarter remain in the top 10 this quarter. FB, which ranked as #2 last quarter, experienced the largest net increase in popularity among all stocks during 1Q. AAPL, AMZN, GOOGL, and NFLX ranked among the stocks with the largest decreases in popularity, but remain near the top of the VIP list.
Here are the hedge funds that could have a tough day on Thursday (compiled by Bloomberg based on public filings as of March 31):
- Viking Global Investors 9.346m shares (0.39% stake)
- Bought 5.485m shares in 1Q
- AQR Capital Management 7.937m shares (0.33% stake)
- Bought 1.026m shares in 1Q
- Lone Pine Capital 7.701m shares (0.32% stake)
- Bought 3.3m shares in 1Q
- Appaloosa Management 6.21m shares (0.26% stake)
- Bought 681k shares in 1Q
- Coatue Management 5.697m shares (0.24% stake)
- Bought 804k shares in 1Q
- Tiger Global Management 4.968m shares (0.21% stake)
- Bought 2.545m shares in 1Q
- Arrowstreet Capital 4.044m shares (0.17% stake)
- Sold 480k shares in 1Q
- Third Point 4.0m shares (0.17% stake)
- Bought 600k shares in 1Q
- Lansdowne Partners 3.364m shares (0.14% stake)
- Bought 557k shares in 1Q
- SRS Investment Management 3.132m shares (0.13% stake)
- Bought entire position in 1Q
Bloomberg’s Eric Balchunas has the details on ETFs and mutual funds. “Ouch, Fidelity Contrafund has $9.3b worth of Facebook, that’s double what any ETF owns”, Eric wrote, as the carnage unfolded.
He went on to note the following:
Here’s the deal: About 200 ETFs collectively own 6% of Facebook shares, which is about $35b worth, here’s look at top 15. Meanwhile, 1,600 mutual funds own 5x that amount.
And here’s a look at the ETFs with the most weighting to Facebook. Note XLC, that’s the new Communications sector ETF.
Although analysts are likely still trying to come to terms with what they heard on the call, it’s worth noting that this wasn’t something that anyone saw coming. Goldman, for instance, was expecting a “strong quarter” as late as Monday morning:
Fast forward to Wednesday evening and the bank was out saying this:
Our unchanged $225, 12-month price target is based on an equal-weighted blend of DCF (terminal FCF multiple of 15X), EV/EBITDA (16X CY19E), and P/E (25X CY19E). Key risks to our investment thesis include worsening macro environment, user fatigue, privacy missteps, and user backlash from new ad formats.
That was as of 5:06 PM. Let’s check back on that in 12 hours or so.
On July 2, Wells Fargo’s Ken Sena published a note that carried the following upbeat headline:
As of Wednesday evening, there was no word from Ken, at least not in the form of an official update.
On July 19, Deutsche Bank published a Q2 preview called “Facebook, Inc.: We see further room to run”. Well, it ran alright – just in the wrong direction.
For their part, Barclays published a preview on July 13, which at least came across as a bit more cautious:
On the call, Barclays’ Ross Sandler (who penned the note shown above) sounded incredulous. Here is the exchange between Sandler and David Wehner:
Sandler: Dave, I think you said that the quarter-on-quarter growth rates are going to be high-single digits lower than the prior-year quarter-on-quarter growth rates versus 3Q and 4Q, that would imply around a 20% year-on-year growth rate exiting fourth quarter. So just want to clarify, is that what you actually said? And if so, what’s driving this fairly dramatic deceleration in revenue growth?
Wehner: Ross, so, yes, so we grew at 42% in the current quarter and we would expect decel in the high-single digits for the next couple of quarters. In terms of what is driving the deceleration, it’s a combination of factors, and I think I outlined those in my commentary. First of all, there’s the currency, which is going from being a tailwind to being a modest headwind, we expect.
Secondly, we’re going to be focusing on growing engaging new experiences like Stories and promoting those. And that’s going to have a negative impact on revenue growth. And then, finally, we’re giving people who use those services more choice around privacy, and that’s coming both in terms of impacts that could be ongoing from things like GDPR as well as other product options that we’re providing that could have an impact on revenue growth. So it’s a combination of all those factors that is leading to the deceleration of revenue growth in the second half.
Pivotal’s Brian Wieser was out on Wednesday evening suggesting that the company’s days of 30%+ growth may be behind it. “The advertising industry -– and digital advertising no less -– has limits to growth, which we think is the primary factor constraining Facebook’s revenue opportunity,” he wrote, in a note to clients lowering his price target to $140.
Again, we’ll see what the verdict is 12 hours from now. One certainly imagines some folks on the sellside are having a bit of an existential crisis trying to wrap their heads around this.
I would simply quote Howard Marks, from his infamous summer 2017 memo “There They Go Again – Again“:
The FAANGs are truly great companies, growing rapidly and trouncing the competition (where it exists). Some of them doubtless will be the great companies of tomorrow. But will they all? Are they invincible, and is their success truly inevitable? That raises the question of whether investors in technology can really see the future.
Finally, for those who are in the mood to laugh (a group that most assuredly doesn’t include Facebook investors), I’ll leave you in the capable hands of that other social network, Twitter.
— Quoth the Raven (@QTRResearch) July 25, 2018
— Quoth the Raven (@QTRResearch) July 25, 2018
— Steve Burns (@SJosephBurns) July 25, 2018
— Ryan Essain (@RyanEssain) July 26, 2018
— Bag Holder (@BagholderQuotes) July 25, 2018
$FB today earnings
— PatoNet (@patonet) July 25, 2018
Facebook’s share price plunge wipes out the equivalent of an entire Nike (or McDonald’s) from the company’s market cap. pic.twitter.com/tQWEJuRvhB
— David Ingles (@DavidInglesTV) July 25, 2018
— CNBC (@CNBC) July 25, 2018
— Carl Quintanilla (@carlquintanilla) July 25, 2018