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Did Facebook Just Put a Top on the NASDAQ?

Written by Briton Ryle
Posted July 29, 2018 at 8:00PM

It was inevitable that Facebook would have a day like Thursday. It got whacked for $40 and lost something like $150 billion in market cap. The specific reason for the big earnings miss is that Facebook has had to spend more on security. New privacy policies have certainly affected ad revenue numbers. And it seems likely to me that the "delete Facebook" thing has probably had an effect. 

But the bigger picture issue is one I've written about before.

It's something that will inevitably affect any growth company, especially one that has a unique business model like Facebook. 

In that March article I just linked to, I wrote, “The last few years have been like the Wild West on Facebook's ad platform. It was completely automated. You could literally do whatever you wanted, and exactly nobody would question it.”

The vast majority of growth stocks enjoy this “Wild West” period. They add users, revenue grows leaps and bounds, they make acquisitions, they raise cash... and it all happens in an environment where just about everybody is collaborating. New clients are flocking to get on board, users are enthralled with their new toy, peripheral companies that provide support are highly motivated...

It is truly all good. And those good times can last a few years.

Eventually, the romance period ends, and the relationship becomes a day-to-day grind. Those acquisitions have to hit the balance sheet, and maybe the ROI numbers don't look so hot. Users find a new toy that fires the imagination...

Sure, there is usually a specific catalyst you can pinpoint in retrospect that says the honeymoon is over. For Facebook, it was the data breach back in March. At the time I wrote: 

How will it [the data breach] affect earnings? 

The simple truth is, most stock-related news should be completely and unapologetically ignored. Because most news you see is not going to affect earnings. This is why, despite my dislike of Facebook, I have never taken or recommended a downside trade in the shares. 

But now? Ohhh yeah, this news can absolutely affect Facebook revenue and earnings. In fact, I think it's inevitable. It doesn't even matter if the regulators step in. 

This was the first earnings report since Facebook had to make changes to its policies. Expenses were up 50%. User growth slowed. That's a lethal combination for a growth stock

Twitter, Facebook, and the Nasdaq

Twitter got whacked on Friday for basically the same reason. About a month ago, Twitter decided to purge the fake accounts on its platform. Long term, this is the right move. Fake accounts impact the user experience and dilute the response to ads.

Out of around 320 million users, Twitter deleted 70 million accounts. Just a huge number. And be forewarned: Facebook is gonna have to do this sometime, too. Can you imagine if Facebook has a similar percentage of fake accounts as Twitter? Could be 500 million accounts...

No doubt these big earnings fails from Facebook and Twitter are going to get some people talking about the decline of FAANG and the end of the big tech rally. After all, it's a pretty standard conclusion that a bull run might be in trouble when the leaders stop leading. And out of the FAANG stocks, the F (Facebook) and the N (Netflix) have hit some hard times.

But before you load up on put options, let's talk about the two As and the G. 

Amazon and Google just reported really good quarterly numbers. And it's likely that even if Apple doesn't come in great, the company is just not going to come in terrible. Apple's already had its day in the Wild West sun. Its business today is very predictable, downright boring. That's why it trades with a P/E (18) that even Warren Buffett is comfortable with. 

I would also argue that Apple, Amazon, and Google are far more connected to the actual economy than Netflix and Facebook are. 

Yes, Google and Facebook are hugely dependent on ad revenue. And when the economy tanks, ad revenue will fall as companies adjust their budgets. But we can easily see that ad revenue went in different directions for Google and Facebook. The issue isn't demand; advertisers still want to spend money because they know they can grow sales. 

Amazon and Netflix have some similarities to their subscription services. But here again, Netflix subscriptions would actually be expected to rise in a tough economy, because it's cheap entertainment that can take the place of going out to dinner or dropping $60 to take the family to the movie theater. 

Amazon is the one that would be hit by a weak economy. That didn't happen. 

Now, you could look at today's 4.1% GDP print and think, “What's he talking about, weak economy?” My point is the economy is still saying it's a good environment for companies to grow revenue and earnings. So I'd say it's premature to think the rally is over...

Amazon and the Wild West 

Here's the thing. I actually think Amazon is in a Wild West phase, largely due to growth from Amazon Web Services. 

Back in April 2017, I wrote about why Amazon was undervalued at $900. My thesis was basically that Amazon could turn its massive operating income into net income any time it wanted to. I wrote: “You telling me that with $26 billion in [2018] cash flow, Amazon can't report $10 billion in profit and drop that P/E down to 30?”

The P/E is higher now because the stock doubled(!) since then. But my math was spot on. Amazon just reported $5.07 a share, which was a net $2.5 billion profit. Do that for four quarters, and there's your $10 billion in net profit.

(If you check Yahoo Finance for AMZN's current P/E, the numbers are not up to date yet. Analysts still have full-year earnings at $12.56 a share, the company has already reported $8.34, and — with two quarters to go, including Christmas — it could finish the fiscal year around $18. Fiscal 2019 is estimated at $20. That could easily be $30, which puts the forward P/E closer to 45 instead of 90 where it is now.)

I don't think there's a CEO out there that "gets it" better than Jeff Bezos. He plays the game magnificently well. He's a Michael Jordan: You know he can turn it on whenever he needs to. 

For the last few years, he's held down net income to reinvest in the business. Growth is ridiculous across the board:

And so now he's letting the cash hit net income. Amazon Web Services growth will slow at some point. And acquisitions like Whole Foods will have to hit the balance sheet, too, and I find it hard to believe the ROI there is going to look good.

So what will happen when these things look like they can take the share price down? Well, Bezos will probably be right back in a Wild West phase, as his health care company (with Buffett and Jamie Dimon) is just getting going.

Are you kidding me?

Until next time,

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Briton Ryle

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A 21-year veteran of the newsletter business, Briton Ryle is the editor of The Wealth Advisory income stock newsletter, with a focus on top-quality dividend growth stocks and REITs. Briton also manages the Real Income Trader advisory service, where his readers take regular cash payouts using a low-risk covered call option strategy. He also contributes a weekly column to the Wealth Daily e-letter. To learn more about Briton, click here.

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