Is Facebook Cooked?

Posted On December 8, 2016 2:34 pm

It’s well known the post election monster rally has favored financials and cyclicals at the expense of technology shares. This is broadly highlighted in the sector performance in which the SPDR Financials (XLF) and SPDR Industrials (XLI) are up 18% and 12% respectively over the past month, while SPDR Technology (XLK) is a up a mere 2% in that time frame.

Some of the premier big cap companies such as Amazon (AMZN), Alphabet (GOOGL) and Salesforce (CRM) are down an average of 4% since the election. The reason for the sector rotation could be due to higher interest rates making it harder to justify high p/e ratios of these tech firms, as technology companies tend to do more business overseas, so would be hurt by a stronger dollar and wouldn’t benefit as much from reduced tax rates.  Also, many investors were probably simply taking profits in these names, which had big gains, reallocating the money to sectors likely to be winners under Trump policies.

But Facebook’s (FB) slide began prior to the election and seems to have other issues, suggesting the company’s, or at least its stock price, might face further headwinds. Before getting to some of the fundamentals it should be noted the technical picture recently took a negative turn.

The chart shows FB gapped down on 11/03/16 following somewhat disappointing earnings report. It then subsequently broke below its 200 dma for the first time in over two years and faces significant resistance at the $120 level.

When based on usual metrics, FB shares are expensive relative to the broader market, but the case could be it does so for a reason and the stock is not too highly overvalued.

It’s current P/E ratio of 44. Well, price is what you pay and value is what you get. As a matter of fact, a P/E ratio of 44 stands at a three-year low for the company while growth in EPS Diluted has been hitting a three-year high – an investor is clearly paying less in price for bigger profits.

But it would be a natural trend for any company as its business matures and especially so for one of Facebook’s size, which now with nearly 2 billion users, faces the law of large numbers and the limits of the earth’s population.

I’m not predicting Facebook is going the way of MySpace, the fact is both user growth rates and revenues are declining for its main platform. Indeed, industry experts point to reports showing the FB user base is already aging beyond the 18 to 35 year old coveted by advertisers.

Younger people have switched to platforms such as Snapchat, WeChat and half a dozen others I’ve never heard of. In fact, it’s safe to say many of the next generation may never know or use Facebook.

Facebook does benefit from much higher levels of user engagement (in terms of time spent on the site, frequency of use, etc) and has done well to make crucial acquisitions such as Instagram and Oculus, which may offer good growth through a virtual reality platform.

However, the company makes no secret of the need to reduce dependency on advertising revenues, which easily make up 85% to 90% of overall revenues, with the rest coming from user payments for different Facebook services.

Moreover, revenue from payments and other fees has been on the decline. As the switch to mobile accelerates, the company has seen less revenue from games traditionally played on personal computers. The challenge for Facebook is being able to maintain strong advertising revenue while concurrently increasing revenues from payments and other fees. Much of the increase in this sector will come from Facebook’s ventures into artificial intelligence – although it will be some time before we see this monetized.

To be clear, I’m not a roaring bear on the company. It has too many good things going on and Mark Zuckerberg has proved to be not only a quick learner, good manager but also a keen sense for what’s next. But with the nature of technology in general, and social media specifically, it’s hard to keep pace. The fact he has had to purchase companies such as Instagram and has all but copied many of the Snapchat features speaks to the challenge staying a step ahead.

I just think like other great and dominant businesses from IBM to Microsoft (MSFT) to Apple (AAPL) to Google (GOOGL) there comes period in which the business model goes through a transition, new products get introduced to respond to competition. And the stock price usually has a draw down during such periods, as expectations for future growth take a more conservative outlook.

From an investor standpoint Snapchat poises an additional threat. Until now Facebook had been about the only game in town for money managers to get exposure to social media. But with Snapchat filing for an IPO, slated to come to market during the first quarter and expecting to garner a $40 billion valuation, money may exit FB to relocate some of that money to buy a piece of Snapchat.

And we’ve seen during the month since the election just how powerful a force rotation and reallocation can be.

I think shares of FB could dip back to $100 level within the first few months of 2017.

I’m buying the March 120/105 Put Spread for a $5 Net Debit.

Here is what the risk graph looks like.

About author

Steve Smith

Steve Smith have been involved in all facets of the investment industry in a variety of roles ranging from speculator, educator, manager and advisor. This has taken him from the trading floors of Chicago to hedge funds on Wall Street to the world online. From 1987 to 1996, he served as a market maker at the Chicago Board of Options Exchange (CBOE) and Chicago Board of Trade (CBOT). From 1997 to 2007, he was a Senior Columnist and Managing Editor for TheStreet.com, handling their Option Alert and Short Report newsletters. The Option Alert was awarded the MIN “best business newsletter” in 2006. From 2009 to 2013, Smith was a Senior Columnist and Managing Editor for Minyanville’s OptionSmith newsletter, as well as a Risk Manager Consultant for New Vernon Capital LLC. Smith acted as an advisor to build models and option strategies to reduce portfolio exposure and enhance returns for the four main funds. Since 2015, he has worked for Adam Mesh Trading Group. There, he has managed Options360 and Earning 360, been co-leader of Option Academy, and contributed to The Option Specialist website.