What a difference a call makes.
Facebook's (FB) strong third-quarter earnings results proved short-lived, with shares getting slammed in after-hours trading in reaction to management's cautious 2017 commentary, which left traders scrambling, investors confused and perma-bears emerging from the shadows to claim rarefied (albeit shallow) victory in a fight that has eluded any investor who has attempted to stand in the way of the stock's 150% run over the past three years alone.
In fact, the company's vaulted status as the bastion of clarity, visibility and consistency -- counting 14 consecutive earnings beats -- appeared emboldened by its third-quarter release and slide deck, with every metric pointing to yet another resounding victory for shareholders such as ourselves who have had the benefit of witnessing the stock's parabolic share appreciation.
For the AAP team, shares headed into the print trading a healthy 102% above our $62.91 cost basis while up nearly 22% year to date. Anyone who has owned FB for more than several months can relate to the relative comfort and resilience of the position, one based not on cultlike support but on compelling fundamentals, tangible, formidable results and strategic transcendence, which is certainly taken for granted.
Regardless of tonight's confusion, we recommend members avoid panic and evaluate the situation through the lens of sensibility and logic. Ultimately, there are three components to analyzing a conference call that leaves investors with more questions than answers.
First, what they (management) really mean. Second, what we think they mean. Third, what Wall Street analysts think they mean. We will come back to these three components after first placing our members in our very seats, chronologizing our thoughts -- and concern gauge -- from the call's beginning to its end.
Concern Meter: Low
The relative comfort enjoyed by the masses was not uprooted immediately (although hindsight leads us to perceive a slight change, with cool confidence replaced by a modestly more formal, perhaps even defensive tone). Ultimately, however, CEO Mark Zuckerberg's opening remarks followed his thematic script, which focuses more on societal benefits and specific examples of community engagement in action along with the usual string of sublime meta-anecdotes (Facebook Live posts have touched every continent, and outer space, too; the Olympics had 270 million people creating 1.5 billion interactions; the election has made Facebook the hub for perhaps less-civil interactions, albeit 5.3 billion; etc., etc.).
Concern Meter: Mild (Briefly Look Up From Slide Deck)
The first sign something was amiss came toward the middle of Zuckerberg's remarks, when he noted that while "Instagram, Messenger and WhatsApp each have large communities … we have a lot more work to do on all of them," going on to list the three strategic phases: building great consumer experience, enabling organic interaction with businesses and giving businesses tools to reach more people.
Concern Meter: Moderate (Is it just me or is something amiss?)
After describing each phase through the lens of the three products, the first real bomb was dropped in Zuckerberg's closing sentences, starting with "while I'm happy about what we've accomplished, we're just getting started," then crescendo to "we want to continue to invest aggressively to accomplish our goals, which is why we are hiring -- especially engineering -- which is going to be one of our top priorities going into 2017."
Concern Meter: Mild (probably just me being paranoid)
COO Sheryl Sandberg took the helm for the next 10 minutes or so of the call to discuss the company's impressive results, particularly the continued ability to capture and monetize the shift to mobile, the increased relevance of video advertising going forward and a smattering of the standard "optimized for each platform," "tailoring for the creative" and "making it easier for advertisers to manage campaigns from a mobile phone."
Concern Meter: Back to Moderate (OK, now I'm listening)
Sandberg took Zuckerberg's cue by closing her remarks on stirring terms, qualifying the major advertising opportunity long term by noting, "To prove the value we're driving for our partners, we continue to invest in measurement," and, "We also have a lot of hard work to do to help our partners around the world use mobile to drive their business." By this point, the defensiveness had our antennas on alert.
Concern Meter: Heightened Alert (Something's off, but the 3Q results were so good….)
Next up, CFO Dave Wehner, who spent the first five minutes speaking to the sublime growth across every data point and metric, which, combined with decelerating expenses for 3Q, teed up perfect operating leverage. His comments around 4Q expectations included a brief mention that revenue deceleration would continue (when revenue growth is falling from 50%+ to just 50%, then incremental deceleration isn't necessarily a concern, especially since the company had always said 4Q would face tough year-over-year comparisons).
Concern Meter: Code Red (Did he just say what I thought he said?)
The nuclear bomb was dropped when he provided comments on 2017. First, he explained that ad load -- a key factor underpinning prior revenue growth -- would be a much smaller contributor going forward, as a result "expect to see ad revenue growth rates come down meaningfully."
To hear ad growth -- which comprises all but a fraction of Facebook's sales -- is forecast to come down "meaningfully" sent immediate, profound shock waves across the investment community. Subsequent commentary was absorbed with a combination of shock and confusion, as Wehner explained that although premature to provide specific expense guidance, "2017 will be an aggressive investment year," echoing Zuckerberg's earlier, far-less-hostile comments and followed by "we expect to grow capital expenditures substantially as we continue to fund the ongoing data center efforts that we have under way."
The question-and-answer session clarified little and added to the opacity that management bestowed upon investors without context or specificity. Qualifying statements such as "although it is premature to provide specific expense guidance" and refusing to provide any level of detail fed the uncertainty (sometimes negative certainty is better than negative, unspecific uncertainty).
Most Unsettling Word: the use of the word "meaningfully" when discussing slowdown in ad revenue next year.
Most Unsettling Phrase: defining 2017 as an "aggressive investment year."
Most Confusing Void: absence of any detailed explanation to quantify "meaningfully" lower sales and "aggressive investment year."
Now, back to the three components of conference call analysis. We pose each question followed by our answers in bold.
What does management really mean? We don't know.
What do we think they really mean? We can only guess.
What will Wall Street analysts think they mean? We expect sell side’s need for inputs combined with lack of clarity to lead to some impulsive downgrades and/or attempts to quantify what is not quantifiable (as we always say, “The machine needs an input” when it comes to the sell side) but we expect a lot more reiterations of buys and defenses than anything resembling a wholesale change of heart. No sane analyst could expect this juggernaut to continue at this amazing pace because of the law of large numbers. In fact, some decline in the rate of growth was already built in, which is why we are obviously concerned. We don’t want to panic and go overboard as we believe we could look back and be more regretful that we didn’t buy. In the case of Facebook’s commentary, the lack of specificity combined with the unwillingness to offer specificity will likely frustrate analysts enough to make reactive decisions as a way to express their frustration. Also, the more robotic analysts may attempt to back their way into an estimate for the sake of updating their estimates, but that’s the nature of the beast, which is why we like to do our own work.
This final component is critical because, for better or for worse, Wall Street analysts will control the story over the next several days at minimum. In the end, though, those who follow this stock know Facebook is among the least-expensive and highest-quality companies in their universe.
For us, the absence of certainty leads us down a rabbit hole in which the lack of information must be recognized. Did Facebook guide down? No. Consensus estimates for 2018 are $6.50 EPS. Did management say anything to make us believe they cannot achieve this? We didn’t hear one. Is there a reason to believe they can beat it? Absolutely, the company’s resilience is historic.
Bottom line: In the absence of answers, it is important not to conflate confusion with conclusions. We expect the sell side to force the latter on behalf of the former, but until further notice we leave our One rating and $160 price target unchanged. To tweak it would be a fool’s game. We recommend members avoid selling into any panic, wait out the next several trading days to see how Wall Street decides to respond, and trust the decisions of a management team that has earned at minimum the benefit of the doubt. Let the haters rejoice for the time being and trust management knows what it’s doing, irrespective of the fear-inducing words. Lending them that benefit of the doubt during moments of panic has never betrayed us. We will be back with more analysis in the morning, but we’ve been hard at work trying to get you something now so you are ready for the a.m. session.