Why Facebook Inc Stock Isn’t Rallying After a Blowout Earnings Report

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FB stock - Why Facebook Inc Stock Isn’t Rallying After a Blowout Earnings Report

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Facebook Inc (NASDAQ:FB) put up a great quarter two weeks ago. However, FB stock has traded softly since then. Long-running Facebook skeptics, this author included, have mostly failed to change their minds following the third-quarter earnings report.

What is holding back FB stock here?

First, let’s start with the positives. Facebook’s business continues to grow at a tremendous rate. Every time you think Facebook has reached the limit where its growth rate will have to slow down, it finds some new lever for maintaining its torrid expansion.

And give credit where it is due, Facebook has proven it’s no flash-in-the-pan like so many other social networks before it. Even if you’re long-term bearish on Facebook’s namesake platform (as I am), the company’s success in integrating Instagram and WhatsApp purchases has been outstanding. I doubt even FB stock bulls expected Instagram to turn into half the property it is today at the time Facebook paid a seemingly huge premium to buy the start-up.

Zooming in on this past quarter, Facebook’s results blew away analyst expectations. The company posted $1.59 in earnings, beating the consensus $1.28 estimate by a mile. Revenues grew by 47% year-over-year, greatly exceeding the 42% consensus forecast.

The Catch: Soaring Costs

I was fairly negative last month when I last discussed FB stock. As I noted at the time, the Russia meddling scandal caused me to think that Facebook would have to change its business model. A month ago, Facebook continued to reiterate that it didn’t want to be more like a traditional media publisher, and that it wasn’t responsible for policing the content on its site. As Facebook COO Sheryl Sandberg said then, Facebook doesn’t “hire reporters. No one is a journalist.”

However, it appears Facebook has reconsidered that position. That’s good for both society and Facebook’s long-term odds at shedding the “fake news” label and remaining a trusted source of information. In the short-run, though, this change is going to cost FB stock — dearly.

Zuckerburg’s Warning for FB Stock

As I mentioned last month, I don’t think it should come as a surprise that company Chairman and CEO Mark Zuckerburg is looking to sell almost $13 billion in FB stock in coming quarters. No one would blame him for taking profits; however, the timing does seem opportune, given the challenges Facebook will have to tackle over the next year.

And now, with this Q3 earnings release, Facebook prominently put a warning right at the top of its statement, quoting Mr. Zuckerburg as saying: “Our community continues to grow and our business is doing well […] but none of that matters if our services are used in ways that don’t bring people closer together. We’re serious about preventing abuse on our platforms. We’re investing so much in security that it will impact our profitability. Protecting our community is more important than maximizing our profits.”

As a FB stock owner, you should take notice when he specifically says the company won’t be focusing on maximizing profits anymore. You rarely hear management address a situation that directly.

How bad will the hit be? Zuckerburg had the following to say on the company’s Q3 conference call: “We already have about 10,000 people working on safety and security, and we’re planning to double that to 20,000 in the next year to better enforce our community standards and review ads. In many places, we’re doubling or more our engineering efforts focused on security.”

You read that right, Facebook is planning on hiring ten thousand new people just to police content and beef up security. Ten thousand! As I previously warned, if Facebook makes the pivot from bots to human oversight, you’re going to see Facebook’s profit margins take a dive. 10,000 employees don’t come cheap — especially in the pricey geographies where Facebook tends to have its offices.

Downhill From Here

For this most recent quarter, Facebook grew revenues by 47%, while operating costs grew by only 34%. That allowed Facebook’s all-important gross profit margin to swell by 600 basis points. It’s classic economies of scale at work. Once you build the network, every new user adds a lot of incremental revenue and not much cost — at least if your platform doesn’t require much human oversight.

Now, though, Facebook projects costs rising by 45% to 60% next year. That’s a massive change from just 34% this year. Unless Facebook manages to accelerate revenue growth, its profit margin will go from rapidly expanding, as it did this quarter, into outright contraction.

FB stock is trading at 33 times trailing earnings and 27 times forward earnings (and expect earnings estimates to come down further for 2018). That’s not cheap for a company that has a bruised reputation and has to pay through the nose to try and fix it now.

Long-Term FB Stock Thesis Intact, but 2018 Will Be a Lost Year

InvestorPlace contributor Laura Hoy recently argued that Facebook’s increased spending is a good thing. She makes some excellent points, particularly that the increased spending will help repair the site’s image, and also, more effectively, fend off challenges from Snap Inc (NYSE:SNAP) and other such upstarts.

I agree. However, it won’t help FB stock much in 2018. Facebook is about to transition from a company with exploding profits to a company that only modestly grows the bottom line in 2018, as costs escalate significantly faster than revenues.

I do think Zuckerburg and company are making the right move for the company’s brand. But it’s going to hurt a lot in the short-run. Facebook took a big hit with the Russia scandal, and the solution won’t be cheap.

I’d have no problem with FB stock here if it already reflected the cost problems going forward. But Facebook stock is still within 5% of its all-time high. FB stock is up 55% on the year, despite its forward prospects taking a material hit. Investors are pricing Facebook as though its best growth days are still yet to come. But there’s a good chance that, with hindsight, investors will look at Q3 2017 as the transition point where Facebook went from an explosive growth stock to a much more mature and lower-upside tech company.

At the time of this writing, the author held no positions in any of the aforementioned securities. You can reach him on Twitter at @irbezek.

Ian Bezek has written more than 1,000 articles for InvestorPlace.com and Seeking Alpha. He also worked as a Junior Analyst for Kerrisdale Capital, a $300 million New York City-based hedge fund. You can reach him on Twitter at @irbezek.


Article printed from InvestorPlace Media, https://investorplace.com/2017/11/facebook-inc-fb-stock-not-rallying/.

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