Mark Zuckerberg. Photo credit: Stuart Ramson/AP Images for Facebook
First, full disclosure. I sold most of my Facebook stock on the news. The colorful verb “red-dogged,” belonged to my departed old friend, Jerry Goodman, then Adam Smith, recounting the Street’s myopia and hysteria when Motorola management announced its bad quarter. Analysts raced to the phone booths – no cell phones around early sixties. Updated, 42 of 46 analysts carried a buy rating on Facebook and then about-faced.
Lest we forget, investors and analysts, remain always on the outside looking in, particularly for tech houses. But, even General Motors and AT&T do blindside their following. Who dreamed Trump would slap tariffs on steel and aluminum or that Netflix would come along and put cable television into a secular funk? No end in sight as yet.
Hubris is a killer trait, starting with kings, but it worked down to Silicon Valley headmen, namely operators in grey T-shirts who reached $500 billion market capitalizations within a decade. I am talking not just about Facebook, but the old Google as well as Amazon. Alphabet faces a $5 billion fine in Euroland which they shrug off purely as a competitive nuisance, easy to weather.
For Mark Zuckerberg, recorded disdain for his clientele dates back several years, when he demeaned them as the great unwashed, worthy of no respect or consideration. Later, all this was reflected in Facebook’s sale of clients’ data to third parties without their knowledge or consent. What was supposed to be private became a commodity for sale of the deplorables to avid bidders.
Let’s move on to accounting issues like GAAP vs. non-GAAP versions of reported earnings. The SEC still remains a silent bystander. Tech houses annually grant stock to deserving employees counting up to 20% or more of reported earnings. Should they be allowed to recast such dilution from their financial reports? Salesforce.com managements’ largesse runs even more, but nobody cares and analysts dare not mention this outlandish take or they’d be denied access, nothing to slap a “buy” on.
Facebook’s headcount, over 30,000, up 47% year-over-year disturbs me. My fear is they’re adding pure overhead rather than revenue producing operatives. Capex, rising at a $15 billion annualized clip is offset by $42 billion in cash equivalents. It suggests wherewithal to capture investment opportunities. If you feel that annualized operating cash flow of $24 billion is doable, Facebook would be selling close to 20 times, an acceptable valuation. Operating cash flow is my focus as a critical variable. You must believe operating cash flow after its near-term demise can reattain this level to hang onto this baby.
Facebook’s R&D spend runs at a $10 billion annualized clip, probably holding above a mid-teens ratio to revenues. This is aggressive spending, even for a tech house in software or cloud computing.
As for share-based employee compensation expenses run over 20% of net income. I can’t stomach anything higher because it raises the issue of who management is running the company for – shareholders or themselves? The Street, SEC and NYSE need to tackle this issue drowned in silence.
Why shouldn’t investors use GAAP numbers in calculations? After all, this management shot itself in the foot with aggressive resale of client accumulated data. Shouldn’t share based employee compensation be cut in half or even eliminated for a year or 2 until Facebook is right-sided? Who can say whether there’s a brain drain coming if advertising revenues lose momentum for more than a year.
This metric rose 42%, quarter over quarter, to a $13 billion clip vs. $9.1 billion year ago numbers. What if the advertising run rate subsided back to year ago numbers of $9 billion? Well, operating income easily could shrink from its $5.8 billion run rate, maybe halved to under $3 billion. After all, overhead rose quarter-over-quarter $2.4 billion, by nearly 50%.
For Internet houses, investors find no security in book value. Facebook sells at over 6 times book. I’d ignore some $18 billion in good will on the balance sheet because it probably represents the price paid for Instanet which has turned into a homerun with capacity to earn billions looking ahead.
Pressing this what-if operating scenario into a stock valuation level isn’t pretty. We’re talking about $12 billion in operating income annualized. If you give ‘em a 20 multiple we’re at a $240 billion market cap number. In short, Facebook, in a difficult operating setting as a stock could be cut in half from its current market cap near $500 billion.
Sticking around to see the next couple of quarters is a Texas Hold’em game for operators who can shrug off adversity and move on to the next story stock unfolding. Curiously, after FB was taken out and shot, AT&T and General Motors popped a couple of points. GM, beset by rising steel and aluminum costs, is a tariff war casualty. Still there’s $6 a share in earnings power. How many stocks sell at 6 times earnings, about one-third of the market’s price-earnings ratio?
As for AT&T, nobody cares that it yields 6%, more than a junk bond. T sells at half the market’s valuation, tortured by a vindictive Justice Department and declining subscription rolls for its cable network. Time Warner becomes a transforming acquisition, if upheld.
I’ve taken my Facebook money and bought more T and GM. The bigger question is whether value now is poised to outperform growth. In an environment of above average GDP momentum, a fair question, but industrials, selling at the market multiple at 18 times earnings, aren’t bargains.
I’m picking my way through the minefield of materials properties and retailers, looking to go against prevailing opinion. Big cap energy names trade overvalued along with healthcare and the nondurables sector. If tech needs a breather, there’s no market upside. At 26% of the S&P 500 Index, with at least 1.5 times in volatility, tech is the market’s leading indicator.
Sooo… the kid’s $100 billion faux pas does radiate trouble. If FB’s quarterlies are sketchy documents, so are Amazon’s and Alphabet’s opaque reports. Until they’re good and ready they’ll tell you nothing, only what’s good for them.
Contrast this mufti-pufti with GM’s financial reports which are detailed on the state of operations, here and abroad. Their quarterly forecasts seem realistic. This is not Jeff Bezos gaming a roomful of analysts with lowball numbers or Mark Zuckerberg treating investors like cast-off children.
Say it isn’t so, Mark.
Sosnoff and / or his managed accounts own: Facebook, General Motors, AT&T, Alphabet and Amazon.
msosnoff@gmail.com