As Zuckerberg Testifies, The Markets Are Indicating Facebook’s Growth Has Peaked

&l;span style=&q;font-weight: 400&q;&g;As Facebook&s;s CEO Mark Zuckerberg testifies before the House Energy &a;amp; Commerce Committee, it&s;s an opportune time to refocus on the valuation of &l;span&g;Facebook&l;/span&g; stock. Facebook&s;s current market capitalization is $484 billion and the company generated only $40 billion of revenue last year. Zuckerberg has to keep generating extraordinary levels of growth to justify that valuation, and so the most value-added activity for a &l;span&g;Facebook&l;/span&g; shareholder today (yes, even more value-added than monitoring&a;nbsp;minute-by-minute stock quotes or watching CNN during the day) is to analyze &l;span&g;Facebook&l;/span&g;&a;rsquo;s most recent earnings report.&l;/span&g;

&l;img class=&q;dam-image getty size-large wp-image-944762312&q; src=&q;https://specials-images.forbesimg.com/dam/imageserve/944762312/960×0.jpg?fit=scale&q; data-height=&q;640&q; data-width=&q;960&q;&g; Facebook CEO and founder Mark Zuckerberg testifies during a US House Committee on Energy and Commerce hearing about Facebook on Capitol Hill in Washington, DC, April 11, 2018. / AFP PHOTO / SAUL LOEB (Photo credit should read SAUL LOEB/AFP/Getty Images)

&l;span style=&q;font-weight: 400&q;&g;From an investment perspective, the main problem facing &l;span&g;Facebook&l;/span&g; shares is the company&s;s fourth quarter. &a;nbsp;No, it wasn&s;t a &q;miss,&q; as the talking heads on CNBC would put it, it was a terrific quarter. In fact, as I was just re-analyzing&a;nbsp;&l;span&g;Facebook&l;/span&g;&a;rsquo;s earnings release I thought to myself &q;this is one of the best financial performances I have ever seen in 26 years of analyzing quarterly earnings reports.&a;rdquo; &a;nbsp;The key data point was noted by Facebook&s;s CFO David Wehner on the company&s;s January 31 earnings call: &q;In Q4, the average price per ad increased 43%.&q;&l;/span&g;

&l;span style=&q;font-weight: 400&q;&g;Can you imagine that? &a;nbsp;Consider that you own a company making widgets, and the price you charge your customers rose 43% versus the price you charged last year. &a;nbsp;That level of pricing power is astounding, and it is the key driver for Facebook&s;s ridiculous margins. &l;span&g;Facebook&l;/span&g;&a;rsquo;s gross margin in the fourth quarter was 88% (flat with Q42016,) and that profit capture increased as we look toward the bottom line, as Facebook&s;s operating margin was 57% in Q42017 vs. 52% in Q42016. &a;nbsp;As the post-Millennials who mostly prefer &l;span&g;Facebook&l;/span&g;&a;rsquo;s Instagram platform to its core social site would say, that margin is &q;sick.&q;&l;/span&g;

&l;span style=&q;font-weight: 400&q;&g;But stocks are valued based on rate of growth, and at some point that has to slow. &a;nbsp;The markets seem to be forecasting a slowdown for Facebook. FB shares have fallen 8.2% year-to-date versus a 1.9% percent increase in the Nasdaq Composite Index. &a;nbsp;In my opinion those 10 percentage points of underperformance are entirely attributable to a fear that the inevitable slowdown in &l;span&g;Facebook&l;/span&g;&a;rsquo;s growth trajectory is upon us. Wehner noted on Facebook&a;rsquo;s earnings call that &l;span&g;Facebook&l;/span&g; had 700,000 fewer daily average users in the U.S. in Q42017 versus the prior quarter, and that was before #deletefacebook became a legitimate campaign.&l;/span&g;

&l;span style=&q;font-weight: 400&q;&g;Facebook&s;s growth will slow. &a;nbsp;Advertising represented 98.5% of &l;span&g;Facebook&l;/span&g;&a;rsquo;s revenues in the fourth quarter, and those advertisers can&s;t possibly keep spending 43% more per ad than they did a year ago. &a;nbsp;Zuckerberg may claim that &q;Facebook will always be free,&q; but &l;span&g;Facebook&l;/span&g; generated $26.26 in average revenue per U.S. user in the fourth quarter. That is a stunning figure for a non-transactional site and it points to the major issue facing &l;span&g;Facebook&l;/span&g; shares. &a;nbsp;&a;nbsp;As good as it gets is a real concern when investing in growth stocks, and &l;span&g;Facebook&l;/span&g;&a;rsquo;s fourth quarter was really, really good.&l;/span&g;

&l;span style=&q;font-weight: 400&q;&g;To understand that one must have some kind of historical perspective in stocks and know that as industry fundamentals evolve, individual stocks can be left behind. &a;nbsp;Load your charting program and look at a 20-year chart of the following names: Cisco, Blackberry, Juniper Networks, Nokia. All are still quite viable companies, but the move to cloud computing and intelligent smartphones has left those stocks behind. &a;nbsp;That&s;s the downside risk with any high-flyer.&l;/span&g;

&l;span style=&q;font-weight: 400&q;&g;So, is seeing &l;span&g;Facebook&l;/span&g; CEO Mark Zuckerberg in business attire&a;mdash;as media reports scream &q;he&s;s wearing a tie!&q;&a;mdash;in front of Congress the sign that Facebook&s;s inevitable slowdown has begun? &a;nbsp;Well, the stock market has been telling you that that progression has already commenced. &l;/span&g;

&l;span style=&q;font-weight: 400&q;&g;FB shares are currently trading at 22.2x analyst consensus of $7.27 for 2018 EPS. As of year-end 2017 that multiple was 28.9x ($181/$6.26.) This is what analysts call &q;re-rating&q; and it is a process that takes quarters and years, not weeks and days. &a;nbsp;That is a bigger threat to Zuckerberg&s;s net worth than Cambridge Analytica, fake news or even restrictive neckwear.&l;/span&g;

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