The Bottom Line on Facebook's Historic Plunge

A rout for the record books... The bottom line on Facebook's historic plunge... Earnings are surprising to the upside again... History says the next three days could give us a big clue about the market's next move...

More than $100 billion...

That's how much value was erased from social media behemoth Facebook's (FB) market capitalization overnight.

Shares opened 20% lower this morning following the company's weaker-than-expected second-quarter earnings report last night.

At $120 billion, this loss in market cap officially ranks as the biggest one-day loss in American history. The previous record was set by chip giant Intel (INTC), whose shares lost roughly $91 billion in value one day back in September 2000.

If you're a Facebook shareholder, today's decline was certainly jarring...

But it's important to keep things in perspective.

First, even after today's unprecedented fall, Facebook shares are merely trading back where they were in early May... less than three months ago. And they're still up roughly 50% over the past two years.

We'll also note that this news isn't necessarily the ominous signal it might appear to be. As Bloomberg columnist Matt Levine pointed out this morning, the list of largest-ever one-day market-cap "losers" puts Facebook in surprisingly good company.

Rather than the defunct firms you might assume like Enron or Lehman Brothers, the list is something of a who's-who of great American companies. Microsoft (MSFT), Apple (AAPL), ExxonMobil (XOM), Google's parent company Alphabet (GOOGL), and Amazon (AMZN) top the list, with troubled industrial firm General Electric (GE) the only notable exception.

Most important, Facebook's quarterly report wasn't really all that bad...

While revenue was lower than expected – $13.23 billion, versus estimates of $13.36 billion – it still rose 42% year-over-year. Likewise, earnings growth was a "miss," but Facebook still earned more than $5 billion for the quarter, which is better than 30% more than it made last year. And both daily active users ("DAUs") and monthly active users ("MAUs") rose a solid 11% to new all-time highs.

However, the company did warn that growth would likely slow further in the near term. As the Wall Street Journal reported last night...

In a call with analysts, Facebook Chief Executive Officer Mark Zuckerberg called the results "another solid quarter" – but those comments were quickly overshadowed when other executives warned that tougher privacy laws, a shift toward less lucrative advertising products and currency headwinds would clip revenue growth.

They noted that the revenue growth rate fell seven percentage points in the second quarter compared with the first three months of the year and said the company expected quarter-to-quarter revenue growth rates to decrease by "high single-digit percentages" in the second half of 2018.

Our colleague Austin Root – portfolio manager for our Stansberry Portfolio Solutions product – shared his team's thoughts on the news this morning...

As he wrote to in a special update for Total Portfolio subscribers, who currently hold Facebook shares...

We feel this market reaction was overblown.

The good news is that Facebook remains the greatest advertising platform ever built (ahead of Google), given its ability to reach huge numbers of people and target them individually in a personalized, data-driven, and intense way... And nothing in the company's earnings release and conference call changes that.

The bad news is that Facebook provided some notably disappointing guidance for reduced revenue growth and increased expenses that does materially lower our outlook for future free cash flow (and therefore, valuation). This guidance, while perhaps conservative, implies that Facebook's days of ultra-rapid growth may be in the rearview mirror. Instead, we may see the company grow its earnings in the high-teens going forward.

As Austin pointed out, this bad news wasn't entirely unexpected...

Facebook had already hinted that its growth could begin to slow this year. And the reality is, even the world's best businesses can't grow at a breakneck pace forever. Still, the market was clearly disappointed by the forecast...

We knew this slowdown was coming eventually. After all, with 11% user growth, Facebook couldn't grow revenues by 40%-plus forever. It's worth noting that most of the deceleration in growth rates is self-inflicted, and is probably the right call for the company's long-term value. Nevertheless, it's a material change to Wall Street's discounted cash-flow models.

But while Austin and his team believe a pullback was justified, they also think today's 20% pullback is an overreaction, especially for long-term investors...

Facebook is still an excellent business with huge moats, user loyalty, and strong network effects. It continues to be a capital-efficient free cash machine... albeit one that will grow at a rate of 17% or so per year, not upwards of 20%.

Remember, Facebook has four apps that more than 1 billion people use regularly – Facebook, Instagram, Facebook Messenger, and WhatsApp – and only the first two are currently being monetized in any material way. As Facebook continues to grow its user base on all four apps and begins to monetize Facebook Messenger and WhatsApp (and create other popular channels), the company should grow at a market-beating rate for years to come.

We recommend you continue to hold your shares of Facebook.

On a brighter note, it appears Facebook's disappointing results were the exception, rather than rule this quarter...

More than one-third of the companies in the S&P 500 Index have reported second-quarter earnings through this morning, and the results have been excellent again so far.

According to JPMorgan equity strategists, 74% of companies have reported better-than-expected revenue, while 91% have reported better-than-expected earnings. Revenue is on pace to grow 8% year-over-year. And earnings per share is set to grow 20%-plus for the second straight quarter.

Meanwhile, market-research firm FactSet notes net profit margins for S&P 500 companies are averaging an impressive 12% so far. This would tie the first quarter of this year for the highest average margins on record.

We should have an even clearer picture by the weekend. By tomorrow evening, more than half of the S&P 500 will have reported. We'll keep you posted.

In the meantime, the next several days could give us one more clue about the market's next move...

You see, according to data from research firm Bespoke Investment Group, the market's performance from April through July has been a remarkably reliable indicator over the past century.

In short, going back to 1928, the S&P 500 has risen for the four consecutive months from April through July a dozen times. In every single case, the market has continued higher over the second half of the year, for an average gain of more than 10% from August through December.

Barring a sudden reversal before next Tuesday, this year could be No. 13. The S&P 500 rose 0.3% in April, 2.2% in May, 0.5% in June, and is currently up nearly 5% so far this month.

New 52-week highs (as of 7/25/18): Apple (AAPL), Amazon (AMZN), Becton Dickinson (BDX), Blackstone Mortgage Trust (BXMT), Enterprise Products Partners (EPD), Facebook (FB), Fidelity Select Medical Tech and Devices Fund (FSMEX), Alphabet (GOOGL), Grubhub (GRUB), iShares Nasdaq Biotechnology Fund (IBB), ETFMG Prime Mobile Payments Fund (IPAY), Microsoft (MSFT), Okta (OKTA), ProShares Ultra Technology Fund (ROM), Verisign (VRSN), and Williams Partners (WPZ).

A quiet day in the mailbag. What are you seeing out there? Let us know at feedback@stansberryresearch.com.

Regards,

Justin Brill Baltimore, Maryland July 26, 2018