Few mistakes sting quite like selling a wonderful business too early. The best businesses can steadily compound their intrinsic values over many years, providing an ongoing reminder of your foregone wealth. For this reason, I am generally hesitant to sell companies with very wide or expanding economic moats, even if the valuation looks a little rich in the near term.
Consider MasterCard (MA). StockInvestor's Hare portfolio bought 100 shares of MasterCard shortly after its IPO in 2006 for about $44 per share. Half of our position was sold in 2007 for $200 per share. An additional 20 shares were sold in 2011 for about $307 per share. Ten more shares were sold in 2012 for $428 per share, leaving the Hare with 20 shares. To quote the managers of the Sequoia (SEQUX) at a recent investor day: "Every sale has been a mistake. Every failure to purchase, same thing." The Hare's remaining shares are valued at $620 apiece by Morningstar's analyst. More importantly, I think MasterCard's growth story has a long way to run--it is hard for me to picture a scenario where we won't continue to own the stock for many years.
This brings me to my main point: What should we do with Facebook (FB)? The Hare has owned Facebook for a little over a year, with an average cost basis of $20.31 per share, including commissions. The Hare's current weight toward Facebook is 5.3%. The stock has had an incredible run in the last couple of months, and at the recent price of $48.45 (as of the close on Sept. 24), it is up 139% from our cost basis. More importantly, Facebook is now trading at a 43% premium to Morningstar's $34 fair value estimate, making it the most expensive stock in the Hare on this basis.
The change in sentiment toward Facebook has a very legitimate cause: second-quarter earnings that were far better than anyone anticipated, myself included. Consider Facebook's results before the most recent quarter. In second-quarter 2012, revenue increased 32%, but the adjusted operating margin deteriorated by 10 percentage points, so adjusted earnings per share were flat year over year. In the third quarter of 2012, revenue increased 32%, the adjusted operating margin deteriorated by 9 percentage points, and once again adjusted earnings per share were flat. In the fourth quarter of 2012, revenue growth accelerated to 40%, but the adjusted operating margin deteriorated by 9 percentage points again, and adjusted earnings per share were up 13%. At this point, investors were worried about the company's ability to monetize its mobile applications, whether "Facebook fatigue" could be setting in, and whether the stock's lofty price/earnings multiple could be justified by the growth trajectory.
I trimmed StockInvestor's position in half back in February at $27 per share, shortly before the first-quarter earnings release. This has turned out to be my biggest mistake this year by far. Facebook's first-quarter 2013 report showed 38% revenue growth (a slight deceleration from the prior quarter), 9 percentage points of adjusted operating margin deterioration, and earnings per share that were once again flat versus the prior year. The stock traded as low as $22.67 in the subsequent weeks--not a great result considering we still held a decent-size position, but this provided at least some satisfaction that I had made the right decision by trimming at $27.
However, the second-quarter 2013 earnings report supplied a dramatic plot twist to the Facebook story. Revenue growth accelerated to 53%--an incredible 15 percentage points better than the previous quarter. Not only that, but the adjusted operating margin actually improved by a percentage point, allowing adjusted earnings per share to advance 58%. Suddenly Facebook went from a company facing growing competition and struggling to navigate the transition to mobile to the global leader in mobile advertising with nothing but blue skies ahead. Sell-side analysts have since piled on with upgrades. The stock is up an incredible 82.8% in just the two months since that earnings report, and even IPO investors are making money for the first time since Facebook came public.
Still Worth Liking?
So ... what do we do now? The latest consensus estimates call for Facebook to earn $0.72 per share this year, which would give the stock a P/E multiple of 67. However, analyst estimates appear to exclude stock-based compensation, which I view as a very real cost for Facebook. This adjustment added about $0.10 per share to earnings in the first half--assuming a similar level of share-based compensation in the second half, Facebook is probably on track to earn around $0.52 for the full year. On this basis, the P/E multiple is an even more nauseating 93.
It is inevitable that Facebook's P/E multiple will decline. What we don't know is how long it will take, and how much the company can grow earnings in the meantime. Let's say it takes 10 years for the stock to trade at 20 times adjusted earnings, and that the consensus forecast of $0.72 for this year is accurate. Our analyst predicts adjusted earnings to reach $4.92 per share in 2022, which would be a 24% compound annual growth rate between now and then. At a P/E of 20, Facebook would be worth $98 per share at that point, and assuming the company doesn't pay any dividends, our total return would be about 8% per year. However, if Facebook can grow adjusted earnings per share 34% annually, EPS will reach $9.89 by 2022, and the stock might be worth $198 by then, for a 17% total return per year. Alternatively, if adjusted earnings per share compound at just 14% per year, they will only reach $2.31 by 2022, and the stock might be worth $46--about where Facebook is already trading.
Any of these scenarios seems entirely within the realm of possibility to me. Unfortunately, history doesn't provide much guidance--there's never been a business quite like Facebook. Social networking predecessors like MySpace have generally ended in disaster, but MySpace never had the reach of Facebook or became quite as ingrained in its users' daily lives. Google (GOOG) was growing at a similar rate to Facebook around 2007, and earnings per share have compounded at about 20% per year since then (although Google could arguably be earning much more now if not for its wide-ranging investments in ancillary businesses). Facebook's competitive advantage comes from its huge network of users--1.15 billion monthly active visitors--who spend an inordinate amount of time on its websites and apps. Can the company keep these users engaged, especially as it shows them more advertising? And how much are advertisers willing to pay to get in front of all those users?
My biggest near-term concern is the inherent lumpiness of Facebook's business. The company basically has three ways it can grow: (1) by adding more users, (2) by creating new advertising products, and (3) by capturing higher prices on its existing advertising space. Facebook continues to add users at a healthy clip--27% growth in daily active users last quarter and 21% growth in monthly active users. However, with 16% of the global population already using the service regularly, this will inevitably slow, and incremental users are likely to be less valuable to advertisers. On the second source of growth, Facebook no doubt benefited in the most recent quarter from adoption of newer advertising products, especially mobile news feed ads. There is still room to create more products, such as Facebook's latest push into video ads, but most of the easy opportunities have likely already been tapped. The third growth factor may need to bear much of the burden for future growth. The company will have to cap the amount of space it devotes to advertising to avoid annoying users. Will advertisers be willing to bid up the value of existing ad real estate?
As I said at the beginning, I am hesitant to sell a very high-quality company with a long runway for growth just based on valuation. However, we should be mindful of the unusually wide range of possible outcomes for Facebook. An eventual decline in the P/E multiple is certain--the longevity and rate of growth in the interim is unknown.
What do you think? Is it time for investors to take profits in Facebook and move on? Or does the stock have room to run? Leave your comments below.
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