The Days Ahead: More corporate earnings, including Apple. Job numbers.
One-Minute Summary: Google and Amazon beat by a large amount and had small rallies. Netflix, Facebook and Twitter beat by small amounts and were hammered. There’s a lot of high expectations in the market. High, consistent growth is tough to find. Those companies that provide it are priced for perfection. But one miss and the leveraged and momentum buyers dump the stock. Volumes in the three that missed were 8 to 10 times higher than normal. We stand aside when that’s going on. It's not so much price discovery as sell first and ask questions later.
The S&P 500 didn't quite hit its all-time high of 2,872 but it probably would have if Facebook had behaved. It's 2% of the index. News on the trade front was better. The Trump/Junker deal was progress, even if some of the promises don't materialize. The ECB was optimistic on growth. European and Emerging Markets rallied. U.S. Treasuries were mostly unmoved, which is impressive given a big August refunding.
1. Everything is awesome. In the most anticipated news of the season, Friday’s report on the Q2 GDP number was a barnstormer. It came in at 4.1% more or less in line with consensus and pretty much as every economist on the street and the Atlanta Fed GDP Now guys predicted. Well done everyone.
So why are we skeptical? Well, first remember that GDP is skewed to the top 10%. They own/earn around 35% of GDP while the bottom 50% earn around 25% of GDP. Here are two scenarios which both produce GDP growth of 5%:
In Growth 1 everyone is happy. Everyone grew. Some more than others, yes, but all OK. In Growth 2 half the population saw negative growth, 40% none and 10% a nice jump. The outcome for total growth is the same in both: 5%. We think Growth 2 is far more like what is going on in the U.S. Which is why people look at the growth headlines and wonder where they missed out (h/t Equitable Growth via FTAlphaville).
Some of that is just the way economists calculate GDP. After all, in that world, the birth of a human detracts from GDP/PP and the birth of a calf increases it. We don't have a better way to measure growth. So, you know, good headlines and all but not a mic drop.
This is how GDP looked:
- U.S. economy shot past $20 trillion. All the tariffs announced so far amount to less than 0.75% of the economy. At this rate, the U.S. economy would make that up in 10 weeks
- Q1 revised up for Q1 and prior years
- Exports were a big driver of growth. Have not been this big since 2016 and second biggest number in five years
- Personal consumption (70% of the economy) was up 2.7% or 65% of the growth
- PCE inflation (the one the Fed measures) was 1.9%
- Nominal GDP grew 7.3%...good for equities
Not so great
- Inventory buildup was negative. We see inventories very simply. If producers expect demand to be higher, they build up inventories. If they don't, they don't.
- Some exports (the soybeans we’ve discussed) were brought forward to beat the July tariffs.
- Nominal GDP growth is way ahead of wage increases…consumption may not keep up
- The 2017 tax bill front-end loaded spending and tax cuts.
The market had other things on its mind, like corporate earnings, trade stuff (stop me if you've heard this). Neither bonds nor equities moved much. It was all in the price. But, we’d still say it’s a good setup for the rest of 2018.
2. One Fang just got smaller. The stock was down 20% in after hours trading on Wednesday and didn't recover much on opening. Why?
- User growth was less than expected
- Revenue growth revised down in 2H 2018
- Expenses up
- Missed (only slightly but there’s little margin for error with a stock like FB) advertising revenue target
- Headcount up 47% YOY
- Some negative comment about the EU privacy regs General Data Protection Regulation (GDPR…expect to hear more of this) where they lost 1m subscribers due to the new rules.
Quotes from the transcript (here) probably didn't help:
- “…deceleration in ad revenue growth, kind of consistent with the trends we've seen” CFO
- “…because the effective levels of monetization in Stories [videos and photos with a story; disappears in 24 hours] are lower.” CFO
- “We're being very slow and deliberate with monetization [with Messenger]” COO
- “But we won't know for a while if it's going to monetize at the same rate [when FB places Stories across Messenger, Facebook and Instagram]”. COO
- “[Europe monthly average usage (MAU) was down] On Europe, yeah, we don't have any update on trends. We had indicated in the first quarter that we would expect to see a decline. We're not providing any guidance on MAU and DAU in Europe on this call.” CFO
Some of the +30% growth days must be numbered. This is a stock that's under regulatory scrutiny but, unlike Google, the facts and fines aren't known yet. There wasn't one reason for the miss…just lots of small ones such as privacy, currency, new ad formats etc. Since 2013, revenue and expenses have “beat” (i.e. been better than forecasts) by 5% to 7%. This time they missed by 1% and 2%. So, that's new for them.
But it’s a cash fortress. FB has a very strong balance sheet. More than $50bn in cash, which is half the balance sheet. Operating margins dipped but are at still at 44%. High ROE, EPS growth of 40% and large cash position, all shown here.
Bull case: New products, management tends to guide low, mobile ad volume, ad pricing, not overly expensive
Bear case: Regulatory problems will grow, slower growth, expenses higher, opting out/privacy issues
Bigger picture: We’ve written about the FAANGs a fair amount in recent blogs. They’re big, profitable and growing. But there are high expectations around the stock and it sells at 75% more than the market and 85% more than Apple.
It’s one reason why we like small cap and the dividend Aristocrats. They lag when Big Tech is on a run but they're less likely to have a big sell off.
And if you own it: Many clients have low cost positions in FB, so selling is not an option. The stock is not going to crash. It’s a 20% correction so needs a 25% increase to break even. We'd certainly trim where possible if only for diversification reasons and we can help on that. Also, if you have tax gains elsewhere, or want to create a loss to offset some current income, we can help on that too. But otherwise it’s a HOLD.
Bottom Line: Earnings are matching the hype. They’re good and numbers for the back half of the year are being revised up. The market is on forward P/E of 16.5, cheaper than all of 2016 and 2017. But growth will slow.
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--Christian Thwaites, Brouwer & Janachowski, LLC
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