We're Still Bullish on Facebook

This morning, small boutique firm, Janney Capital Markets downgraded Facebook FB to Neutral from Buy and the stock is down 1.8%. The reasons were on valuation as well as the expectations of its 2015 revenue growth to begin to decelerate.

First off, we don’t agree with the call and would be buyers of the shares but for the fact that our cost basis is $64.23 (we were aggressive buyers in the low $60s in the spring). With the stock at $74.86 currently, we’d have to see a bigger pullback to add more, otherwise it would violate our cost basis.

Second -- and more importantly -- we disagree with the call on a fundamental basis. Yes, at first glance the valuation is rich on an absolute basis at 45x forward earnings, but the growth rate for top and bottom lines has been extraordinary at the 60%-plus range and we expect to see 30%-40% growth (conservatively modelling) for several more years. As of last quarter the engagement numbers were very impressive, with daily active users (DAU) at 829 million and up 19% y/y and monthly active users (MAU) came in at an impressive 1.3 billion, which rose 14% y/y. And Mobile DAUs were equally as impressive, up 39% y/y and Mobile MAUs improved 31% y/y. These are lots of eyeballs, giving the company big pricing power and big potential advertising dollars. So, on a multiple to growth basis, the stock is very attractive at 1.25x price/earnings to growth (PEG). Speaking of advertising, revenues from advertising in its last quarter rose 67% y/y and 15% q/q and mobile ad revenue now accounts for 62% of total (up from 41% last year and 0% two years ago). Clearly these rates will come down given the law of large numbers, but the momentum continues to be strong and visibility even more so. In fact, the recent July mobile and desktop data most recently showed that their market share continues to be 18% of overall Internet time vs 16% in the past year and 20% of mobile time, which excludes Instagram and WhatsApp. Other competing services combined held flat at 3%, so, in other words, FB’s U.S. minutes are 6x greater than minutes spent on any other device. If we include Instagram and WhatsApp with Facebook, the total minutes grew 29% y/y.

We call that powerful and very compelling for advertisers, especially now that these companies can monitor how users move between screens, making it easier to track cross-device conversion rates. This jives exactly with what Home Depot (HD) said last week on its quarterly conference call. It has gone from 60% of its total ad budget to 10% in print and will spend 36% on digital media.

In addition while mobile monetization continues to be the near-term focus at the company, the medium- and long-term sets up even better as the company begins to monetize video (a 2015/2016 event) and WhatsApp and Oculus (2016/2017 events). Today, Kleiner Perkins agreed to invest $20 million in WhatsApp competitor Snapchat, which has just 100 million subscribers. That values the company at $10 billion. This clearly validates the $19 billion FB purchase of WhatsApp (recall it was $4 billion in cash and $12 billion in stock), especially with 600 million subscribers currently, which is growing at 1 million users daily. In addition, payments continue to be the wildcard (as was referenced by the Janney analyst as well), which could provide another leg up for growth and valuation, even as it will likely be rolled out slowly in order to preserve the user experience. This is one of the reasons we see $3-$4 a share in earnings power in 2016, which makes the valuation call a lot more reasonable.

We continue to like the social media/Internet sector and own Google GOOGL and Facebook as our two ways to play this theme. We are also looking at Twitter (TWTR) for the first time, wanting to create a hyper-growth basket in our technology weighting. We’ll continue to watch all three positions for adding.

Regards,

Jim Cramer, Stephanie Link, and TheStreet Research Team

DISCLOSURE: At the time of publication, Action Alerts PLUSwas long FB and GOOGL.