Facebook (FB) shares are down 18% this morning following slightly weaker than expected 2Q18 earnings and more significantly a dramatic and totally unexpected slashing of its revenue growth and profitability outlook over the next several years.  Northlake sees FB shares trading in a range of $160-$200 looking ahead to the rest of the year with risk to the downside in the near-term.  Despite the muted near-term outlook, we are holding FB shares as we suspect the new guidance is too conservative and ultimately by resetting expectations, FB will be able to better positon the company for the myriad challenges it faces due to privacy concerns, stagnating engagement, elevated investment, and a transition in usage of Facebook and Instagram toward stories and video and away from the news feed.

Management attributed the massive cut to revenue growth to a shift to Stories on Facebook and Instagram that monetize weakly at present, foreign exchange headwinds, and users opting out of sharing data with advertisers after GDPR.

With all this new information in hand, last night after listening to the company’s conference call, we built a simple spreadsheet to try to gauge the possible new earnings estimates for 2018, 2019, and 2020.  One issue in this exercise is that the company’s guidance commentary left a wide range of outcomes for revenue and expense growth and profit margins.  We settled on accepting management’s guidance that each of the next two quarters will show revenue growth “high single digits” lower than the prior quarter.  With revenues up 42% in 2Q18, we assumed a worst case scenario and decelerated revenue growth to 32% and 22%.

Guidance on margins was much less explicit beyond reiterating 50-60% operating expense growth in 2018 as investment in security and privacy and video content ramp. So far this year, expenses are up less than 40%, so we assumed 58% growth in each of the last two quarters to bring the full year into the guidance range.  All that management said about the future outlook was that margins would compress in 2019 and steady in the mid-30% in a few years.

With revenue growth exiting 2018 in the low-to-mid 20% range, we decided to assume 28% growth in 2019 and further slowing to 23% in 2020.  In order to create a path to margin compression in 2019 and mid-30% margins in a few years, grew expenses by 40% in 2019 and 30% in 2020.  This seems fair given that the security and privacy issues have continued with new revelations since the initial Cambridge Analytica scandal, and video spending is exploding at all conceivable FB competitors.

Our inputs gave us 2018 EPS of $6.94 and 2019 EPS of $7.73.  To get a sense of the magnitude of the change, consensus for 18/19 hearing into the earnings report was $7.63/$9.16.  This type of reset for a heretofore never missed earnings, high growth company is unheard of.  There is little wonder that the stock is down 18% this morning.  In fact, we are somewhat surprised it is not a little worse but the perception that management has guided conservatively and thrown out the proverbial “kitchen sink” is prevalent this morning.

The reason we expect the shares to be in the lower end of new valuation range for the time being is that a review of sell side analyst reports this morning shows a very wide range of new earnings estimates.  Our estimate came out on the low end of revised street expectations.  There are a few close to us at $7/$8 in 18/19.  But we see estimates as high $8.60 in 2019 and $9.60 in 2020.  This range of 10% is unusual for a widely followed stock with a fairly predictable financial model.  An old saying on Wall Street is that investors do not like uncertainty.  So while we expect ultimately that FB will materially exceed our estimates and its own guidance, it is likely to take some time for investors to get comfortable with this concept.

In the meantime, we hope we are wrong and note that even on our worst case estimates, the shares trade a low 20s P-E multiple of 2019 earnings, a reasonable valuation for a company that despite facing headwinds is still growing its top line in excess of 20% in a world where even mid-single digit growth is considered decent.

Whether FB gets back to being a superior growth stock will be determined by if this reset is setting up a new leg of growth or the beginning of a steady deceleration in growth as social media matures.  With Instagram still booming, Messenger and WhatsApp barely being monetized, and Facebook having unprecedented global reach and return on investment for advertisers, we think the most likely future is steady, above average, high margin growth and superior stock returns.

FB is widely held by clients of Northlake Capital Management, LLC, including in Steve Birenberg’s personal accounts.  Steve is sole proprietor of Northlake, a registered investment advisor.  Northlake’s regulatory filings can be found at www.sec.gov.  Steve is portfolio manager and managing partner of Entermedia, long/short equity hedge funds focused on media, entertainment, leisure, communications, and related technologies.