We Need to Talk About Facebook

By David Stockman  |  August 9, 2018

I’ll tip my hat to the new constitution
Take a bow for the new revolution
Smile and grin at the change all around
Pick up my guitar and play
Just like yesterday
Then I’ll get on my knees and pray
We don’t get fooled again, no, no

– The Who, “Won’t Get Fooled Again”

On the eve of its second-quarter earnings release, Facebook (Nasdaq: FB) was priced for perfection.

It was valued at $630 billion. That’s 36 times the free cash flow it reported for the 12 months ended June 30, 2018.

That’s even though free cash flow has plateaued.

Of course, the market inflicted the biggest punishment it’s ever meted out on a single company after Zuckerberg coughed up some very un-fake news about Facebook’s performance and outlook.

FB shed $130 billion of market cap between the close on July 25 and the open on July 26.

We’ve seen this kind of thing before, of course.

But Facebook’s faceplant is the all-time record.

And it’s reminiscent of Intel (Nasdaq: INTC) and Microsoft (Nasdaq: MSFT) at the peak of the dot-com bubble.

So, Facebook begs a lot of questions today.

But let’s start with this one.

Why was an advertising company (it accounted for 98.5% of quarterly revenue) valued at 36 times free cash flow in the first place?

Advertising is a GDP-driven, low-growth industry.

Over the last 17 years, the real growth rate of the global advertising spend has averaged just 1.87%. And it’s only 1% during the decade since the pre-crisis peak in 2007.

In inflation-adjusted dollars, the industry stood at $279 billion on a worldwide basis way back in 2001. It’s crept all the way up to $375 billion.

Facebook has benefitted – enormously, sure – from a one-time shift in advertising dollars away from traditional TV, radio, newspaper, magazine, and billboard spots to digital and mobile platforms.

Here’s a fundamental truth about finance. You can’t capitalize temporary growth rates as if they represent a permanent rise in earnings and cash flow. “Temporary” always reaches its “sell by” date – and soon.

The bottom line is the big gains have been made.

Facebook is not a “growth” company. FB is not a “growth” stock.

Its trailing five-year revenue growth rate of 47% is not remotely sustainable.

Over the next five years, ad revenue growth for digital will inevitably be pulled into the low teens. After that, it’ll slouch toward the low single-digits rates that drive the industry on a long-term basis.

And all that ignores the certainty of another recession in the next few years.

The trajectory of Facebook’s market cap is absurd. It went from $60 billion in July 2013 to $450 billion as recently as April 2018.

By late July, it’d soared by 10.5 times over the last five years. And it’d been gaining about $2 billion of value per day since April.

This type of expansion is the symptom of a mindless, momentum-driven casino.

In today’s world, a global company growing at the rate of nominal GDP and posting steady margins should generate annual free cash flow growth of about 5%.

That’s 3% real growth and 2% inflation.

At two and a half times the growth rate – and that’s aggressive in an historical context – the implied free cash flow multiple is 12.5 times.

The operating free cash flow needed to justify FB’s valuation would be $50 billion. That’s nearly three times what it actually reported for the 12 months ended June 30.

The odds of FB tripling its free cash flow in the next five years are somewhere between “slim” and “none.”

You can only kill off the competition once. That’s why Facebook’s growth math has been prohibitive all along.

At the end of the day, Facebook isn’t about real growth for the overall economy. Zuckerberg simply won a food fight in a high-profile corner of the market.

FB’s soaring market cap is a case study in the destruction of honest price discovery. It’s not evidence of a healthy economy being led into the future by a booming technology renaissance.

Talking heads insist FB’s plunge has no bearing on the roaring bull market. It’s a “one-off.” It’s a “pause that refreshes.”

It’s not an aberration. Indeed, Facebook is the poster child for the third central-bank-blown bubble of the 21st century.

That $130 billion meltdown?

It’s prologue.

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David Stockman

David Stockman is the ultimate Washington insider turned iconoclast. He began his career in Washington as a young man and quickly rose through the ranks of the Republican Party to become the Director of the Office of Management and Budget under President Ronald Reagan. After leaving the White House, Stockman had a 20-year career on Wall Street.MORE FROM AUTHOR