Grant's Almost Daily Interest Rate Observer:

FACEBOOK ZUCK, ZUCK GOOSE

As Yogi Berra once said, 

"You can observe a lot just by watching."

A bump in the road, or something more?  As investors the world over are by now well aware, yesterday evening Facebook, Inc. (FB on the Nasdaq) shocked its cadre of bullish boosters by forecasting sharp slowdowns in both revenue growth and operating margins in coming quarters and years. What’s more, net daily active user growth of 22 million quarter-over-quarter was its smallest since early 2011, while European usage saw an outright decline and the North American daily user count remained flat. Growth that would be the envy of nearly any other large-cap (revenues and operating income jumped 42% and 33% year-over-year, respectively) was relegated to afterthought status.

In some corridors, the business update elicited disbelief.  Of the dwindling growth outlook, Brent Thill, analyst at Jefferies LLC, remarked on yesterday’s conference call:  “I think many investors are having a hard time reconciling that deceleration. It just seems like the magnitude is beyond anything we’ve seen, especially across a number of tech [companies] we cover.”  Investors echoed Thill’s sentiments, sending FB shares down by 19%.  With the company sporting a gargantuan $630 billion market capitalization heading into the report, the decline represented the single largest one-day loss of stock market value in U.S. history according to FactSet. Since Aug. 11, 2017, shares are up by 3%, compared to a 17% gain in the S&P 500.

Of course, a dramatic fall first requires a great ascent, and few companies have enjoyed a steeper rise than Mark Zuckerberg’s social network. From July 2013 to yesterday, FB shares gained 861%, a 55% annualized pace. One can hardly argue the stock price rally was disconnected from fundamentals either. Over the trailing 12-month period, the company has generated $48.5 billion in revenues, $19.1 billion in net income and $28 billion in cash from operations. That’s up from $7.9 billion, $1.5 billion and $4.2 billion, respectively, in 2013.

But it’s a different environment in light of the Cambridge Analytica data-leaking scandal of March, one that Facebook has opted to manage through a litany of new hires and extra spending that looks set to cut into its future earnings potential. On the conference call, Zuckerberg had this to say about Facebook’s enhanced security and privacy initiatives:

Looking ahead, we will continue to invest heavily in security and privacy because we have a responsibility to keep people safe. But, as I've said on past calls, we're investing so much in security that it will significantly impact our profitability. We're starting to see that this quarter. 

But, in addition to this, we also have a responsibility to keep building services that bring people closer together in new ways as well. 

Now, in light of increased investment in security, we could choose to decrease our investment in new product areas, but we're not going to, because that wouldn't be the right way to serve our community and because we run this company for the long term not for the next quarter.

It’s no empty talk. Capital expenditures footed to $3.46 billion in the most recent period, well more than double the $1.44 billion capex line for the second quarter of 2017. According to yesterday’s earnings press release, current employee headcount at Facebook totaled 30,725 as of June 30, up a whopping 47% year-over-year.

Even without the baggage from Cambridge Analytica and the associated fallout, Facebook was set to brush up against commercial gravity sooner or later. There are only so many people in the world (7.6 billion according to the United Nations and Facebook reports 2.2 billion monthly active users), and only so many advertising dollars for the taking.  In the Aug. 11, 2017 bearish analysis of Facebook, Grant’s suggested that “maybe growth, momentum and a dazzling stock market performance have obscured the problems that will ensure that not even Zuckerberg’s tree reaches the sky.”

That analysis incorporated the views of Pivotal Research Group’s Brian Wieser, who was one of only two analysts to label FB shares a sell, compared to 44 sell-siders who rated the stock a buy into yesterday’s earnings release. By way of reaction to the second quarter results, Wieser reiterates the simple fact underpinning his bearish thesis:

The advertising industry – and digital advertising, no less – has limits to growth, which we think is the primary factor constraining Facebook’s revenue opportunity. . . While the company is still growing at a fast clip, the days of 30% plus growth are numbered.

For investors, the pain from today’s sharp pullback is distributed far and wide. According to analysts at Goldman Sachs Group, Inc., 97 hedge funds counted Facebook as among their top-10 holdings as of the end of the first quarter. That’s the heaviest concentration of any one stock, and up from 81 funds that counted FB as a top-10 holding in September of last year. It’s not just the financial blue bloods who are taking a hit: Bloomberg’s Eric Balchunas estimates that 27% of Facebook shares are held by mutual funds, while an additional 6% are in the hands of various ETFs.

As Wall Street has accumulated, Menlo Park has vacated. The persistent, aggressive open-market sales by Facebook executives and directors that have been extensively chronicled on these pages, continue apace: In the five trading days preceding yesterday’s update, CEO Zuckerberg disposed of 1.23 million shares, generating proceeds of $262 million.  Chief operating officer Sherryl Sandberg sold 55,000 shares for $11.5 million, while chief product officer Christopher Cox cashed out of 10,600 shares to the tune of $2.2 million.

As former Yankees catcher Yogi Berra once said: “You can observe a lot by just watching.”