$FB Q2 Earnings Preview

by Enis July 23, 2013 11:33 am • Commentary

Event:  FB reports their fiscal Q2 earnings tomorrow (July 24th) after the close.  The options market is implying about a 8% one day move, which is a bit below the 4 qtr avg of about 9.5%

Sentiment:  Wall Street analysts are relatively bullish on the stock, with 31 Buys, 10 Holds and 3 sells with an avg 12 month price target of ~$33.  Short Interest is at only 2% of float, much lower than it was a year ago when the stock was at a similar level (though last year’s high short interest was partly in anticipation of the lockup expiry of employee and investor shares).

Options Open Interest:  Call open interest outnumbers put open interest by a ratio of 1.4 to 1. The activity over the last month has favored calls over puts by a ratio of 1.8 to 1.  There is a lot of call open interest between the 27-30 strikes in August, September, and Jan14.

Today there was a buyer of the Aug 30 calls, 24,500 trade on the offer for .22, looked closing, and could be an over-writer covering in front of earnings.

Fundamentals:  Facebook has 3 main business lines to monetize its huge user base and platform.  The first, original business is the desktop advertising business, with simple display ads on the side of each user’s page (to which they have since added news feed ads as well).  The second, higher growth business is the mobile division, which is going to be the focus of earnings for the market given its future earnings potential.  Finally, the payment division is smaller and relatively stable (about 12% of revenues)

The bull case for FB lies in its mobile division.  Even if user engagement remains stagnant, can FB convince advertisers of the increasing utility of its targeted mobile ads with such a broach reach, and drive higher pricing as a result?

To get a sense for the potential for growth in the mobile business, mobile accounted for almost $500 million in revenues in 2012.  In 2013, analysts estimate it could amount to almost $2 billion, and possibly over $3 billion 2014.  That’s massive growth.  In contrast, the desktop business booked about $5 billion in revenues in 2012, expected to grow to $6.5 billion 2013 and $8.5 billion in 2014.  Solid growth (around 30% yoy), but dwarfed by the rate of growth in mobile.  In that sense, investors today are paying 35x 2014 estimated earnings because of that potential in mobile.  The company must execute and deliver there to meet or surpass those expectations.

Price Action / Technicals:  FB stock has made some big moves, but is close to where it was last July before its weak earnings report.  In fact, ever since the stock sold off right after its IPO at $38, the stock has traded on both sides of $25, but has continued to gravitate back to that level:

Lifetime daily chart of FB, Courtesy of Bloomberg
Lifetime daily chart of FB, Courtesy of Bloomberg
There is not much else about the chart.  The local high from May is around $29, while the local low from June is around $23.  Given the 8% implied move, it would take a major surprise to breach either of those levels after earnings.

Volatility:   With the stock’s slow grind higher of about 14% from the June lows, the stock’s 30 day at the money realized volatility (white line) is at 52 week lows, while implied volatility (blue line) has creeped up, but not to levels one would think given GOOG’s high profile earnings miss last week. If the stock does not realize its implied move, I would expect IV to fall back to the low 30s.

FB 30 day IV vs Realized vol from bloomberg
FB 30 day IV vs Realized vol from Bloomberg

My View:  Mobile is the key to this earnings report.  While many reports show decreased engagement on FB, the fact remains that it is the largest social media platform on the internet.  So the opportunity is there.  The real question is whether FB can entice advertisers to pay up for mobile and desktop ads.  In that respect, GOOG’s recent earnings report highlighted the continued concern of decreasing cost per click in the internet advertising space.  Analysts have modeled in a decline in desktop CPM, but mobile is still a nascent market where little historical information exists about user experience and ad effectiveness.

Barring a major upside or downside surprise in the mobile division, I expect the stock to remain range-bound between 22 and 30.  The potential for strong future earnings growth remains, but execution risks in a nascent market are still a key concern.