Facebook (FB) Threading a Falling Needle

by Dan October 26, 2018 3:19 pm • Trade Ideas

On Sept 18th I laid out a scenario where Facebook’s (FB) stock (then $161) retests its March lows near $150 in the near term, while also suggesting that earnings and sales estimates might have been lowered enough for them to beat going forward, making the stock look very cheap at new 52 week lows:

Since the spring I have taken a few cracks at Facebook (FB) playing for a reset of what I felt was exuberant investor sentiment (hereherehere & here). WIth the stock down a whopping 26% from its all-time highs made in late July, just prior to their Q2 earnings, I now wonder if another leg lower, back towards the 2018 lows, and possibly lower sets up for a fairly epic long entry? Wall Street analysts have massively reset their forward expectations for eps, sales, and margins based on the company’s guidance given in July. At this point though expectations might be low enough that the company might be able to beat them going forward, which would make the stock very cheap trading at 19.5x expected 2019 eps growth of 15% on 24% expected sales growth, which would be close to $70 billion with gross margins north of 82%. But I suspect it will be prudent to wait for two events, the company’s Q3 call that should come the last week of Oct, and then the result of the mid-term elections in the first week of Nov to make sure the company has visibility into their business and the practices of participants on their platform. Investors on the call will take a specific interest in user behavior, advertiser spend, margins and a general level of confidence that the company is self-regulating its platform to avoid the involvement of the federal govt.

Well, the stock broke the prior lows, down about 10% since I wrote that post and there are two massive catalysts for the stock in the next two weeks, earnings on Oct 30th and the midterm elections on Nov 6th.

The options market is currently implying about a $13 move in either direction between now and next Friday’s close, or about 9% (most of which is for the day following earnings), which is well below the 19% one day decline the stock suffered on July 25th following their disappointing Q2 earnings call, but just a tad above the 8.35% average over the last four quarters.

If the company were to miss already lowered estimates in the current environment then the stock is likely to be down in-line with the implied move. But if the company were to beat and raise the stock is up 10% quickly!

At this point, it makes sense to focus on valuation, which I think will be a key determinate once it appears the coast is clear on further guide downs. FB trades at 18.50x expected 2019 eps growth of 13%, which I suspect is low when you consider that sales are expected to rise 24% from $55 billion this year to $68 billion next. Obviously, a big reason for the deceleration in eps growth is the increase spend to shore up security on the platform which has resulted in lower gross margins, which this year are expected to be 4 points below their 2016 peak of 87.5% and decline to 82% in 2019. What could cause GMs to go back up next year, moderated spending on from 2017 & 2018 levels and the ability to monetize properties like WhatsApp and their 1.5 billion monthly active users?

So what’s the trade? If you want to be a bit contrarian and try to catch a falling knife, you have to first get through next weeks earnings and mid-terms without any major issues and the stock could set up as a good long candidate into the new year. Sell short-dated out of the money calls to finance owning longer-dated out of the money calls….

Bullish Trade Idea: FB ($145) Buy Nov / Jan 160 call calendar for $2.70

-Sell to open 1 Nov 160 call at $2.50

-Buy to open 1 Jan 160 call for $5.20

Break-even on Nov expiration:

The ideal scenario is that FB stock is near 160 on Nov expiration and the short 160 call expires worthless or can be covered for a small amount and you are left long Jan 160 call for $2.70 or less than 2% of the stock price.

The max risk of the trade is $2.70 on a sharp move lower than current levels or a sharp move above the $160 strike price.