Once again, Wall Street spent the week drifting between generally solid 4Q18 earnings and a sense that the best of the economic cycle is behind us. We believe the first part of that statement. It’s been a strong season and despite a few glitches here and there, our active recommendations are up an average of 2% after reporting their numbers.
But we’re far from convinced that investors or the economy have hit a wall. Granted, the broad market is now looking at minimal earnings growth for the next few quarters and whole sectors like Energy are already in an outright profit recession. Last week’s report that U.S. Gross Domestic Product is “only” up 2.9% from early 2018 levels was a drag on sentiment as well.
However, even in those statements, we have at least two reasons to remain bullish about our recommendations. For one thing, we aren’t following “the broad market.” Our only exposure to the Energy sector is a hedge against a sudden jump in oil prices and we remain extremely underweight other problem spots like the Banks and most Consumer companies. Instead, our stocks have much more robust growth profiles.
We’re where the action is, and whatever happens to the economy as a whole, that relative strength is unlikely to evaporate. If anything, we suspect our lead will only expand if other investors start pulling the plug on underperforming themes and crowd into our area of the market. We’ve seen this happen again and again over the last few years. There’s no reason to assume history won’t play out that way again.
And that’s where the second source of our confidence comes into play. Our stocks have outperformed in much more anemic economic conditions. If you’ve been following the market for any length of time at all you know that 3% growth used to be an effective ceiling on GDP and double-digit earnings expansion was a rare and precious thing. Now here we are with growth that we would’ve killed for a few years ago and watching other people fret over whether it’s good enough.
It’s good enough for our stocks. We’re overweight companies that are building their sales by at least 20% in a world where most of their peers are hard pressed to generate 1/4 of that top-line growth. In most cases, that revenue profile is either translating into explosive earnings trends or taking our more Aggressive recommendations toward breakeven at accelerating speeds.
There’s always a bull market here at The Bull Market Report! This week's Big Picture discusses our thought process when it comes to cutting a stock from our universe whether it triggers the Sell Price or not. We're not happy with Box but our other stocks are doing extremely well . . . of course, you'll need to subscribe to get our winners. With earnings season almost over, this is also a good place to update you with our thoughts on Tesla, Facebook and Netflix.
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Key Market Measures (Friday’s Close)
BMR Companies and Commentary
The Big Picture: Respecting the Sell Prices
Any time a BMR recommendation sells off like Box did last week, we take a step back and review all of the assumptions that got the stock its place in our portfolios in the first place. The question is always whether the company itself has been materially impaired to the point that our initial thesis no longer applies.
If so, we cut our losses and liquidate the position. That’s what happened with Box. When we added the stock back in May, everything management had told us gave us the confidence to forecast 20% revenue growth for the remainder of 2018 and then a slight acceleration in 2019.
That growth rate was enough to earn our attention in its own right and also because it meant Box had what it took to break even by the end of this year. Now, however, new guidance for the year is going to come in $20 million below what we were led to believe. It happens. The world often changes around our companies, forcing them to adapt.
In this case, Box is facing more direct competition than we expected 10 months ago. We aren’t bothered by that because we also recommend the most ferocious of those competitors, Dropbox (DBX: $24, up 2% last week). But with that $20 million failing to materialize, it means that Box is only looking at 15% growth this year and will need at least another six months to breakeven, much less start generating the kind of profit that will support the stock in the long term.
Keeping Box on our screen that long requires a lot of faith. When we could see the top line expanding 20% a year, we had that faith: Customers were crowding onto the platform eager to pay and all the sales team needed to do was open the doors and cash the checks. With revenue actually headed down from quarter to quarter, that momentum is gone.
We can trust Box management to get their act together in the next year, but that’s a long time to be patient and it’s a long time for the situation to get worse before it gets better. Maybe we’ll come back when growth does. For now, the risk outweighs the immediate rewards. We’re gone.
Talking about when we sell points out an important aspect of the BMR experience. The Sell Prices are there as a way to shield you and your profits from deep downside, not as a firm exit trigger. If we let them force us to cut coverage on every stock that plunged below that guideline last quarter, we’d have to lock in a lot of losses, effectively liquidating with the weakest hands on Wall Street.
Imagine an index fund dumping Apple, Facebook, and other heavily weighted holdings just because they temporarily dipped below a certain threshold. It doesn’t make sense for them and it makes even less sense for us because our portfolios are built around potential and not current market capitalization. And so we hung on even though it meant carrying recommendations below the Sell Price. Several of our best BMR recommendations would never get a chance to recover from the correction.
But we think they’re all worth keeping. As it stands, we’re still healing, but at a rate faster than the market as a whole. A staggering 35% of S&P 500 constituents are down 20% or more from their 52-week highs. Just 20% of our stocks are in that position.
And on the other side of the profit curve, a healthy 20% of the BMR universe is already back within 3% of last year’s peaks if not breaking records. We’re looking at stocks that only subscribers can see . . . the list goes on and on. Barely 10% of the broad market can match that strength. As long as our winners outnumber our losers and our losers outnumber the broad market’s winners, we wouldn’t want to be anywhere else.
Facebook (FB: $162, flat -- all returns are for the week)
It’s no secret that Mark Zuckerberg’s behemoth faced some serious PR challenges last year. The stock dipped 40% last year from its peak and has yet to fully recover despite a strong start to 2019 (up 24% YTD).
Simply put, Facebook got a little ahead of itself in 2018 on the way up and then the downside reaction was equally overdone. The company had a magnificent 4Q18, which saw revenue increase 30% year over year to $17 billion while EPS edged up 8% to $2.38. Both daily active users and average revenue per user increased 9% and 20% to 1.5 billion and $7.40, respectively.
Try to reconcile those numbers with the negative press and something just doesn’t add up. Despite all the fretting about people deleting their accounts and leaving Facebook (which we believe to be of little import), the company is still expanding its user base and the amount of revenue it books per user. Margins have felt the pressure of aggressive hiring to police the platform.
A year ago, Facebook converted a full 50% of its revenue into pure profit. Now that margin has narrowed to 40% and this year we’re braced to see it drop to 30%. That’s a much more sustainable base for future profit expansion.
In the meantime, that revenue curve is attractive on its own merits. Make no mistake, the company is still dealing with the fallout from the array of scandals which plagued it last year, but nothing can stop this behemoth from continued growth.
Facebook is even being proactive when it comes to protecting users from data piracy and illegal/offensive material. The company has hired thousands of new employees to address those very issues and over the weekend filed a lawsuit against Chinese companies selling fake followers to advertisers eager to artificially enhance their profiles. It’s worth some short-term expense for Facebook to nip any new scandals in the bud before they become existential threats.
BMR Take: We expect Facebook to grow revenue 25% this year and maintain 20% growth through at least 2021 as the company starts monetizing other huge platforms (1 billion+ users) like Instagram and WhatsApp. Here at 21X earnings, that top line trend may not be enough in itself to take the stock back to its peak, but we can wait. Now that the scandals are in the rear-view mirror, we have every reason to believe Facebook will return to mid-2018 glory.
Netflix (NFLX: $357, down 2%)
We don’t lump Netflix in with larger Technology stocks in an artificial “FANG” grouping because it’s so much smaller and more volatile than the true giants. The scale differential speaks for itself: at best this company is 1/7 the size of Microsoft, Amazon or Apple and 1/6 as large as Alphabet. And in terms of volatility, it’s been a true rollercoaster, up 33% YTD and still 16% from the July peak.
That’s right. Netflix soared 50% early last year and then crashed 45% after that. Now the stock is once again nudging into the upper levels of that range, largely thanks to rising confidence that increased investment on original content will be only a temporary drag on the margins.
As it is, 4Q18 revenue surged 27% to $4.2 billion with 9 million new subscribers signing up across the planet. The audience isn’t just growing; it is exploding. The growth has accelerated from 6 million a quarter last year. Management is predicting another 9 million for 1Q19.
And why shouldn’t they? Top-notch programming has drawn millions away from traditional cable TV and movie theaters. The company even had its first legitimate Oscar contender, in Roma. (Cuaron won Best Director even though the film came up short in the Best Picture category.)
Netflix’s market dominance has grown so pronounced that former Paramount and Fox CEO Barry Diller recently declared to The Hollywood Reporter that “Hollywood is now irrelevant” and “Netflix has won this game.” Of course competing with Hollywood is expensive, with already-thin 5% margins compressing to 3% last quarter as the company burns a lot of capital on assets that won’t be amortized for years if not decades.
Shareholders understand this. Spending the money now will feed massive growth in the near term. We’re expecting revenue to double between 2018 and 2021, by which point profit should come roaring in.
BMR Take: While some investors fret about existing content producers like Disney getting into the Streaming Video arena, we see room for multiple subscriber services as the traditional Cable TV bundle breaks down into channel-by-channel pricing. In that world, Netflix is already light-years ahead of the competition, and after years of relentless user growth, this is the entrenched leader to watch.
Tesla (TSLA: $295, flat)
Elon Musk’s rollercoaster continues. Tesla surged 17% in early January, then nosedived back below $300, leaving shareholders down 11% YTD as we all wait for the next wild move to take us back to glory.
This week was all about Musk’s continued efforts to pivot his luxury electric car brand to a more mass-market presence via the $35,000 Model 3 sedan and now a retreat from traditional dealership sales. While the decision to roll up the Tesla stores and sell direct online didn’t win a lot of applause, we suspect it’s the best way to preserve profitability at that price point.
Musk needs that to make the Model 3 happen, especially after cutting 7% of his work force. The car goes from zero-to-60 in under six seconds and provides 220 miles of driving range for its $35,000 price tag. As long as Tesla can sell 10,000 of them a week, Musk is still operating according to plan. After all, he’s already built out truly massive manufacturing capacity. Now it’s time to scale what’s already a narrowly profitable business in order to take advantage of those sprawling Mega Factories.
BMR Take: With or without the Model 3, Tesla has turned the corner in terms of sustainable profitability, booking earnings in 3Q and 4Q of last year on roughly $7 billion in sales per quarter. This year doesn’t need any revenue boost at all to deliver a full $5.70 per share in profit, which is enough to fuel a lot of Musk’s more strategic plans. The threat of selling more stock and diluting existing shareholders looks dead now. As long as Tesla can make its debt payments, the right swing in sentiment can easily take it back within sight of $400.
Todd Shaver, Founder and CEO
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