DCF Model Analysis: I'm going to be loading up on META on the next crater.
DCF Conclusions Analysis for Members: Meta's Upside and Downside Potential evaluated
Note to Folks: As an ongoing way to show my tremendous support for my broader community, I am sharing 3 premium weekly letters here with paywalls removed. Inside them, you will see the research opinions that have worked in my favor and some that are against my favor. Transparency is something I shall always practice.
→ My view on BABA and Mosaic/CF Industries/Oil in early July
→ My view on Pinduoduo (PDD) and New Oriental (EDU)
→ My view on a tactical watch level on Netflix as well as Applied Materials leading market signals
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Members,
Hope everyone is having a great weekend. This past week was one of the busiest weeks for event-driven macro and fundamental outcomes for the markets.
We’ll talk about Meta down below. But first, a bit of commentary.
While we are indeed witnessing bull market price action, my macro view has pushed me to avoid the indices at this price juncture, and instead use stock-selection and sector rotation to find alpha.
To that extent, I have shared a host of great ideas to our folks here (with recent ideas linked above). And as always, the ideas I discuss here are the same setups that I take.
My ideas have helped my retirement account to a nice 25% total return in 2023 without passive index SPY or QQQ exposure. What is important to note is that having a system to select good companies with good entry points is a repeatable process.
What I am trying to express here is that although the markets have run up significantly this year, there is absolutely no reason to FOMO.
Why is this? This is because the markets are open every single day of the week, and for 250 sessions per calendar year.
There are 500 companies within the S&P 500, and many more global high-quality stocks outside of the U.S.
There is Always opportunity that is shaping and forming. There is No need to feel regret to have missed a move. There will always be more setups coming.
Here I will show you what I mean, and share previous premium content to be made public for my public following for continued goodwill. All these ideas are linked above & below and publicly accessible to be read by all:
I liked Pinduoduo in the mid/high 70 region as I believed the consolidation period post earnings rally would serve to be another entry point. I view the TEMU app to be a winner in foreign markets, and PDD now trades 88. This was quite a winner with a 15% return in less than 2 weeks.
I also liked New Oriental on a Breakout of 46/share as I believed its business model pivot is starting to regain a more solid footing. It now trades 55. Another 15% winner.
I discussed Beike having the potential to run back to 17 if it defended 14 as China’s stimulus policies may help this specific name see more upside than say BABA. This was a 20% winner.
I also talked about the global protectionism dynamic that is occurring at the internal meetings between politicians after China’s non-rare earth ban. This has pushed Oil ETF XOP and fertilizer names Mosaic/CF industries up 10% above my discussed entry points.
Look folks, let’s say the market comes back down - which I expect it will - I will still have a plan to help the Community continue to advance their account growth and investment goals in a defensive and thoughtful way.
It is true that my macro view has been too cautious on the broader markets, but I have not let my aversion to the indices prevent me from identifying stock-specific opportunities.
Readers may well know that stock-selection is significantly more difficult than simply holding onto a broad based market ETF.
However, I will continue to use my approach as I believe there are still stocks in the market that can demonstrate relative strength when SPY/QQQ trade flat or modestly down.
Now I wish to provide a very brief recap on U.S. and China drivers of this week.
On the U.S.
This week was marked by the July FOMC as well as several key earnings outcomes that will be discussed below.
My sense is that the Fed sees wage growth and a still-hot labor market being something that needs further cooling before they can confidently reach their 2% inflation target.
Across asset classes, we witnessed credit spreads continue to tighten and the indexes continue to rise.
It is a well understood truth that rising interest rates sows the seeds for a VIX reading (volatility proxy) that has lengthier tail risks that eventually expand credit spreads.
Given that shorting the VIX has been one of the most profitable trades of 2023, any unwind of this strategy (which has a lot of capital devoted to it) will create riveting shocks across markets.
Perhaps that risk is not imminent, but one that should be watched.
On China
This week, we received optimism over future policy action from the Mainland to engage in further stimulus to aid the real estate sector, boost consumer confidence, and lower the unemployment rate that is plaguing China’s youth.
This sent the Hong Kong Hang Seng Index up over 4% and the KWEB Constituents up 5-10% depending on the name.
China EVs had a historic week with many of the names advancing 40-60%.
Whether this is a durable rally or not is something I will closely follow.
Every week, I rotate the focus of the topic from Fundamental, Technical, Macro, and DCF Company Analysis.
This week’s focus will be on a DCF Conclusion Analysis of Meta to understand the company’s upside (and downside) potential based on scenario analysis.
And I will also provide a short list of stocks that I’m watching for further upside as well.
I have a lot more in store for the folks in my public and private communities at large, so make sure to subscribe below if you haven’t yet already.
My future content model will be as follows:
A very high-quality free personal finance blog (one of my biggest projects in 2023) that is under development to be released by end of year. Stay tuned for that as this is one of my biggest missions to help every reader improve their financial journey in conjunction with my Youtube channel.
The current extremely affordable and modestly priced Investment Community format here that provides one high-quality strategy update once per week on the weekends. This Community tier is best suited for long-term investors who have at least an intermediate-term timeframe (6-9 months). I do my best to share setups that will work as soon as possible, but any experienced investor knows that ideas take time to play out.
A more advanced program for folks who are looking for more frequent commentary/strategy, options setups, and my personal journaling in reaction to market, which I will have a separate Community for that in the coming months. In other words, you would get to see ideas discussed here get live commentary in a dedicated group chat.
In other words, I will serve my public readers at a higher level than ever later this year.
At the same time, I will also have a deeper level of service for those who truly understand/have benefitted from my work, and want to scale their outcomes with further education and strategy.
Now let’s talk Fundamentals and DCF conclusions below.
A Week in Recap in Holistic Fashion
Leaning back on my previous weekly letter where I studied the fundamentals of companies that had reported earnings, I had concluded a few items:
That Netflix’s valuation (and therefore the stock) would need to see much further compression before a bounce after their earnings revealed single digit growth in the context of their 10X EV/EBITDA multiple. Netflix traded as low as my watch level 413 before a bounce. Beautiful, if you were trading the name.
That Applied Materials drifting back towards 145 to invalidate its previous double top pattern would mean the SOXX ETF is still prone to stay supported.
American Express’ management commentary on the macro being unfavorable to small-medium enterprises (SMEs) which may lead to the Russell 2000 see relative weakness against the S&P 500. I continue to believe R2K will underperform SPX.
American Express’ management comments on travel related sectors continues to support Marriott (which is now at an all time high ahead of earnings)
These focal points were all in alignment with market forces this past week as we observed.
This week, we received more updates on the state of corporate earnings with more outcomes that have been released, which I will concisely discuss below. Please note that my Letters are increasingly conclusions-oriented to keep the length readable for an audience that I assume is extremely busy. Although my notes on companies may be brief, know that I have done exceptional due diligence in studying their price action together with their fundamental backdrops in today’s macro context.
For people who follow my opinions closely, this is demonstrated by key levels that I share and the corresponding market action that follows.
Onto earnings that have been released:
On Microsoft: Previously in a DCF discussion on this name, I concluded that most scenario analysis pointed to the 330-340 region as the magnet level for MSFT until further distinctive new information. This quarter, in my view, did not provide distinctive new information that we do not already know about. The result? MSFT got pulled right back to my DCF estimate range. I have studied the earnings transcript and conclude that MSFT continues to execute well despite softer than hoped cloud results. In my opinion, there will be a bit of an overhang on MSFT as scarce capital decides to chase names that are more immediately promising. The wick high at 367 achieved on 7/18 after the AI subscription announcement implies that many short-sellers were pushed out or longs got trapped at that price level. Recall that 370-380 on MSFT was my most optimistic scenario in my DCF report. The Street pushed the name to near that level for half a day, and we may very well have seen the highs for MSFT for the next 3 months (absent any fundamental catalyst). That said, I remain long-term bullish on Microsoft and if it can consolidate at 330 or better, it remains in an uptrend (just perhaps more modest than previously).
On Meta (will be discussed below more in detail): Meta has turned around its fortunes as my DCF model on it flags three favorable developments - reaccelerating revenue growth, improving EBITDA margins (because they fired a lot of people), and also because they are stabilizing Capex spend. The model is sensitive to these 3 factors, and Meta has the three of them working in its favor. Given the sheer amount of cash that Meta has on its balance sheet relative to debt, a rising rate environment has actually helped Meta’s financial positioning. The latest Fed rate hike does not impact Meta’s financials as other high-growth companies with debt laden balance sheets.
On Google: In tandem with Meta, the advertising sector is seeing a post earnings bump due to re-accelerating advertising spend. Generally speaking, advertising is the first place to spot economic weakness or strength, so this growth reaccelerating is going to support the sector (at least for now).
Let’s now talk about the DCF Considerations of a key company in the market: META
For this discussion, I’m going to discuss Meta. I will first provide a fundamental overview and then discuss my DCF findings.
Meta is at the crossroads of a reacceleration in ad revenue as well as its participation in the AI sector boom.
At the heart of its business is its advertising segment which allows the company to funnel free cash flow generation to making future bets on AI and the Metaverse (via their Reality Labs segment).
Broadly speaking, the Street likes to pay attention to the following metrics for social media companies (this applies to companies like Pinterest, Snapchat, etc):
Monthly Active Users (which provides a network growth picture)
Daily Active Users (which provides a glance into engagement)
Average Revenue Per User (which provides data on monetization trends)
Advertising Revenue growth (this is the core driver of free cash flow for social media companies)
For Meta specifically, there are a few product lines that the Buy Side is watching:
Engagement and watch time on Instagram Reels. The revenue run rate from Reels has exceeded $10B in 2nd Quarter 2023, which is a rapidly growing clip within their business.
The integration of Whatsapp into advertising solutions within Facebook and Instagram. Now that Meta has 200 million users on Whatsapp, they command a larger and larger presence over consumer communication channels.
The prospects surrounding advertising on Threads now that it has over 100 million users signed up on the platform. I don’t think Zuckerberg will try to monetize Threads until they’re over a certain threshold for users.
There are a few blurbs from their prepared remarks that I believe are important. I’ve linked it here if you want to read and I’m screenshotting the one that I believe is key.
We can see here that a few major takeaways include that the rest of 2023 is going to be able “creating stability for employees” and meanwhile, Zuckerberg is going to run the company as lean as possible with “newly budgeted headcount growth to be relatively low”.
As a Strategist who attempts to surmise how Sell Side Analysts interpret these remarks as they update their own DCF models, I have a few thoughts to share:
The mass layoffs that we’ve seen in 2022 in Meta are most likely over
That said, the growth of headcount is also going to be relatively tamed
In simple terms, this means that the easiest part of the massive rebound Meta’s EBITDA and operating margins has now passed as they are no longer looking to cut headcount in a draconian manner. I would expect that their margins will be steady in the quarters ahead.
Translated into the stock price action, it means that much of the cost-cutting benefits is now completely baked into Meta’s stock price. To take it higher from here, I believe we would need to see upside surprises on growth areas such as Reels, Whatsapp, and Threads.
Expectations are moving significantly higher for Meta. In the last quarter before this one, my YCharts dashboard showed me the following for revenue expectations:
Fiscal Year 2023: 126.4 Billion
Fiscal Year 2024: 140.03 Billion
Fiscal Year 2025: 154.2 Billion
Fiscal Year 2026: 166.7 Billion
Fiscal Year 2027: 181.17 Billion
Now let’s take a look at the expectations after this past quarter:
Fiscal Year 2023: 132.73 Billion
Fiscal Year 2024: 147.15 Billion
Fiscal Year 2025: 163.6 Billion
Fiscal Year 2026: 176.60 Billion
Fiscal Year 2027: 195.27 Billion
In terms of EBITDA expectations, here is the change:
Fiscal Year 2023: original forecast of 62.7 Billion has been upgraded to 68.9 Billion
Fiscal Year 2024: original forecast of 72.5 Billion has been upgraded to 80 Billion
Fiscal Year 2025: original forecast of 81.4 Billion has been upgraded to 90.8 Billion
As you can see, these upward shifts in expectations explain the rapid rise in Meta’s stock price and valuation from the past 3 months.
With higher expectations comes increased scrutiny on execution of business performance.
Let’s now talk scenario analysis of Meta’s stock using various assumptions that move the needle.
Scenario 1 (Base case): We apply this past quarter’s 32% EBITDA margin as the terminal margin rate, 10% revenue growth rate (very doable for Meta), and 20X EV/EBITDA multiple (its historical average is 24X). The result is that the stock is valued at 325-330 using these inputs. In other words, perfectly priced. So for those folks who think that Meta is very “overbought” and want to short the name, my fundamental work suggests doing so means shorting at fair value (as that’s my DCF base case output) which isn’t a good idea.
Scenario 2 (Optimistic): We apply a terminal EBITDA margin of 45% (which is close to the highs of Meta’s corporate history), a 15% revenue growth rate, and a 20X EV/EBITDA Multiple. In this scenario, we have the potential to reach 450-470/share in a couple years. 50% Upside.
Scenario 3 (Conservative): We apply a terminal EBITDA margin of 31% (which is the exact low of Meta’s corporate history back in 2022), a 5% revenue growth rate, and a 16X EV/EBITDA multiple (which is the average in 2023 for Meta). This results in 265/share. Roughly 20% downside.
With these model outputs, I believe long-term multi year investors have quite a run way for upside potential.
It may 2-3 years for the bull case scenario to play out, but I think Meta’s efforts in driving its Ads business along with the potential for its future bets to payoff make this scenario more realistic than one may think.
On the other hand, a reset to 260 per share (assuming no other change in fundamentals) is likely a good entry point as I believe Zuckerberg and team will likely defend a 30% EBITDA margin level at all costs. So fundamentally speaking, if a 30% EBITDA margin holds through (which is the historical corporate low for Meta), a share price under 260 will eventually rebound.
Today’s level has Meta being perfectly priced. As is usually the case, the FAAMG stocks are closely analyzed by the Street so mispricing for closely watched names doesn’t usually last very long. My job with a DCF is to reverse engineer their implied growth rates and assumptions in their models so that we understand what today’s share price actually means in terms of fundamentals.
Net/Net, the long-term outlook for Meta is increasingly favorable and dislocations in the market that pressure the name will be opportunities to add exposure.
Every week, I also would like to share themes and setups that I’m watching that I believe have positive intermediate term potential.
The following setups are personal opinions, and my own journaling of names I follow and is not financial advice.
Firstly, all previously shared ideas continue to be in play. Just raising stop-loss levels in case the market reverses. But still like all ideas previously mentioned.
Longer-Term Ideas that I like (this will take quite some time to work out)
The FXY Japanese Yen ETF: I’m going to be giving this macro idea of the BOJ normalizing their interest rate policy a second entry at the 65-66 region for a 9-12 month hold. The BOJ will struggle to indefinitely to continue their QE program to suppress bond yields as inflation starts drifting to 2% and higher. This trade may be frustrating for the time being, but the BOJ cannot keep bond yields this low indefinitely and they will have capitulate on their current infinite QE program at some point. Traders often call betting against Japanese Bonds and being long the Yen the “Widowmaker”. Pain for quite some time, and then abruptly a swing into profit.
Gold ETF GLD: GLD now trades 181 and eventually I do see GLD breaking its previous high of 191. In terms of timeline, I’d say 12-18 months. Gold increasingly curries favor among folks who want to diversify equity exposure, and I agree that it is an important tool to hedge against currency debasement. Downside may see 165-170, but I don’t think we’re looking at structural downside for Gold on dips.
TLT ETF: This past week’s dislocation in TLT was due to fear that the BOJ would trigger a repatriation of Japanese capital and create a need to sell US Treasuries. While that may pressure TLT, there are limits to how high long-term US Yields can rise as short-term rates pressure the broader economy towards weakness. I continue to believe that lower prints in TLT are levels to be bought and held rather than to be sold. I’m buying again at 99, and will buy further at 95 and 90 if needed.
Bounce Ideas (With a tight stop)
Chipotle (CMG): There is fear that resumed student loans will cause Chipotle to see slowed spending in a major portion of their customer base. This week’s earnings report triggered a 10% selloff and a revisit to 30 RSI with a follow-up bounce. CMG at 1910 is an interesting entry with a tight stop at 1870-1880. I’d say there’s 2% of downside risk for what could be 3-4% of upside in the coming weeks. There’s no reason to stay in CMG if it stays under 1870-1880.
Raytheon (RTX): RTX saw the stock visit a 9-month low after engine problems were found in its Pratt & Whitney unit. The stock made a stunning fall from 96 to 80 (a 9 month low) but that was wick low and the stock now is back to 87 and change. RTX has about 1:1 risk reward with upside back to 91-92 and a stop-loss at 85.
Contrarian Ideas (This list may frustrate people before it delivers rewards)
Disney (DIS): Disney has been one of the biggest market laggards as the company faces cultural battles as well as a challenging environment for their streaming and parks business. Valuation wise, Disney is fair. I won’t say that it is extremely undervalued because it’s not. However, compared to the broader market, it’s valuation is not as stretched. This means the margin of safety is larger if markets experience softness. As long as Disney does not violate 85 (which is the line in sand) for this name, I see DIS as a trade that has rather small downside for what could be upside potential to 90 first, and a bit of digestion, and then to the 94-95 area. So, about 1.5-2% of downside potential for what could be 8-10% upside.
Microsoft (MSFT): I personally think MSFT is heading much higher over the long-term. If MSFT can defend 330 and consolidate above it for several weeks, we could eventually see 350-360 again within 6-8 weeks. Beneath 330, and I would wait for the 310 area. Anything in between 310-330 isn’t an area I have much visibility into.
Continuation ideas (intermediate-term timeframe):
Interactive Brokers (IBKR): Previously discussed as a winning name at 70 back during March SVB crisis (feel free to check), IBKR now trades 87 as bullishness in the market is good for trading volumes and their business. I see IBKR taking out their all time high of 89 in due time. But first, some digestion may be in order as the stock recently ran up 10% from 81 just this past week. A retest of 83-84 may be healthy to recharge the advance. A clear break of 80 on the downside is a change of trend. I stay constructive on IBKR above 80, and but cannot vouch for it when it is below 80.
FIVE Below (FIVE): Along with my thrift shop ideas Dollar Tree and Dollar General, I’ve also consistently talked about FIVE as the momo (momentum) name within this peer group. I see FIVE revisiting close to all-time highs of 218 in due time, and I am going to use any pullback to 190-195 as a region to add further.
Downside Ideas (intermediate-term timeframe):
Vanguard Real Estate (VNQ): Previously, I mentioned that VNQ could see a small bounce on Traders pricing in fewer hikes. And that has indeed happened. However, I remain net bearish on Real Estate, and if I had to choose a vehicle to sell short as a way to hedge my long book, it would be VNQ ETF. As long as VNQ does not rise past 87 (now 85), the macro setup is against Real Estate until the Fed cuts rates. If we can break the neckline of 83.5 on the downside, I see this ETF eventually retesting 80. There is no reason to stay in a short position in VNQ if it trades above 87. A short on VNQ is explicitly used as a hedge against other longs, and not designed to be a full portfolio one-position strategy. This is one position in the context of a diversified set of holdings. This setup implies that risk is about 2% and reward is about 5-8%.
Goldman Sachs (GS): GS holds quite a bit of exposure in commercial real estate and if we see a credit event later in 2023, GS is more vulnerable than other banks such as JPM. GS saw 4 attempts on 4 different days to take out 360 this past week and failed each time. It’s made a powerful bounce off 310 from July 7th (3 weeks ago), and if the Dow’s long winning streak begins to stall and reverse, I believe GS will see 345 again. Now 353. There is no reason to bet against GS if it takes out 360.
In many of my ideas discussed above, you can see that I share conditional information such as if this level is breached, I close the position (or don’t even start it). This is particularly important as it make being wrong not as costly as if I were to be stubborn.
In markets, like many investors/traders, I have been humbled many times in the past and will continue to get humbled. However, by keeping defined levels where I know to get out if it’s against my plan, I keep losses manageable.
By keeping losses manageable and finding a greater volume of winners, we are stacking probability and statistics on our side for long-term success.
By being flexible with markets and committing to constant learning/education, it’s only a matter of time until you get to your goals in a consistent fashion.
~Larry
