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Whatever You Do, Don't Sell Facebook Now

Posted
7/25/2013 2:00:00 PM
By: StreetAuthority
Referenced Stocks:

How does a company worth $60 billion manage to completely shock investors and deliver a 25% one-daygain ? That's the question being asked at traders' desks across the country after Facebook delivered a rock-solid second quarter that exceeded the mostbullish of forecasts.

The answer is simple. Facebook, despite its massive size, had largely been forgotten by most investors. Earlier this month, I noted how this once-hotIPO had been steadily falling this past spring, even as the rest of themarket was in party mode. 

Suddenly, thisstock is touching 52-week highs again, and if you were savvy enough to own this stock going into the quarter, then this is no time to be a seller. After a quick move to $33, this stock may be headed toward the $40 mark byyear 's end.

The Great Second Quarter
Facebook's impressive second-quarter results have been discussed in many other forums, so I'll only recap the key metrics here:

Yet as solid as those numbers are, they don't explain why this stock still has considerableupside . In my recommendation of Facebook earlier this month, I discussed the management initiatives that are still in their infancy and not yet significantly contributing to financial results. For example, the company's purchase of Instagram -- which now has more than 130 million active users -- continues to look like a master stroke, as that division's user growth shows no signs of cooling.

Facebook management has moved slowly to monetize Instagram's user base, wisely preferring to let it grow as large as possible before shifting the platform toward ads. It's a transition that Facebook users now accept, and Instagram userswill slowly be weaned into advertising in a similar fashion.

Another growth initiative to monitor: video advertising. Facebook concedes that advertisers are clamoring for more video display ad opportunities and this is likely to be a key focus for management over the next six months. (In the third point I made in my look at the stock a few weeks ago, I also highlighted many other mini-platforms that Facebook is developing.)

The other key trend is very impressivecapital management. Facebook's IT team is becoming so much more adept in its hardware and software purchasing that the company was able to pursue all of its growth initiatives with just $268 million in capital spending. That's more than $100 million below consensus forecasts.

After a rocky start, Facebook's stock is now touching 52-week highs, and may be headed toward the $40 mark by year's end.

Surging revenues and controlled expenses will set the stage for Facebook to post some of the most impressiveoperating margin profiles of any major tech company. Merrill Lynch believes thatfree cash flow will exceed $2.5 billion by 2015, up from just $53 million last year. Projected EBITDA of $7.4 billion in 2015 would be roughly triple the EBITDA generated in 2012.

Wall Street Sees The Light
Wall Street analysts, who tend to move as a herd, have been suddenly boosting target prices at a feverish clip. Here's a quick sampling:

Why should you care about these analysts' price target and views? Because Facebook is about to become a major topic of conversation among these analysts and theirhedge fund clients. Analysts tend to "talk up a name" as long as its current price is a reasonable distance from its target price.

Risks to Consider: There are a few negatives to the Facebook story. First, the games category continues to underwhelm and is becoming a decreasing part of thesales mix. Second, Facebook's "Graph Search" feature, which was the product of a considerable amount of R&D spending, has not yet become a hit with consumers. And thanks to a rebounding stock price, Facebook could soon be hit by a brain drain as valuable employeescash in theirstock options and migrate to smaller, pre-public tech companies where other options bounties await. 

Action to Take -->  Shares of Facebook are hitting fresh 52-week highs but remain well below the IPO price. The company burned alot of bridges with lackluster quarterly results in 2012. Yet it's increasingly clear that management now understands the need to deliver solid financial metrics both now and in the future. That said, it's the probable growth in 2014 and 2015 that should really have you focused on this stock. This week's sharp run for the stock reflects the fresh set of quarterly results -- but the nextleg of share priceappreciation will come from even betterquarters yet to come.