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Facebook – attractive, yes, but at what price?

Persistent rumours continue to abound that a Facebook IPO is imminent, with an expected value of US$ 100billion. While this is generating a lot of excitement and hype it remains impossible for us to form an investment opinion. This is not because we do not believe in the strength of the trend towards social media (we very much do) or that we do not believe in Facebook’s competitive position (clearly dominant with a strong competitive moat). The spectacular hype surrounding the extraordinary proliferation of Facebook makes exciting headlines but it is only when the more prosaic aspects of profit and loss and balance sheet analysis are able to be properly considered in relation to market value that any genuine investment decision can be made. And we have only vague details of these at best.

The devil is thus in the detail. As exciting a growth prospect as Facebook presents, we are therefore wary. The level of hype surrounding social media in general, and Facebook in particular, is so high that an attractive entry point (from a valuation point of view) may not be achievable. As we have seen so often through the history of technology a ‘hype cycle’ tends to envelop new and exciting technology developments. We only need to cast our minds back a short time in history to remember the stock market excitement that surrounded the rise of the internet, nano technology and solar technology, to name but a few. These are all genuine long-term growth markets but were each subject to periods of hype which destroyed returns for unwary investors. Analysis of this ‘hype cycle’ is an embedded part of our process in the technology team, and we prefer to become involved at a later stage – when the hype has passed, strong growth prospects remain and valuations have become attractive. As strong believers in the social media trend we would love to have an investment in Facebook – but only at the right price.

Apple – where reality beats hype

Apple has been our largest position for some time so it is worth noting the quite extraordinary quarterly results they recently announced.

This is a company with a market cap in excess of US$ 400billion and a US$ 160billion run-rate in annual sales who grow revenues 73% year over year (accelerating from 39% in the prior quarter) and earnings per share by 116%. In just one 3-month period they sold 37 million iPhones, 15 million iPODs, 15 million iPADs and over 5 million Macs. They beat top line consensus expectations by an amazing 18% and their earnings per share (EPS) beat was a whopping 37%! They generated US$17bn in cash in a single quarter. This is clearly phenomenal. And we believe more strong growth and earnings beats are likely going forward given their product momentum, high-growth end markets and conservative expectations. And, above all, despite their extraordinary growth, market position and competitive advantage, the stock appears very attractively valued. They trade on a price/earnings (P/E) ratio of 9x calendar 2013 consensus earnings – which is a significant discount to the S&P 500 and the technology sector. And this valuation metric does not give them credit for the enormous cash position they have built on the balance sheet. Excluding cash they are on an unusually attractive forward PE of 7x. In the many years we have been involved in the stock and despite the huge performance generated over the period, I do not think we have seen a more attractive valuation.

Apple’s stock market performance has clearly been stunning, often leading to the erroneous view that the equity must be expensive. The truth is that share price appreciation has been less than earnings growth and the stock has thus beende-rating.

The most recent quarter illustrates this perfectly as the scale of the earnings beat has led analysts to increase earnings expectations for forward years by around 18%. As the share price only rose by 7% the equity actually became cheaperon a forward PE basis!

There has been some concern over the last year or two about increased competition in smart phones, maturing market penetration, the law of large numbers and of course the impact of Steve Jobs passing. We consistently stayed with our large position based on a belief in the stickiness of their eco system (iTunes, AppStore and now web services), their leadership position in some of the fastest growing markets and, quite amazingly, a very attractive valuation.