Every day, Wall Street analysts update some stocks, downgrade others, and "initiate coverage" on a few more. But do these analysts even know what they're talking about? Today we take a professional Wall Street pick and place it under the microscope.
Last week started with good news for Facebook (NASDAQ: FB) investors, like Investment Banks Nomura Instinet upgraded the shares to buy, which helps push up Facebook shares and more than 1% – but it's easy to get around, easy going.
Today, an equal and opposite downgrade takes the roof of Facebook stock more than 3% from Monday afternoon.
Here's what you need to know.
No changes – except for a very big change
Banks Needham & Co. removes the profit Facebook earned last week – and more – by downgrading stocks in the social network. Now Needham has not named a new price target, according to SmarterAnalyst.com. StreetInsider.com reported it to $ 170 in December, and in today's note, the analyst indicates that the share's approach to "within 2% of our target price" suggests that this hasn't changed. Hardly, Needham says, changing that expectation for Facebook's sales or earnings over the next couple of years.
Who raises the question: If Needham's near-term expectations for Facebook have not changed and the price target has not changed either, and if Facebook's share price is below this target, then … why downgrade at all?
Why Needham downgraded at all
Needham's thinking goes like this:
Research suggests that companies in S & P 500 can basically be divided into two types: 5% of companies benefiting from "network effects" (ie, their services and their shares become exponentially more valuable as more people join) 95% of companies that do not like such networking effects. You can think of it as a telephone company and its customers. If there is only one phone and one phone number in the world, it is not very useful to anyone. When there are two people in the world with phones, they can call each other. Three, and they can call more people – and so on.
Thus, gain in popularity gives a stronger and even more popular company, giving even more gains – a virtuous cycle – attracting both users and high-quality employees. Companies that enjoy network effects often tend to dominate their industries, attracting both users and talent in a phenomenon called "winner-tar-must". Facebook is one of the lucky 5%, along with other "FAANG" members Amazon.com Apple Netflix and Google (ie Alphabet ).
The problem is that when a company stumbles and begins to lose popularity, the network effect can change to the other way, in a subsequent phenomenon that Needham dubs a "negative network effect". Here, when a company begins to lose popularity, this loss gets itself and becomes difficult to stop. This is what Needham's fear has begun to happen within Facebook's management.
Error in the corner office
To catch a glimpse of what the future holds for Facebook, Needham suggests investors investigate what's happening in Facebook's corporate offices, where the analyst sees a "negative network effect" that excels his team of top executives.
In recent months, Needham says, we have seen co-founders of Facebook-transferred companies WhatsApp, Instagram and Oculus leaving the mother ship. Also gone are Facebook's "Chief Product Officer", "Communication and Policy Head", "Chief Communications Officer," "Chief Security Officer", "Chief Legal Officer", "VP of Partnerships" and "News Products Chief".
Noting the extent of the errors, Needham worries that these more leaders "no longer believe in FB." Furthermore, "other people in the organization agree with them and leave too, and every person who leaves makes it more likely that the next person leaves," accelerating the tide of departures at a time when Facebook is already heavily involved in a revolution of its business model for focusing on private communication, combating tightening of congressional regulation, and plagued by "headline risk" from stories such as the issuance of violent video images on the network.
At the same time, Needham rightly points out that highly qualified executives who leave Facebook are very likely to land somewhere – probably with a competitor, where they will put their talents at work and put even more pressure on Facebook's business.
What It Means to Investors
Now it is important to note that Needham does not see the situation with Facebook after reaching critical proportions – yet. At least, it's not worried enough to actually recommend selling Facebook stock.
But Needham is clearly concerned with the leading mistakes and the effect this may have on the business. With Facebook stocking now more than 30% in three months, selling for more than 30 times free cash flow – but indulging in less than 17% long-term growth on Wall Street, analysts asked by S & P Global Market Intelligence – Investors might think on harvesting some profits and going on the exits.