Social networking companies Facebook and Twitter both reported earnings this past week and both saw violent drops in their stock price after the reports. Facebook dropped 19% on Thursday and according to Bloomberg, that decline erased $120 billion in market cap, more market capitalization than any decline in history. Twitter reported Friday morning and opened over 13% lower and was down 18.5% at Noon.
Facebook beat its consensus EPS estimate, but missed its revenue estimate. Twitter beat both the EPS estimate and the revenue estimate. The problem came from the user growth forecast for each company. For Facebook, user numbers in the U.S. and Canada were stagnant on a quarter over quarter basis and the number of users in Europe declined from the previous quarter.
In the conference call following the release, it was revealed that the company expects the revenue growth to continue decelerating. “Our total revenue-growth rates will continue to decelerate in the second half of 2018, and we expect our revenue-growth rates to decline by high-single-digit percentages from prior quarters sequentially in both Q3 and Q4,” David Wehner, Chief Financial Officer.
In Twitter’s case, the company saw monthly active users decline from 336 million last quarter to 335 million in the second quarter. Analysts expected Twitter to grow monthly active users to 338.5 million.
Both companies are dealing with several issues, including privacy changes by the European Union. The General Data Protection Regulation (GDPR) is a regulation in EU law on data protection and privacy for all individuals within the EU and it went in to effect in May. The decline in Facebook users in Europe can be attributed to the new laws and it likely played a role in Twitter’s monthly active user decline.
In addition, Facebook is still facing criticism from the Cambridge Analytica scandal and the election meddling scandal. For Twitter, President Trump criticized the company for “shadow banning” Republicans. Shadow banning is a practice of limiting the visibility of a Twitter user in the platform’s auto-populated search box. Twitter denied the allegations.
Obviously both companies have issues and both have seen incredible growth in recent years and that might be part of the problem. The growth rates and expectations were unsustainable.
In addition, investor expectations were incredibly high ahead of the earnings reports. I personally put great emphasis on investor sentiment and looked at it for both companies ahead of the earnings reports. Facebook had a short interest ratio of 1.75, and a put/call ratio under 0.5. There were 46 analysts following the stock and 42 of them rated the stock as a “buy”. All three of these pointed to extreme optimism towards Facebook’s stock.
Twitter’s short interest ratio was at 1.67 and the put/call ratio was at 0.49. Analysts were more bearish on Twitter with 21 out of 36 analysts rating the stock as a “hold”. I even posted an article on Seeking Alpha on Wednesday, advising investors that I thought there was too much optimism toward Twitter ahead of the earnings report.
Don’t get me wrong, both Facebook and Twitter have solid fundamentals. The earnings growth for both companies is among the best of all publicly traded companies. Facebook’s profit margin and return on equity are better than Twitter’s, but Twitter’s is still a little better than average.
The problem is that the stocks had rallied too fast and the expectations were just too much. It would have been hard for the stocks to climb after the earnings reports had the user statistics matched expectations. When the sentiment is extremely bullish and then you get negative news like Facebook and Twitter delivered, that is when you get 18% and 19% declines.
I have one last observation to share with you. I have written a couple of cautious articles on Seeking Alpha. In most instances I get lots of comments about how I am crazy or upset that I missed out on the bullish run, etc. The comments validate what I am saying that investor sentiment is too bullish. Even when the stocks fall, some will come back and say that the stock may have fallen, but not for the reasons I said it would.
These investors are caught up in the minute details of the reports—the usage in Southern Ukraine dropped by 50% and that led to lower user numbers for Europe overall. Don’t worry about what is said, worry about the reaction in the stock. Stocks with extreme bearish sentiment are unlikely to drop by 19% in a single day. Only when you have extreme bullish sentiment are you going to drops like that.
I am a fan of Tony Robbins, the motivational speaker. He talks about how you don’t need to know every detail of how electricity works in order to flip the switch and get the light to come on. That is how I feel about the earnings’ reports of companies. I don’t worry about the details of the report, I look at the reaction of the stock after the report.