Wall Street is littered with examples of high-growth stocks that flamed out spectacularly.
Consider Crocs CROX, -3.42% which rode a footwear craze to 400% gains in a roughly a year — before a change in consumer tastes coupled with the financial crisis caused the stock to give it all back. Or 3-D printing stocks, such as 3D Systems DDD, -5.77% and Stratasys SSYS, -3.07% which were nearly 200% winners in 2013, only to give back all the gains in a year or two.
There are countless other examples, and it’s a cycle all investors should be familiar with: A great narrative that connects with Wall Street, a stock chart that looks like a hockey stick and the promise of near-certain growth.
Until, you know, the growth isn’t there anymore. And the bottom falls out.
In the last few years, many tech investors have seemingly forgotten this arc and instead placed big winners, including Netflix NFLX, -2.17% and Facebook FB, -0.78% in a class by themselves. Yes, funky footwear products were doomed to hit a ceiling eventually. And yes, it’s natural that investors looked beyond the hype and hot air that lifted 3-D printing stocks at one time. But many thought Facebook and Netflix were different.
And after Facebook’s epic flop of nearly 20% after earnings and a similar showing for Netflix a few weeks ago, many investors learned just how costly that thinking can be.
Here’s why the growth stories at Facebook, Netflix and other highflying tech stocks may not be as bulletproof as many have been led to believe.
We’ve reached the end of the internetThe promise of any internet-oriented company is that growth is limitless. Software scales quickly and with amazing margins, and every human with an internet connection is a potential customer.
But what happens when you run out of humans?
That’s not a rhetorical question. According to Pew Research Center, 89% of Americans are active on the internet. Exclude Americans 50 and older, and that jumps to 97%. Almost a quarter of Americans say they are almost constantly online.
The idea that America’s internet addicts simply haven’t heard of Facebook or Netflix is just plain dumb. And the numbers bear that out.
Facebook’s daily active users in the U.S. and Canada have gone almost nowhere in the last year, increasing from 183 million in the second quarter of 2017 to 185 million in the second quarter of this year. Europe is equally bland, with growth from 271 million to 279 million in the last year. Collectively, these two regions added just 10 million new daily users — a mere 2.2%.
That’s what happens when you have so many users. Even 10 million more people simply don’t dramatically move the needle.
Netflix admittedly has done a bit better, showing domestic streaming subscriptions rose by double digits year-over-year in its latest report.
But the other problem both Facebook and Netflix have to deal with is much more sinister than simply tough comparisons — namely, tough expectations.
Who cares if the Netflix brand is synonymous with streaming, that it has won multiple Emmys for its original programming or that it has grown its revenue by 26% in the last year and its overall membership by about 30% in the last 12 months from 109 million to about 130 million customers?
That simply wasn’t good enough, either for Wall Street’s lofty expectations or against its own internal estimates announced just a few months ago.
Therese Poletti: Is Netflix stock falling down a mountain, or just tripping over a molehill?
The weight of expectations was equally crushing for Facebook’s stock. Consider that investors burned down Facebook for missing its daily active users target of 1.49 billion by about 20 million people.
For the record, that’s one out of every five people on the planet that Wall Street expected to be logged on every day. And shares lost one-fifth of their value because Zuckerberg & Co. didn’t deliver.
Read: How Facebook’s $120 billion loss ranks among the biggest one-day stock disasters
How long can investors really expect these growth icons to keep growing? Is it realistic to expect every human in the Western world to spend their waking hours streaming Netflix on a smart TV as they surf Facebook on a second screen?
Or, more likely, is there simply a fundamental misunderstanding of just how big these companies can realistically get before they run out of customers?
A simple focus on margins is not so simpleFor the record, I don’t have a Facebook account and never have. Frankly, it’s a cesspool of self-indulgence that nauseates me. And while you may consider me part of an insane minority, as an investor you should consider that there is a small but very real portion of the population that is not interested in spending ever-increasing time (and money) on this platform for the benefit of Zuckerberg and other Facebook shareholders.
Read: Want to delete Facebook? Read what happened to these people first
Products like Netflix and Facebook are not bulletproof, lifesaving utilities that must be a part of our lives at any cost. And that puts them in a bind if organic growth stalls and they need to focus on margins or financial engineering to “maximize shareholder value.”
Think back to 2011, when Netflix had a fairly reasonable idea: Prepare for the inevitable end of the DVD side of its business. But thanks to a series of corporate blunders, including some self-righteous self-justification from CEO Reed Hastings, Netflix drove away 800,000 subscribers in a quarter as a result.
More importantly to investors, shares crashed roughly 75% in three months.
Facebook has never had such a public and painful bloodletting, but instead has been torturing users for years with a thousand smaller wounds. Facebook loves to tweak how it serves content to users, most recently angering publishers by gutting referrals to news sites and a short-lived experiment where brands would get their posts relegated to a completely different tab.
But make no mistake: these efforts are driven by a business perspective of maximizing profit. And if you think Facebook was guilty of too much tinkering in the good old days when growth was great… well, you ain’t seen nothing yet.
In the absence of significant growth in general users and engagement, both Facebook and Netflix will have to figure out other ways to pay the piper.
And as past efforts like Qwikster show, there is no room for error.
This is not to say that Facebook and Netflix are doomed as companies, or even that they are bad buys for patient investors willing to ride out this volatility.
But the challenges posed by market saturation are very real, and Wall Street will be quick to punish both of these names if they fall short.
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