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It's not the earnings, it's 'the metrics' that really matter

'Bots' are usually behind the most extreme technology stock swings, because they're reading past the financial news and zeroing in on a company's market penetration. Can investors keep up?

  • By Tiernan Ray,
  • Barron's
  • – 02/08/2014
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Tech investors of late seem more than ever caught in something I'll call "The Metrics," which, like the sci-fi film of a similar-sounding name, may be a world run mostly by machines.

We know that algorithmic trading has shaped market ups and downs in recent years, and it's hard not to feel the invisible hand of the bots when glancing through the extreme reaction of some stocks during this earnings season.

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The Metrics are those details of an earnings announcement that defy traditional headline news, the sort of stuff buried a paragraph or two down in the press release, below the revenue and earnings numbers, that can be scanned by non-human eyes before it can be fully absorbed by the human mind. The prime example was Twitter's (TWTR) fourth-quarter earnings report last Wednesday. The social networker beat Wall Street's expectations and projected revenue for this year higher as well.

What torpedoed the shares, almost immediately, was something else, which was the tally of users who are active on the service during any given month. That number, at 241 million, was too low compared with expectations on the Street that ranged from about 243 million to more than 250 million. The stock sold off 24% the next day.

There were other equally intriguing examples last week. LinkedIn (LNKD), which runs a social network for professionals to connect with one another, and also sells software used by corporate human resources departments, beat Street expectations for its fourth quarter on Thursday evening, but it forecast disappointing full-year revenue. Beneath the numbers, The Metrics were not entirely satisfying: Unique visitors to the company's site declined to 139.2 million from 142.3 million a quarter earlier, and 142.6 million the quarter before that. And page views were down 9% from the prior quarter. It was the second quarterly slide in such metrics.

Moreover, the number of members rose by only 31%, noted William Bird of FBR Capital Markets, "suggesting some deterioration in engagement."

The Metrics — numbers such as user growth and engagement, whether they're rising or falling, speeding up or slowing down, the things that hobbled Twitter and LinkedIn — have become equivalent to, if not more important than, the results themselves. Why is that? Two reasons. First, much of the value of the companies is now fully reflected for the moment in the share price, meaning the market's got to find a justification beyond the quarter's results to keep buying.

Even after its fall, Twitter, at a recent price of $54.35, trades at 247 times the 22 cents it might earn next year, if it actually does become profitable — and not including the huge cost of its stock-based compensation.

Slightly less demanding, LinkedIn, at $209.59, fetches about 79 times the $2.66 per share in net profit it may make next year, again, not including noncash compensation. One approach to LinkedIn's valuation, offered by Rob Peck of SunTrust Robinson Humphrey, is 40 times projected operating profit of $753 million next year.

Now, there's no inherent reason why a dollar of LinkedIn profit is worth nearly six times as much as every $1 in profit from, say, Apple. But The Metrics reassure one that there is still a glide path to world dominance, given that present value stands on shaky ground.

Second: On a much deeper level — unlike, say, diapers, where demand is strictly a function of the likely needs of the population, income levels and such — technology products, and especially networks such as LinkedIn, are supposed to create their own demand.

For those interested in a more technical explanation, Bob Metcalfe, the professor of electrical and computer engineering who invented the Ethernet networking standard, offers one. Metcalfe, who has seen his invention explode during the 40 years since he introduced it, explained in the December issue of the IEEE Computer magazine how networks become more and more valuable as more and more people join them. Hence, if The Metrics slow, it is not just bad for business, it is a violation of one of the totems of technology.

Measures such as user growth are supposed to indicate whether management has found the right formula to continually entice new users into the fold. That's why Twitter sinks when investors think its growth may be capped. Ditto for LinkedIn.

The only way the premium on such stocks is justified is on the premise that over time, with a commanding lead in a marketplace, a company's business becomes self-sustaining to the point that it's nearly all profit.

That reality, though, keeps getting pushed out. Most analysts on Friday were cutting their estimates for LinkedIn's profit this year, as the company spends more to lure more users.

Hillside Partners analyst Rory Maher doesn't formally rate LinkedIn, but considers it the Street equivalent of a Hold. "We believe investors have likely been assuming more growth with limited investment over the long-term," he wrote, explaining the potential disappointment with that spending.

The same logic works wonders when The Metrics deliver, as they did for Facebook (FB) two weeks ago. The same night Twitter was plunging, local advertising network Yelp (YELP) rose sharply even though it accomplished no more than Twitter, namely beating expectations. Yelp's stock rose 19% the day after the report.

Even though analysts were cutting Yelp's profit estimates as the shares rose, to account for higher spending, they noted with approval some improving metrics. The number of local businesses listed on the service and deemed "active" rose by 69%, which was faster than the 61% in the prior quarter.

The same ebullience reigned three weeks ago when the number of new subscribers for Netflix (NFLX) turned out better than expected. Wild valuation? At 60 times next year's earnings, you betcha. But world dominance awaits, as long as The Metrics keeps rising.

As long as The Metrics can whipsaw a stock, investors will keep rolling the dice each quarter to see which way things shake out for pricey names, including Facebook, Twitter, LinkedIn, Yelp, and Amazon.com (AMZN). What we have here is not an investment, but a gamble. That's not a moral judgment, just a warning. One has to remember that the machines are reading the press releases, too, and they can respond to The Metrics a lot faster than you or I.

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