The Ratings Game: Facebook Stock Falls As Worry Of Negative Network Effects Prompts Downgrade

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Shares of Facebook Inc. fell toward a third straight loss Monday, after Needham & Co. analyst Laura Martin downgraded the social-media giant, citing concerns that “negative network effects” could speed up the destruction of value for investors.

Martin cut her rating on the stock to hold, after being at buy for at least the past three years, citing worries that regulatory and headline risks are growing given all the recent senior management defections. She removed her $170 price target, which the stock closed above as recently at Thursday.

The stock FB, -3.32% slumped 3.6% in afternoon trade, and has lost 7.7% since closing at a 6 1/2-month high of $173.37 on March 13.

Martin said the three risks to Facebook’s stock are:

The negative financial impact of the company’s “strategic pivot” toward privacy and encrypted messages.

Growing risks of regulation.

The “horrific images” that have been uploaded to Facebook, such the live-streaming of the mass shooting in New Zealand last week, which are technologically difficult to completely block and could hurt the company’s brand.

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Martin said she is concerned that those risks will hurt Facebook’s valuation more than investors currently believe, given the “negative flywheel” created by “network effects.” She describes networks effects as being based on the notion that the more people who believe something, the more likely the next person will believe it as sell.

While networks effects can have both positive and negative effects on value, all the recent senior management departures suggests the effects are tilting toward the negative. The departures include Chief Product Officer Chris Cox, WhatsApp co-founder Jan Koum, Instagram co-founders Kevin Systrom and Mike Krieger, Chief Security Officer Alex Stamos and Chief Communications Officer Rachel Whetstone.

“A ‘negative network effect’ suggests that departures will continue, and since we believe that people are a key competitive advantage of FAANG companies, this implies accelerating value destruction until senior executive turnover ends,” Martin wrote in a note to clients. “We prefer to move to the sidelines until we see senior employee turnover stabilize.”

FAANG companies refers to shares of technology giants Facebook, Amazon.com Inc. AMZN, +1.74% Apple Inc. AAPL, +1.02% Neflix Inc. NFLX, +0.55% and Google-parent Alphabet Inc. GOOGL, -0.15%  

Martin said she believes Facebook is capable of keeping the network effect from swinging to negative, but winning that fight becomes less likely if it must contend with regulatory and headline risk distractions on top of management turnover.

Facebook’s stock has run up 11.4% over the past three months but has shed 13.5% over the past 12 months, the only FAANG stock to have lost ground over the past year. In comparison, the S&P 500 index SPX, +0.37%   has gained 11.1% the past three months and has tacked on 2.8% the past year.