Image Source: Spencer E Holtaway
By Kris Rosemann
The firestorm among Internet equities didn’t stop with LinkedIn’s (LNKD) fourth-quarter catastrophe, “Three Blow Ups after the Close February 4.” Twitter (TWTR), Zynga (ZNGA), Zillow (Z, ZG), and Pandora (P) also remain challenged.
We’ve never liked Twitter, and we don’t think we ever will, “Twitter’s Valuation Enigma (Feb 2015)” The company’s investment opportunity-to-news ratio is practically nil, in our view, but that won’t stop investors from talking about it, and we do so, if only to explain why the firm is but a lotto ticket, not likely to pay off. Twitter recently turned free cash flow positive in 2015, but most of the cash flow boost came from non-cash stock-based compensation, a tangible expense and one that is driving the company’s share count materially higher, 10% on a year-over-year basis, effectively diluting early shareholders along the way.
Twitter hasn’t yet turned a profit on a GAAP basis (in fact, it lost more than a half billion dollars in 2015), and the social media entity is having difficulty getting its platform to truly catch on. The firm continues to lag considerably behind Facebook (FB) in regards to monthly active users (MAU) and is struggling to drive user engagement. It recently announced yet another change to its core platform that is designed to load the most popular and relevant items to the front of its users attention, and CEO Jack Dorsey has said that more product changes are coming.
Monthly average user trends have not been overly impressive for the embattled social media platform. In fact, in the fourth quarter of 2015, the firm reported MAUs excluding those who receive notifications via text messages had fallen on a sequential basis from 307 million to 305 million. We’re having a bit of trouble envisioning where significant user growth will come from. From our perspective, Twitter is not facilitating connections seamlessly, meaning it is difficult for certain demographics to find the accounts of friends, colleagues and acquaintances on the platform, unlike Facebook, which does this very well. Businesses are also balking at paying $3+ for each new follower, with many just ‘unfollowing’ shortly after, using it as an opportunity to “reverse-market.”
The company still has $3.5 billion in cash and cash equivalents to throw at all of its problems, but the company has seen a mass exodus of top-level talent at the firm, causing additional turmoil within the developer ranks. Those who remain are confident that they will be able to effectively navigate the firm through troubled waters and lead it to its true potential as an up-to-the-minute social updating platform. Focus areas for 2016 include the refinement of the core service, live streaming video, and an emphasis on creators, influencers and developers. Even if these initiatives are successful, however, turning a profit on a GAAP basis cannot be guaranteed.
Now let’s go from bad to worse.
Social game developer Zynga experienced a similar problem as Twitter in the fourth quarter of 2015. Despite breaking even on a non-GAAP earnings per share basis, the firm saw an overall decline in its game audience, and shares were punished, now trading at less than $2 each. Even though the fourth quarter had been a positive point for cash flow, the company remains free cash flow negative on a full-year basis, and material cash burns have taken place in recent years. Now a “penny stock,” the odds of a turnaround are remote.
The continued weakness in Zynga’s monthly active and unique users was partially offset in the quarter by increased ad revenue per user and ad monetization, but we remain skeptical of the firm’s business model, perhaps even more so than Twitter’s. Zynga’s business is dependent on selling virtual goods, and its performance is directly tied to a favorable relationship with Facebook. We’ve never been fond of a firm that burns cash at the rate Zynga does. It has $1 billion in cash left on the books to turn the tide, which cannot be guaranteed.
Shares of internet and mobile real estate and home-related information marketplace operator Zillow Group have also been pummeled as of late. Though it did not experience the same poor user trends in 2015 as Twitter and Zynga did, significant top-line growth in 2015 was counteracted by falling margins. The company attributes its GAAP net loss of $0.88 per share in the year to significant investments in its people, data acquisition, and brand acquisition, and these factors are expected to continue through 2016. The firm will also take on additional costs related to its defense against a lawsuit filed against Zillow by News Corp (NWSA), which continue to add up.
Zillow’s brands saw their average monthly unique users jump more than 60% in the fourth quarter of 2015 on a year-over-year basis, and according to comScore, its brands now boast ~70% market share of all mobile exclusive visitors to the “real estate” category. Though we like the pace of the firm’s top line growth, which it expects to continue in the coming quarters, first-quarter 2016 revenue guidance came in below that of consensus estimates, raising concerns about further disappointments in the back half of the year. For a company that is losing money and burning through free cash flow, negative $32.3 billion in 2015, that’s enough to make investors skittish.
Pandora’s shares have also seen better days, now having fallen into the single digits from nearly $40 each at the beginning of 2014. The Internet radio business may be as tough as it gets, and while the company may get “bailed out” should it successfully sell itself, the rough times will continue for the foreseeable future, in our view. Management remains optimistic, but the company has yet to prove to us that it is a sustainably profitable entity in light of its cyclical advertising revenue and cost structure. In 2016, for example, Pandora is targeting an adjusted EBITDA loss in the range of -$60 to -$80 million, not a promising forecast, especially for one that will exclude stock-based compensation expense of more than $160 million. The company has ~$370 million in cash, but it has layered on more than $230 million in long-term debt. Its fundamental outlook is bleak.
In today’s tumultuous environment, free cash flow generation will take precedent over top-line growth, and many in the Internet space are facing that dire reality at the moment. Savvy investors won’t be caught with these falling knives.