On Wednesday, analysts at Morgan Stanley downgraded the stock of professional-social networking website LinkedIn (NYSE:LNKD.DL) from overweight to equalweight (buy to hold). The downgrade cost LinkedIn shares nearly 6% of their market cap, in a stock market that was trading mostly flat for the day.
Just how bad is this news for LinkedIn investors? Here are three things you need to know to decide.
Thing No. 1: This downgrade is big
A one-notch downgrade from overweight to equalweight may not sound like a very big deal, but reading deep into Morgan Stanley's analysis, it becomes clear that this is a big deal. Alongside the downgrade per se, Morgan Stanley cut its price target on LinkedIn from $190 to just $125 per share -- a 34% price cut.
Morgan Stanley explained the move by saying it's no longer "bullish" on LinkedIn's ability to grow. As detailed in a write-up on StreetInsider.com, "multiple years of assumed strong Talent Solutions (TS) growth" were key to Morgan's bull thesis on the company. But the company's fourth-quarter earnings report, combined with poor "2016 guidance [and] decelerating large enterprise customer growth" all have Morgan feeling less sanguine about LinkedIn's prospects today.
Thing No. 2: Costs are rising
Another factor that played a big part in Morgan Stanley's reversal of opinion on LinkedIn is the fact that LinkedIn is having to spend a lot of cash to grow its business. Data from S&P Global Market Intelligence show that in each of the past two years, LinkedIn invested more than a half-billion dollars in capital spending. Yet in 2014, that spending helped to push LinkedIn into a net loss for the year -- and in 2015 that loss only got bigger.
Thing No. 3: The future's uncertain
The combination of higher spending to grow the business in new ways, with "increased execution uncertainty" over whether that growth will pan out, and worries over the company's own "lower long-term cash flow forecasts," are all combining to convince Morgan Stanley to ratchet back its expectations. Today, Morgan Stanley finds itself compelled to plan for the possibility that LinkedIn will grow only into "a materially smaller platform than we previously thought."
In fact, plotting out a range of possible futures for LinkedIn, while Morgan Stanley sees a possibility that LinkedIn might "reaccelerate TS growth" (i.e., the job recruitment business) and drive the stock's value up to $200 per share, the analyst also doesn't discount the risk that LinkedIn might "mis-execute" some of its growth initiatives, see growth "decelerate" as a result -- and fall to as low as $60 per share in value.
That's about half what the shares are selling for today.
And here's one more thing to consider...
That all probably sounds pretty bad to you. Now here's where it gets worse: Even if Morgan Stanley is wrong about things getting materially worse for LinkedIn in future years, the stock doesn't look particularly attractive even if things continue going as planned for LinkedIn.
Forget the fact that the stock is "unprofitable" from a GAAP perspective. Instead, give LinkedIn the benefit of the doubt, and value it on the $300 million in positive free cash flow it produced last year. At $14.4 billion in market cap, this values LinkedIn at 48 times free cash flow.
That's an awful lot to pay for the company, even if other analysts are right (who, according to S&P Global predict LinkedIn will grow just fine -- 25% annually over the next five years). On the other hand, if Morgan Stanley is right, and LinkedIn's growth is going to "decelerate," then the stock is even more expensive than it looks.
Investors, selling the stock today, are right to be worried.
Fool contributor Rich Smith does not own shares of, nor is he short, any company named above. You can find him on Motley Fool CAPS, publicly pontificating under the handle TMFDitty, where he's currently ranked No. 278 out of more than 75,000 rated members.
Rich's reservation notwithstanding, The Motley Fool still both owns shares of and recommends LinkedIn. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.