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Facebook crisis: Head fake or tipping point?

Assif Shameen
Assif Shameen4/2/2018 08:30 AM GMT+08  • 11 min read
Facebook crisis: Head fake or tipping point?
SINGAPORE (Apr 2): In software as on the internet, the oldest battles have been between the “walled garden” and “open platform” approach. Apple’s late co-founder Steve Jobs, for example, was a big proponent of the “walled garden”. Eventually
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SINGAPORE (Apr 2): In software as on the internet, the oldest battles have been between the “walled garden” and “open platform” approach. Apple’s late co-founder Steve Jobs, for example, was a big proponent of the “walled garden”. Eventually, however, Microsoft ran away with the PC business because it was willing to license its operating software whereas Apple was not.

In the social network space, pioneer Myspace was a walled garden that allowed Facebook to become a truly global network when it rolled out an open ecosystem approach. To outdo Myspace, Facebook in 2007 allowed outside developers to access data such as friend lists, locations, photos and all sorts of other information without letting users know. Although Facebook began putting up walls again two years ago, deciding that a walled garden was better because it wanted to use all the data itself, its open approach came back to haunt it two weeks ago as stories emerged on how its data had been abused.

Facebook stock is now down 24% since Feb 1, wiping out nearly US$150 billion ($196.3 billion) in market value. Is the Facebook crisis a “headline risk” that might just dominate the news cycle for a few weeks before something else takes over or is it a permanent game changer? Is it a head fake or a tipping point for Big Tech?

On March 27, the tech-heavy Nasdaq plunged 211 points, or 2.93% — nearly 7.7% below its all-time record high barely 15 days ago — as regulatory scrutiny drove down shares of Facebook, Twitter and Tesla. Another big loser was market darling chipmaker Nvidia, which dropped 8% after announcing it would temporarily suspend its autonomous vehicle efforts. The main Wall Street barometer, the Standard & Poor’s 500 index, fell 45.9 points, or 1.73%. That bigger gauge is now 9.2% down from its own all-time record of late January. The selloff came in the wake of a huge rebound, particularly pronounced in tech stocks, a day earlier, as the market seemed to shake off the spectre of a looming trade war.

Ironically, the high-growth tech stocks are rolling over just as Wall Street’s overall fundamentals were starting to shine again after February’s correction. Boosted by President Donald Trump’s tax reforms, US corporate earnings are now expected to grow 19% this year and the broader US markets gauge is now trading at 16.7 times this year’s earnings and just over 15 times next year’s, or at the midpoint of its historical range. Even though the market is pricing in at least two more 25 basis point rate hikes this year, 10-year bond yields are 2.77%, the lowest they have been, with unemployment — currently 4.1% — still falling as public confidence in the US economy and the market last week reached the highest levels in more than a decade.

Regulating tech

What is going on? For more than 15 months until end-January, tech seemed immune from any kind of headline risks. These days, it seems to catch cold just as soon as anyone sneezes in Washington. “Headlines matter,” says Ben Schachter, internet analyst for Macquarie Securities in New York. And in the case of Facebook, one of the most loved tech stocks in the world, Schachter concedes that “headlines matter very much” because its entire business model of collecting data and then selling it, or using it to sell ads, has for the first time come under close scrutiny.

Facebook is not alone. Google’s owner Alphabet, Twitter, Snap and others are under the microscope as well. Twitter stock fell 12% on March 27 after short-seller Andrew Left of Citron Research said it was “most vulnerable” to regulations, as much as, if not more than, even Facebook. Twitter, Left explained, expects to generate more than US$400 million in revenues by selling user data this year. Tech stocks now trade at the same earnings multiples as the broader gauge S&P 500 despite their much higher growth.

Facebook, of course, got entangled in a data scamming crisis over its handling of personal data after acknowledging that it had allowed London-based political research and elections operations firm Cambridge Analytica to gain access to personal data of more than 50 million users in the US alone. Clearly, Facebook was aware but chose not to make it public until a whistleblower leaked it.

The social network giant’s business model is simple: to create the world’s most profitable data and advertising company, by keeping as many people on its platform for as long as possible. It has 2.2 billion users for its own platform, its WhatsApp Messenger has one billion users and its Instagram platform has 800 million users. Google and Facebook last year accounted for 59% of total digital advertising. Google has a 39% share and Facebook 20% of the digital ad pie. As the pie grows, however, their share is slowly shrinking, with Amazon.com, Twitter and Snap growing their share at the leaders’ expense. Amazon, already the No 3 in digital ads in the US, is forecast to grow its ad revenues by 76% this year, albeit from a smaller base.

Extracting your data is not illegal. These days, everyone collects as much data as possible, mines it, slices and dices it, and then sells it for a profit. Google, Amazon, Snap and Twitter are just some of the companies that live off your data. The trouble is that Facebook just went too far. For example, it was collecting information from users of its two messaging platforms — Facebook Messenger and WhatsApp — who had Android phones about who they were calling and when and exactly what they were texting. Facebook told Android phone owners that it would save all their text messages or phone logs in the cloud.

Data collection was disguised as a free service. Actually, it was collecting the data to sell it. And it was not only your data that it was after, it wanted your friend’s data and that of your friend’s friends as well. Users of Facebook on iPhones have no reason to worry because Apple’s “walled garden” does not allow user data to be passed on or sold for commercial use or even stored on your phone.

Facing tighter scrutiny

Are regulators setting their fangs in what was the biggest of the FAANGs (Facebook, Apple, Amazon, Netflix and Google)? The Federal Trade Commission in Washington is investigating Facebook’s privacy practices and Attorney Generals in 37 of the 50 US states are looking into Facebook’s practices, as are governments around the world, including the European Union, the UK, Australia and Latin America.

A big concern for Facebook is that regulation requires it to ask users to opt in to surrender their privacy rather than going through the arduous process of opting out as is the case right now. If Facebook were to ask each of its two billion members whether they would like to surrender their privacy, it would make capturing, retaining and selling the data much more difficult.

“I don’t see the US government making the regulatory environment particularly more challenging,” says Ian Bremmer, president of Eurasia, a New York-based political risk consultancy. “Whatever the popular outcry, President Trump and a Republican-led Congress are focused on regulatory rollback, and that’s the more powerful driver for Facebook’s profitability.”

Bremmer concedes, however, that a much tighter data environment from Europe is set to change the way Facebook handles what it collects and how it sells it. The EU’s General Data Protection Regulation will go into effect in May and could affect ad targeting and dent growth in ad pricing. “Given that Facebook’s two billion-plus users are tightly interconnected, a change in Europe will affect how it handles business for those users connected to those in Europe as well.”

Could Facebook users suddenly “unfriend” it and run, leaving it with no ads? In theory, they could. Yet, the #DeleteFacebook movement is unlikely to have the traction it needs to undo a huge global social network. If Facebook users leave, where will they go? Snapchat? Twitter? Search on Google all day? Or just shop around on Amazon.com?

All of the other internet and, more specifically, social media players have been nipping at Facebook’s heels for years, albeit unsuccessfully. And while they might have a slightly better chance now, they are unlikely to remove the social media behemoth from its perch anytime soon. After all, even marginal print, TV and other media players continue to draw advertisers years after their audiences deserted them. So, it is unlikely that Facebook will see advertisers pull the plug in haste. Daniel Ives, a tech analyst at GBH Insights, argues in a recent report that Facebook’s “advertising fortress is not at risk” despite the spectre of increasing regulation.

Like banks or cigarettes

Yet, Facebook stock is likely to remain under pressure for several months, if not years. The movie of regulation has been played out before. At the first whiff of regulation in any industry, investors’ initial reaction is to rush to exit and sell. Still, as things start to settle down, it becomes clearer that regulations do not necessarily spell the end of the world.

Analysts say what is happening to Facebook should be seen in the light of what transpired with “too-big-to-fail banks” a decade ago or with big tobacco companies 25 years ago. When they were first shunned by investors, banks and tobacco stocks became relatively cheap and, as they continued to grow earnings, albeit at a slower pace than before, investors were forced to take another look. Indeed, many analysts argue that regulations are likely to help Facebook, not hurt it.

At some point, regulation on big tech will go from being a negative to being a major barrier to entry because only the biggest and the best will have the resources for the mounting compliance costs, alongside growing costs of R&D and innovation. Younger tech start-ups will find regulations too onerous and will think twice about ever growing to challenge a giant such as Facebook.

Although a few analysts have warned that, in a worst-case scenario, there could be a temporary pullback in advertising, even they concede it is unlikely that the social media giant will see its profit picture change dramatically anytime soon. Repercussions of any reputational damage will only play out over time.

While headline risks will weigh on the stock for several quarters, at just 20 times 12 months’ forward earnings or 15.5 times next year’s, Facebook is the cheapest large-cap internet stock now, sitting on US$41 billion cash and generating more than US$12 billion annually in free cash flow, says Brent Thill, analyst for Jefferies & Co in San Francisco. Facebook has a lot of money to buy out promising startups or potentially lucrative revenue streams or, indeed if need be, buy back its own stocks and pay dividends.

Mark Mahaney, internet analyst at RBC Capital in San Francisco and one of the biggest bulls on the stock, concedes that Facebook and its ilk are, for the first time, staring at onerous regulations. Still, he argues that the company has strong and growing revenue streams, which at the worst would only slow a bit but are more likely to continue growing at a pace far faster than many of its detractors imagine.

Internet brands have taken big hits and recovered just as quickly. Netflix suffered when it raised prices some years ago; eBay suffered when its security was breached; and Uber’s brand was tarnished in the US a year ago but business has stabilised and, indeed, is growing again. Mahaney has a 12-month price target of US$250 on Facebook’s stock, or 62% upside. Facebook, which has the world’s largest database of personal photos, is set to unveil its own smart-home devices later this year to challenge Amazon’s Echo. Unlike Amazon, which uses the cloud for Echo, Facebook is betting that privacy will prevail, so it will save data only on the device rather than in the cloud, from where it could be hacked or sold. It has taken a crisis for CEO Mark Zuckerberg to be convinced that the walled garden approach works better for a business built mostly on trust.

Assif Shameen is a technology writer based in North America

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