(This blog post was written on March 26, 2018 and included in our client newsletter for Q1 2018) 

As many of our clients have undoubtedly noticed, Facebook is currently in a bit of a slump. Its shares are down around 20% from its peak at the beginning of February, and seems to be hit with bad news almost daily. Below is a sample I collected over the weekend:




The Facebook scandal undoubtedly has deep implications for many important social issues regarding individual privacy and elections influencing among others. However, we are a financial services firm whose mandate is to make money for our clients. As such, I will focus this blog post solely on Facebook the stock, and any discussion of the societal impacts will be limited only to the impact on the share price.

As I have previously written in https://baskinwealth.com/know-when-to-hold-know-when-to-fold-the-case-of-stella-jones/, the proper response to a fairly significant price drop like this depends on the reason the stock fell and whether Facebook is a permanently less attractive business than before.

Why we own Facebook

Financially, Facebook generates virtually all of its revenue from selling ads irrespective of all the things Facebook allows you to do. Companies choose Facebook as an advertising medium because it enables them to sell to Facebook’s mind-boggling user base of ~2 billion users across its various sites including Facebook, Messenger, WhatsApp, and Instagram. The users use Facebook’s various services to connect with one another, organize events, share pictures, etc. and Facebook would collect all information and use the data to help advertisers target their ads. In a nutshell, this is Facebook’s business model.

There are two very attractive aspects of Facebook’s business model. The first is that Facebook’s content (i.e. what keeps people from coming back) is provided by its users for free. People voluntarily spend hours on Facebook and Instagram to consume content that Facebook largely does not pay for. Contrast this with a company like Netflix who has to spend billions annually on content for people to continue their subscriptions. Second, Facebook’s massive user base makes it a place where advertisers want to be. The vast majority of companies spend tremendous amounts of money on sales and advertising to convince people to buy their products. Facebook does not need to do this, since it is your loss if you do not advertise on Facebook. The result of this is outstanding economics with Facebook averaging 50% operating margins.

Although Facebook’s main revenue-generating customer is advertisers, Facebook’s primary goal is ensuring that people continue to use Facebook since without users, there is nothing. This is why things like privacy scandals matter, irrespective of what users agreed in the terms and conditions regarding their data. If people get so upset about Facebook that they stop using it, there goes Facebook’s entire business model. With social networks existing on the connections of its user base, there is a tipping point at which a social network implodes if enough people stop using it, since a smaller user count diminishes the usefulness of the site for the remaining users. History is littered with the corpses of former social networks including Myspace and Friendster. But to be fair, neither Myspace nor Friendster ever grew to anything close to the size of Facebook today. Add in the rest of Facebook’s other social-platforms like Instagram and WhatsApp, and Facebook is far more insulated than any other social network in history.

Cambridge Analytica

To summarize what has been going on with Facebook lately, it was discovered that Facebook allowed a personality-test app to collect data on 270,000 Facebook users and around 50 million of their friends. Facebook has since shut down the service that allowed friend data to be retrieved by 3rd parties. The person who created the app sold the data, in violation of his agreement with Facebook, to a firm called Cambridge Analytica. Cambridge is a political consulting firm that uses data to help create campaigns and the Trump Campaign was a client of Cambridge. Facebook sought assurances from Cambridge that the data was deleted, but Cambridge lied and used the data anyways. Regardless of whose fault it was, Facebook allowed this to happen.

In 2011 Facebook settled with the FTC (Federal Trade Commission) on allegations that Facebook told its users that their information could be kept private but shared it to the public anyways. The consent order contains a provision that Facebook could be fined for up to $40,000 per violation which would theoretically put Facebook out of business if Facebook was fined $40,000 for each of the 50 million users.

So what can go wrong?

It is in no one’s interest that Facebook is put out of business because of the billions of people who use Facebook to communicating with each other in addition to the millions of small businesses that rely on Facebook to spread information about their business, so you can rest assured that Facebook is not going to be fined $2 trillion. Facebook currently has around $40b in cash, and should pull in another $20b this year, so any one-time fine is unlikely to put a material dent in the long-term financial health of the company. If we look at the largest corporate fines in the history of the US, virtually all of them were related to some direct malicious intent or fraud such as misrepresenting mortgage-backed securities or hiding safety information on drugs. In this case, Facebook so far appeared merely to be negligent in how it approved the flow of user data and even a Google-EU-level fine of $2.8b is a drop in the bucket for Facebook. To be sure, there is going to be additional compliance costs that Facebook will have to incur, but Facebook still has the benefit of the tremendous

Numerous commentators have made the observation that any regulations regarding stricter controls of sharing user data is more likely to reinforce Facebook (and Google’s) dominance more than anything else since it will deny networks from placing ads on 3rd party websites. Since most of Facebook and Google’s ads take place on their own sites, the lost dollars from the 3rd party sites will end up flowing to Facebook and Google.

The far bigger risk in my view is whether people become so fed up with Facebook that they simply stop using it. This is something we will be tracking and following closely in the quarters to come, but for the most part, we think most people accept that they are giving up some level of privacy when using any online services. As long as people continue to spend time and share on Facebook and Instagram, advertisers will continue to sell with Facebook and the business model remains intact. For now, we think that the valuation for Facebook is more than compensating for any regulatory or user risks, and believe the shares to be very good value at 21x forward earnings.

Ernest Wong