by Charles Roth, Thornburg Investment Management
Facebook’s margins could ebb this year, but they remain at elevated levels and profits could still grow meaningfully.
Investors applauded the performance of Facebook Chief Executive Mark Zuckerberg over two days of fielding questions on Capitol Hill, pumping up the company’s share price 5.3%. The clearly prepared, apologetic and ever-earnest Zuckerberg danced through the grilling without his feet ever getting burned.
“Zuckerberg committed to very little and was largely able to remain cool and avoid arguments as senators and house members grandstanded ahead of their 2018 re-election campaigns,” says Thornburg Equity Analyst Greg Mazares . “Most showed a lack of understanding around what Facebook is, while those who did understand the issues better failed to ask many of the harder questions with limited time allotted for follow-ups.”
Asked, for example, how Facebook makes money if it doesn’t charge users, Zuckerberg hesitated for a moment, perhaps thinking it was a trick question, before answering: “Senator, we run ads.” He then grinned, albeit modestly.
Beyond the theatrics, investors should still be revising higher forecast costs on several fronts. Zuckerberg confirmed that Facebook will comply with the European Union’s General Data Protection Regulation (GDPR), which, as we discussed in this recent post, aims to give E.U. citizens greater control over the use and warehousing of their data. It’s still likely to be slapped with higher overseas taxes and potential fines for illicit handling of user data. It’s also facing higher expenditures on “self-policing,” vowing to deploy a total of 20,000 content cops by the end of 2018 and to employ more artificial intelligence (AI) to contend with the massive amounts of content added to its platform daily. And there’s also the hit to its usage metrics from tweaks to its algorithms aimed at raising the quality of user engagement, which could potentially undercut the quantity of it.
But the key concerns involve the degree to which new regulations around privacy and data usage affect pricing for targeted advertising, and the possible declines in subscriber growth, including users who deactivate their accounts as a result of the negative headlines regarding Russian meddling in the 2016 election and the mishandling of user data by Cambridge Analytica.
Mazares points out that we won’t have solid reads about these impacts before second- and third-quarter earnings reports this summer and fall. But in terms of guidance, Zuckerberg did say Facebook hasn’t seen many users deactivate their accounts, and added that user engagement hasn’t declined noticeably since the Cambridge Analytica revelations. He also noted that audits of third-party data aggregators and ad-targeting measurement firms that had access to Facebook user data will be expensive and will still take months to complete.
Ironically, Facebook might ultimately benefit from its recent travails with user data scraping, as it now raises the “walled gardens” around its users’ privacy. That will effectively make it harder for third-parties to access Facebook’s user data and help advertisers assess the effectiveness of Facebook’s ad-targeting. Advertisers may consider switching or shifting more of their ad budgets to Alphabet, which, like Facebook, has tremendous amounts of data around users of its services. But as Facebook and Google together garner roughly 90% of the digital advertising market, advertisers don’t have many options.
Some lawmakers recognized that regulating Facebook may only entrench it, as it has the resources to cover heavier compliance costs, which upstarts would be hard-pressed to meet. But lawmakers on the both sides of the aisle were also hoping to “do something.” As Mazares continued in a note on the hearings:
At a high level, the Democrats are still steaming over the 2016 election and are calling for regulation being passed by Congress, as they don't trust corporate interests to self-regulate. The Republicans are generally against further regulation, though they remember how Facebook was used to help elect President Obama and a few left the door open to voting in favor of regulation if Facebook fails to take adequate steps from here.
In particular, John Kennedy from Louisiana admonished Zuckerberg, saying, "Your terms of service agreement sucks." The senator pointed out that very few users have likely read a document that spans hundreds of pages of legalese, and asked for a much simpler, plain-English statement that lays out to users how their data are used. The other lines of questioning were around competition—is a Facebook a monopoly? Its business model—is Facebook a technology or media company, curating and in some cases creating content? And the most popular Republican complaint: does Facebook exhibit a liberal bias around what content is shown and censored on the platform via the algorithm and the content monitors Facebook is hiring.
Facebook has noted they are open to further regulation being put in place on the internet industry, which is a mature industry without mature regulations. However, beyond explicit support for the Honest Ads Act around political advertising disclosure, is has not committed to support any other specific forms of regulation. One interesting exchange noted that historically regulation has helped entrench dominant companies within their industries, and one of the concerns was that whatever Facebook might support would be regulation that did entrench its competitive position without impacting their business.
None of the issues raised by Republicans seemed to have widespread or fervent backing for regulation and it is my view that widespread regulation that may impact its business model within the US is unlikely in the near term, at least while we have a Republican-controlled Congress and White House. However, these hearings likely also served as a loud and clear warning that Facebook needs to take real steps to improve its privacy and data collection policies (rather than apologizing and then taking no action, as in the past). If it doesn’t, the political will might be there to ultimately regulate the platform. While difficult to understand how seriously they would consider sweeping regulation, a number of Republicans, particularly in the House, used regulation as an implicit bargaining chip, intimating that they could change their tune if they view Facebook as perpetuating a liberal bias in their data censorship patterns.
Overall, I view material, near-term regulatory changes in the U.S. as unlikely.
Facebook has earned few friends in Washington, D.C. But for now, it appears the social media giant will continue to make plenty of money running ads based on users’ digital dossiers and even the “shadow profiles” of non-users that are assembled via the contacts and email inboxes of Facebook subscribers. Higher operating expenses look likely, but with current projected net margin of 46% and 45% in 2018 and 2019, respectively, Facebook looks set to remain highly profitable.
