Executive Summary
While Wall Street analysts have historically been bullish on FAANG stocks (Facebook, Amazon, Apple, Netflix, Google), this year has proven to be a challenging time for technology and internet businesses. In Facebook’s quarter 3 earnings call, CEO Mark Zuckerberg noted, “seeing the way people connect shifting from private messaging to stories…it will take some time for our business to catch up to our community growth.”
Facebook is in the midst of a complex environment, and strong downside risks include: slowing engagement, especially in the younger demographic and mature markets, peak margins, slowing ad growth and revenue deceleration, a slowdown of shifting advertising revenue from TV and traditional media, sharp competition for online and mobile ad revenue from other online advertising companies, share structure and Zuckerberg’s control, and worse than expected impact from regulatory changes. Undesirable reports of late, including disappointing numbers for revenue and daily active users, only adds to management’s prediction of costs rising 40 to 50 percent next year.
The aggregation theory fuels Facebook, a multi-trillion-dollar technology company that produces no original content yet manages to be the largest news source and distributor. Facebook relies on advertising to sustain a significant majority of revenue margins, but a highly competitive market illustrates an environment where Facebook is likely to see devastating knocks to sustainability if advertising alternatives continue to grow while the ad market does not.
Unless Facebook succeeds in gaining back the trust of users, drives stronger returns on investments, and monetizes platforms beyond advertising, I do not see Facebook as a strong performer in the near future. Unlike the majority of analysts, I believe it would be strategic to sell Facebook’s stock despite a truly unpredictable future and potential long-term opportunity.
Review of Recent History
Facebook has endured incredible stock volatility this year, with a stock price at the end of November 2018 at $139.24 – down 24 percent year to date and 9.9 percent since the last earnings report (Figure 1). While Facebook stock reached a high of $209.94 at the end of July, the price was short lived. The stock dropped roughly 20 percent and lost $20 billion in value just a few days later after warnings that revenue growth would take a hit. Even though the business experienced a modest rebound at the end of November, shares have tumbled almost 40 percent this year (Figure 2).
In the third quarter, costs and expenses jumped 52.6 percent year over year to $7.95 billion. Research & development expenses increased 29.5 percent to $2.66 billion, revealing a major focus on re-sparking growth and innovation. In the third quarter, Facebook’s daily active users only grew faintly to 1.49 billion, missing expectations of 1.5 billion. Although operating income of $5.78 billion grew 12.9 percent year over year, operating profit margins plunged to 42 percent from 50 percent as the giant increasingly invested in data security efforts (Figure 3).
Amazon and Microsoft each saw significantly higher market capitalization and rates of growth in 2018 than Facebook, which has a market cap of $400.448 billion (Figure 4, 5). Many analysts expect Facebook’s market capitalization growth to decline further in parallel with slowing user growth and continued negative public relations as seen at the end of November.
Almost all of Facebook’s revenue comes from digital advertising. Amazon, arguably the social media giant’s biggest competitor, is rapidly growing market share in the advertising business. At the end of the day, advertisers are more important than users when it comes to Facebook’s business model.
Current Market and Competitive Overview
Facebook is at risk of its reliance on ad revenue due to the period of immense growth it has historically maintained, which enabled advertising to reach 90% of Facebook’s revenue growth. Facebook revenue consists of mobile advertising, desktop advertising, and payment systems. Because Facebooks revenue is not diversified, threats and regulations could swiftly ruin the business model. Facebook has begun to transition to video as a major growth area, which does have the potential to balance the arrival of strong ad competitors if it is monetized quickly.
In the past year, Facebook’s user growth ad hit a wall (Figure 6, 7). The company has an opportunity to find growth in the mobile messaging sphere though its ownership of WhatsApp and Facebook Messenger. These channels are the preferred method for business-to-consumer communication in many cases, a channel of choice for closed social networking and content-sharing, and even general communication. In this realm, I think there is great opportunity to expand in the messaging arena with AI technology or sales in the application.
Although Facebook owns Instagram, it is one of the largest competitors that Facebook faces. Instagram is simpler, more private, and visual in nature. It attracts a younger audience, which had led to the acquisition of loyal users who prefer the platform over Facebook. This is worrisome as the youth audience will lead social media trends for future generations, and they manage a lot of the market share. A transition in Instagram leadership may be the right recipe for expanded monetization of the application.
Facebook was just added to the S&P 500 communications services sector as a market weight, which is more cyclical with lower yields than the telecommunications sector. Twitter, Alphabet, Tencent Holdings Limited are ranked by analysts as the most comparable and in competition with Facebook. Analysts believe that Facebook has competitive advantages in digital media and social media given the company’s large user bases and access to user information, but concerns about the priorities and recent scandal are rising.
In the spring, Facebook’s market cap was overtaken by Alibaba after Facebook founder and CEO Mark Zuckerberg publicly addressed reports of misused user data. As of June 2018, Alphabet's market capitalization was $793 billion. Facebook’s main competitors challenge the business’ advertising revenue opportunities; Amazon.com has made aggressive bets, with an expectation to collect $18.58 billion in digital advertising revenue in 2020 and the first-ranked retail platform’s current market cap is $823 billion. Overall, stakeholders have lost confidence in the potential for Facebook to rebound from a rocky year while users are turning away from the platform and the business environment for the technology industry looks increasingly bleak.
As previously mentioned, Amazon is a peripheral competitor that has entered the ad space and is competing for ad dollars with Google and Facebook (Figure 8). Amazon’s platform offers the best alternative for Facebook customers in scale, buying intent and conversion to sales. Until recently, most analysts did not predict Amazon would have this much of an impact when it entered the ad business. Amazon’s advertising model has led many businesses to defer ad spend from Facebook, which will be highly detrimental to their growth and revenue model sooner than investors thought.
It seems as though the behavior of leadership at Facebook and Instagram can have a major card in the vulnerability of Facebook while competitors sail smoothly; Zuckerberg’s role as CEO and chairman has led people to doubt the decisions and future of the company.
Overview of Strategic and Financial Options
Threat: Sector
The cyclical nature of media companies combined with the cooling of the technology and internet sector has driven the Dow and S&P 500 down and led to a bear market. Tech’s big five lost a combined $75 billion in market value at the beginning of November 2018; shares of Facebook stock have performed considerably worse than other reputable tech stocks, including Facebook, Amazon, Netflix, and Alphabet/Google.
Based on Facebook’s recent performance, advertisers, regulators, and consumers have major doubts to trust the company. Advertisers will be less likely to rely on the data they receive from the platform, and they will likely turn to other digital advertising options such as Amazon and Google. Consumer’s growing distrust will impede them from sharing financial and personal information with the platform, inhibiting Facebook’s attempts at direct sales and damaging engagement key performance indicators.
The internet itself is an opportunity and a threat to the success and operations of Facebook. Social networking dominates the amount of time users spend online; the rise of mobile and social networking has forced news media publishers to re-imagine and re-invent their business models. For a company like Facebook, the internet is the foundational platform for the company’s existence – yet, the internet is also the tool through which a competitor could be spring-boarded. There is a high degree of rivalry given absence of barriers to deter new competition from emerging in the market. This is a vital consideration because if the value and ROI of ad spend is inefficient, or a competitor takes over market share, Facebook revenue will not manage balance costs; there is already a trend of slowing growth and market share for Facebook. The potential for this to occur is frightening for stakeholders concerned about Facebook’s results and stock, and many believe the “tech bubble” is finally about to pop.
Threat: Regulation
Increased potential for regulation, surveillance, and law enforcement has grown from a climax of data misuse and mistrusting users this year. Facebook would need to outline clear investments in security to prevent future data breaches to regain the trust of users; however, continuous reports on improper fact checking and a failed focus on consumer security has turned investors and users away.
The very nature of Facebook’s model has challenged its success due to user distrust in data use, security and fake accounts. Most recently, internal emails in court filings reveal Facebook considered charging companies for continued access to user data several years ago, an action that opposes the company’s policy of not selling user information. Most people, including lawmakers, have found trouble in balancing freedom of speech with need for regulation of fake news (Figure 9). Internet regulations, such as the GDPR, may be the biggest threat to Facebook’s business. Government regulators will be of those unable to trust assurances from Facebook, increasing the likelihood of the implementation of burdensome regulations to bridle companies.
In the most recent reporting call with WhatsApp messaging, management expressed pride in the platform’s encryption without addressing the ways in which the mass-forwarding capabilities of the app contributed to the spread of fake news during Brazil’s recent election or in India. These actions certainly won’t endear Facebook to activists and governments concerned about these developments. The nature of the platform inhibits Facebook from every fully avoiding political involvement — the true test will be the method in which management chooses to improve business policies and security efforts on the matter, and what the outcome of meetings with lawmakers will look like.
In the midst of European lawmakers’ activation of GDPR privacy regulations during Facebook’s second quarter, the social media platform reported a loss of about 1 million European monthly active users and even more daily users. Although other technology and internet giants like Google say it is too early to tell how the new European regulation will affect business, most investors fear impending negative reports for Facebook in the next few months.
Regulatory risk is high given the exposure of Facebook and other companies like Google and Amazon. The risks in the industry relate to a high degree of rivalry given absence of barriers to throw off new competition from emerging, high and increasing capital needs, government regulations, and consumer pushback related to data management. Facebook has become a monopoly which leads to reasonable regulatory concern that the platform’s users should be treated fairly since in practice there is no real alternative – unfortunately similar to Microsoft’s position twenty years ago.
Threat: Management
One of the most recent topics of debate is the fear of the unyielding power that Mark Zuckerberg has as CEO and chairman of the board, which he does not intend to give up. Mark Zuckerberg faced a major public reckoning following the massive Facebook data breach as a cascade of crises caught up with the social media giant. Between Cambridge Analytica, Russian election interference, and the spread of disinformation, Facebook’s stakeholders have realized the extent of the business’ negative impact – and the turmoil within the greater technology and media industry.
Management’s comments on security lead investors and stakeholders to believe they do not have a handle on the operational complications the business currently faces. One solution that leadership has proposed to protect user privacy was tighter standards for custom audiences – this reaction came across disingenuous because of the magnitude of data Facebook will continue to collect on consumers, which uses to target ads without informed consent.
Facebook CEO Mark Zuckerberg’s recent aggressive style could be risky or payoff for the tumultuous business environment. Zuckerberg even faces increased pressure from investors to relinquish his position as chairman of the board. A proposal that would create an independent board chairman will be voted on at Facebook's next shareholder meeting, but without a strong bench in position to take over management, there seems to be little light at the end of the tunnel.
Instagram’s co-founders, Kevin Systrom and Mike Krieger, resigned in late September amid turmoil on how to further monetize the branch of Facebook’s business. Sheryl Sandberg reportedly informed and concealed the full extent of Russian involvement in the 2016 U.S. presidential election. Sandberg acknowledge she and Zuckerberg were “slow” to respond to initial ideas of potential election interference. Recent hacks may only be a symptom of a larger problem, which is the company is poorly managed. Facebook may need to establish a new executive team or show better profit margins before investors can be persuaded to reinvest.
Threat: The Greater Economy
Stocks pushed higher this month, but unpredictable trading from equities to bonds to oil to bitcoin has tempered expectations for the market in months to come. Ongoing tariff battles between the U.S. and China are expected to hurt global economic growth, interest rates are falling, and the bond market believes an economic slowdown is coming. A rise in tariffs across the global stage has raised concerns from global investors that the world economy will slow down due to strict trading conditions. With a regulated macro environment and high chance of a recession in the next few years, Facebook is not teed up to climb an uphill battle.
SELL Recommendation & Conclusion
Currently, 24 analysts recommend Facebook stock as a strong buy, 2 recommend it as a buy, and 5 recommend it as a hold (Figure 10). I maintain a minority opinion stance that investors should sell their shares of Facebook stock based on the threats of the competitive sector, impending regulation, a rocky macroeconomic environment, and poor management.
Facebook missed guidance in the most recent quarter due to systematic problems from underinvestment in operating resources and efforts to mitigate risks caused by the platforms. While intentions may be good, Facebook has mismanaged data partners, supplied advertisers with misleading metrics, and provided a platform to users that has aided in social ills and the destabilization of societies.
I see potential for Facebook to dive below the $100-a-share mark soon with little evidence to prove a shallow bottom. Among worries of an approaching recession, the digital advertising and social media power house has faced data-protection scandals, regulation in the near future, slowing growth, and falling margins. I predict 2019 to be another year of heavy investments that will place pressure on Facebook’s ability to grow earnings per share and free cash flow going forward.
Beyond decreasing numbers in advertisers and users, the company has a long list of other concerns to face. Studies show young users are quitting the site by the million, and partisan politics are only part of the problem. With vulnerable weaknesses and only one true revenue stream, Facebook’s critical sources of loyalty are fading. I believe the company is under performing, and I see little motive to believe in the future of Facebook’s rebound.