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Facebook- ‘We Run Ads’

Mathieu Blake, Dealer

 

Senator Orrin Hatch: ‘So, how do you sustain a business model in which users don’t pay for your service?’

Mark Zuckerberg: ‘…we run ads.’

 

Mark Zuckerberg sums up his business model, after the Facebook founder concluded two days of testimony on Capitol Hill last week. Unless you have not glanced at the news in the past month, you most likely know the hearing comes after political consulting firm, Cambridge Analytica, acquired data of up to 87 million Facebook’s users without their consent. The Facebook share price consequently fell nearly 12% and shaved around $45bn off the company’s market capitalisation, causing a sell-off in the broader technology space. During his testimony, Zuckerberg’s media training and robotic demeanour paid off and the market was satisfied enough to hand back $17.3 billion of market capitalisation over the two days. Nonetheless, the scandal puts the spotlight on Facebook and other data driven internet companies, sparking questions of reform and regulation.

Source: Capital IQ

To understand what regulation would mean, we first have to understand the Facebook business model, something that a few U.S Senators struggled to grasp. Facebook’s value comes from a phenomenon known as the network effect: the more people use a particular product or service, the more valuable it becomes. The Facebook platform derives its value from a simple fact: nearly everyone is on Facebook. The service is so pervasive that for users it is often more inconvenient not to have an account, as the platform is often key to organising events and keeping in contact with friends and family. Even if users don’t actually like the service, social necessity almost demands they sign up and hand over their data. This is how Facebook turns the network effect into profits. The 2.2 billion users around the world are in fact not customers, they’re the product. Facebook’s customers are advertisers; entities looking to exploit the data for commercial (or political) gain.

Zuckerberg made a point of clearing up a ‘common misconception’ to Senators, stating that Facebook doesn’t directly sell its user’s data. Companies approach them with a target for their ads and Facebook then discloses the data to the right people.

Facebook grants academics greater access to users’ data than commercial companies and app developers. The Cambridge Analytica scandal began when a researcher built a personality quiz, which harvested data from users’ profiles. Unfortunately, it also gave the app access to the participants’ friends’ data, who had no way to consent. Around 270,000 people took the quiz but based on the average number of friends per participant, the app could have collected up to 87 million users’ data. This fact was actually disclosed (albeit in the fine print) when the user took the quiz, so no rules were broken. The problem arose when the researcher then handed the data over to Cambridge Analytica, who put it to work targeting voters in the 2016 U.S election campaign.

The scandal throws the future of the Facebook business model into sharp focus for investors. Zuckerberg stated that he saw regulation as an inevitability, rather than an option, but the question remains as to how this will impact the financials of Facebook.

In Zuckerberg’s second day of testimony, many representatives brought up Europe’s much anticipated ‘General Data Protection Regulation’ (GDPR), which will take effect on 25 May 2018. This regulation seeks to give people more control over their own data, articulating what counts as personal data and what rights are associated with it. During his testimony, Zuckerberg committed to abiding by the extended requirements of the GDPR and stated clearly that all the protection and controls afforded to the platform’s European users, would be available worldwide. The U.S Federal Trade commission has also launched another investigation into Facebook privacy practices. A 2011 investigation charged Facebook with deceptive practices and the company promised to be more transparent with consumers about the data that is acquired. The current scandal seems to violate this promise and may see Facebook slapped with a fine of up to USD2bn, the largest ever fine handed down by the Federal Trade Commission, but a drop in the ocean for the social media giant.

With the focus on Zuckerberg’s contrition and how little American politicians seemed to know about the opaque world of digital communication, it became clear that Congress had no immediate plans to roll out regulation, at least not until the European GDPR kicks in. Facebook has fought state level privacy laws in California, but on a federal level, the Republican majority in both houses has little appetite for restricting business. Overall, the testimony restored confidence for many investors. After two days of questions, Facebook stock was up 5.7%.

We do not have a position in Facebook in the Arnhem Global Growth SMA portfolio. Whilst regulatory risk, as witnessed in recent weeks, has played a part in this decision, it is not the main driver. In our view, the main negative is the fact that U.S Facebook usage has declined in recent times and we expect that to spread slowly to the rest of the developed world. Recent growth comes primarily from Instagram and WhatsApp (two social media platforms it has bought in the past). The challenge with these two products is replicating the success in selling ads on the traditional Facebook platform. This is especially difficult on WhatsApp which has been an ad-free social media platform and has vowed to remain so, putting future revenue growth for the company as a whole at risk.


Source: eMarketer estimates

Arnhem’s preference is Alphabet (Google’s Parent company), which we hold in our Global SMA portfolios. The company is in a unique position as the global leader in search based advertising. The company does not rely on disclosing the same type of stored personal data to advertisers. Alphabet dominates the search-based advertising micro-industry, as it’s the default search engine for the vast majority of internet users. Although advertising still makes up 90% of revenues, Alphabet has a diverse range of future profit generators like Google Cloud, various Venture Capital investments and initiatives in drone delivery and self-driving cars.

 

Mathieu Blake is a Dealer at Arnhem Investment Management. This is a financial news article to be used for non-commercial purposes and is not intended to provide financial advice of any kind.
This article has been prepared by Arnhem Investment Management Pty Limited ABN 17 129 606 775, AFSL 332484. It has no regard to the specific investment objectives, financial position or particular needs of any specific recipient. You should seek your own professional advice in relation to any financial product referred to. You should also obtain the product disclosure statement relating to any financial product referred to and consider the statement before making any decision about whether to acquire the financial product.

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© Arnhem Investment Management, 2018