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Can Facebook Recover from Its Data Usage Crisis?

Vontobel Viewpoints: Authored by Peter Choi, Senior Research Analyst, Vontobel Asset Management

Facebook has long been viewed as a high growth technology company and one of the world's great business franchises. In March, media reports of a user data breach sent Facebook's stock spiraling downward. While it has since recovered, investors are concerned about the potential negative effects the incident could have on the company—from increasing risk of regulation to declining usage and rising costs. In our view, these risks will not have a material impact on Facebook's long-term earnings power.

Facebook came under pressure following press reports that the British-based marketing firm Cambridge Analytica (CA) compiled user data on 50 million Facebook users. The data was acquired from a Cambridge University professor who developed a personality testing app that collected personal information about the users and their broader network of friends. The professor falsely claimed the app was intended for in-house academic research, and in 2015 Facebook discovered that the data was given to CA. Facebook then demanded that the data be destroyed, and the professor and CA both certified they had done so. 

The app was able to collect this wide range of data through a feature on Facebook Connect, which allows Facebook users to log into third party apps and websites. At the time, Facebook allowed such third-party publishers to access personal data of individual users and their network of friends. This feature was part of Facebook’s platform strategy, which allowed developers to build applications for social gaming, personalized recommendations and dating. This was put in place when Facebook was a much smaller company in an earlier stage of growth, and the company discontinued the practice in 2014 (with already existing apps getting a one-year extension). Hence, this type of access has not been possible for the past several years.

This latest incident has raised concerns that the company may face three potentially negative effects:

  • An increased risk of regulation, which is already in motion in Europe and to a lesser extent in the U.S.
  • The possibility that users may become uncomfortable with sharing information and stop using Facebook
  • Rising costs, particularly higher compliance costs

Facebook may experience increased levels of regulatory oversight around its handling of personal data. Data privacy has traditionally been a sensitive issue in Europe, and standards for protecting personal data will be raised with this year’s implementation of the General Data Protection Regulation (GDPR). Under GDPR, consumers will gain more control over their personal data, as companies will be required to obtain explicit consent in order to use personal data for specific uses.

Curtailing the use of personal data will also restrict the ability to deliver more targeted advertising and may impact the ultimate level of earnings power. However, on a relative basis, GDPR could ultimately reinforce the positioning of the current market leaders. Facebook and Google have direct relationships with a majority of the European population, who find their services valuable and use them frequently. They will be the most likely companies to get broader levels of consent from consumers. Also, Facebook generates a large amount of user data inside its own walled garden and will be able to use that data under “legitimate interests.” In other words, the process of how Facebook delivers ads in the newsfeed is the same as the way in which it delivers organic content. In contrast, smaller publishers will find privacy requirements more onerous. And digital advertising networks (where display ads are auctioned off in real time) will have a much tougher time, as they have a convoluted value chain, each step of which will need to acquire consent.

In the U.S., we continue to view the risk as limited, as the U.S. regulatory system is traditionally hands-off, and the proposed remedies in Congress have been limited in scope. For example, the Honest Ads Act—now a bill in the U.S. Senate—focuses on increased transparency in political advertising (requiring, for instance, disclosure about who paid for a political ad and how it was targeted).

We believe this would have little business impact, as a small portion of overall online advertising spend is allocated to politics. We see a material change in U.S. privacy laws as highly unlikely given a fundamentally different regulatory philosophy. In addition, we believe the current Congress is ill equipped to arrive at any consensus over a novel and complicated issue that would impact many industries. In our view, it is telling that the Honest Ads Act has yet to pass, despite what we see as a modest impact. It is more likely that the threat of increased regulation will spur online companies into better behavior. Facebook has already begun to move in this direction by announcing changes around data transparency and control. We believe management recognizes its situation and will be able to respond accordingly.

The second risk Facebook may confront is that consumers will begin to lose trust in and drift away from the platform. But while the company has stumbled and management needs to be more forthcoming in its communication to assure its user base, in our opinion this is a manageable task. Facebook has steadily added more privacy controls over time, and this will become more complete and intuitive going forward. We have yet to see privacy issues impact user engagement trends, although we will continue to monitor this. We also note that the intensity of the backlash from the media does not necessarily reflect the underlying mood of rank and file Facebook users. The business models of traditional media has long been impacted by Facebook and Google and there is now an opportunity to turn public sentiment against Facebook, and potentially increase government sympathy towards regulation.

The third risk revolves around the potential for higher-than-expected spending associated with compliance—monitoring content and maintaining data privacy, for instance—that could negatively impact earnings. Facebook had already budgeted major spending increases to address these issues, and we believe Facebook can absorb any incremental costs without material impact.

As investors, we reduced our exposure to Facebook at the end of 2017 to reflect rising valuation and the potential for regulatory risk. With the stock’s recent pullback to $160 (as of 3/29/18), Facebook is now trading at about 19 times fiscal year 2019 earnings per share on a GAAP basis. We view this as attractive for a high-growth technology name and one of the great business franchises in the world. While we are aware of the potential for future negative developments, we believe the long-term earnings power would not be materially impacted.

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