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2019 Will Be a Perilous Year for Facebook

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- By John Kinsellagh

A little-noticed but profoundly significant note was added to Facebook Inc.'s (FB) latest earnings release. In the forward-looking statements section of the fourth-quarter earnings release that outlines potential risk factors, the company added: "risks associated with government actions that could restrict access to our products or impair our ability to sell advertising in certain countries."

Even though many analysts may dismiss or altogether ignore the additional language, the seemingly innocuous additional risk factors is an acknowledgement of the perils the company is going to face in 2019.

The company has had a series of clashes with regulators in the past. As I noted previously, the problem for Facebook is that it has been duplicitous and demonstrated bad faith for years concerning its attempt to address data privacy abuses; its actions have belied its pious assertions of concern with potential abuse of its users' private data.

Consumers, many users and, more importantly, regulators have tired of the duplicity and overt misrepresentations that have become all too frequent. Facebook's pending interaction with regulators is going to be profoundly different than its previous and somewhat salutary encounters and should be viewed more as a long-overdue reckoning.

What has changed?

The most menacing peril facing the company comes from Europe. Legislators charged with implementing the General Data Privacy Regulation seem to be more savvy about the company's business practices and are drafting what will prove to be cumbersome and costly provisions accordingly.

Subsequent to the enactment of the GDPR last spring, European regulators are now becoming more emboldened and adversarial in their regulatory relationship with the tech giants, most notably Facebook and Alphabet's (GOOG)(GOOGL) Google. It is inevitable that U.S. legislators are going to follow suit. Many countries are drafting regulations in a strict manner consistent with the intent of the privacy law.

The comprehensive privacy initiative enacted recently in California will be a template for federal legislation. If some Wall Street analysts dismiss pending adverse regulatory factors as de minimis, how do they explain the tenacity with which Facebook attempted to quash the California initiative? Despite abundant evidence to the contrary, some analysts still mistakenly argue the solution is for Facebook to simply self-regulate.

Some of the issues that will be addressed and remedied by more stringent regulations are the adequacy of any disclosure made to consumers so they can make informed choices about Facebook using their private data and restricting that private information from being transferred to unknown third parties.

A French regulator recently fined Google $57 million for violating the European privacy rule concerning adequate disclosure that went into effect last year. Other regulatory provisions will soon be enacted that will directly impact Facebook's lucrative and unfettered business model.

The risks presented by these stricter regulations is they are going to severely circumscribe the company's ability to harvest data and transfer users' private information for enormous profit from advertisers eager to keep shelling out money as long as they reap the benefits of targeted advertising.

The risks to Facebook's bottom line from increasingly onerous and inevitable regulations are significant, yet the impact is completely overlooked by many investors and far too many analysts fail to factor these substantial and looming risks in their projections for the target price of the shares.

The ability to harvest and manipulate users' private data, unfettered by regulatory provisions, is the lifeblood coursing through the veins of the Facebook's high revenue per mille revenue engine. Regulations that hamper its practice of transferring information on consumers multiple times to multiple third parties for enormous profit is going to have far-reaching impact on the company's ability to maintain its historical earnings growth rate. Yet, far too many security analysts have expressed a blithe indifference to these significant perils.

One analyst recently quoted in Barron's said, "We acknowledge it may be difficult for [Facebook] shares to work as revenue growth should step down again in the first quarter. But we expect stability from the first quarter to the second quarter with increasing focus on the potential for re-acceleration and for margin stability."

Here is the basis for another analyst's buy rating on the company:

"FB's status as leader in Social is unchanged and we see continued upside for FB shares as it digests the social hangover," the analyst wrote last Monday. "FB remains a tier 1 platform for advertising spend with Instagram showing positive drivers of growth."

No mention of how regulatory action, however slight, will impact the stock or should at least be acknowledged in any valuation models. Nary a word about whether projected multiples are rational in what will be a drastically different operating environment.

A review of the chart below will prove instructive. Facebook's operating margins have been the envy of the tech industry. Information provided by GuruFocus notes the company's operating margin is ranked higher than 97% of the 379 companies in the global internet content and information industry.


Will the company continue to enjoy 40%-plus operating margins if European regulations become more onerous? If an analyst believes impacts on margins will be negligible, what is the factual basis for that assertion?

Data from GuruFocus notes the median three-year earnings before, interest, taxes, depreciation and amortization growth rate for Facebook is 50.35; the minimum is 19.3; the maximum is 73.2. Based on this data and existing valuations, is the projected rate of future earnings growth for Facebook based too much on the company's past history? Even though the current price of $170 is far below its last August high of $217, many analysts' current target prices are starting to creep back toward the $200 range. If analysts have confidence in these projections, what weight, if any, do they assign to the little note unceremoniously added to the third-quarter financial statements? Why did Facebook even bother to make the disclosure?

Another important factor that is overlooked or never raised is that Facebook is no longer just a tech or social media company. It has evolved into a publishing powerhouse that exerts undue influence on the daily newspapers and other online publications. It is the world's largest tech advertising platform; indeed, it is a monopoly. The House Energy and Commerce Committee as well as the Judiciary Committee are exploring ways to address Facebook's concentrated economic power through privacy and pro-competition regulations. These ancillary and perhaps unforeseen effects will become a significant albatross around the company's neck.

From a legal standpoint, the note to the earnings statement was added because of the company's liability exposure under the federal securities laws. The real question is why were no additional risk disclosures made previously?

The note to its third-quarter earnings release has significant ramifications and those security analysts who are incapable of awakening from their slumber are going to receive a rude awakening.

Disclosure: I have no position in any of the securities referenced in this article.

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This article first appeared on GuruFocus.