The timing could not be better. The same week that Facebook stock prices went into full meltdown (the largest one day loss in market history (though that headline is a little bit of hype - percent decline is the real thing to look at)), was also the same week that George Gilder's new book, Life After Google (henceforth LAG), was published.
I had the honor of being able to read the original treatment for the book last year and then the pre-pub galleys last month, so I had already read two versions of the book before it went on sale. It is a powerful and explosive book that is going to change more than just the technology discussion in this country. For more on that, look for my full review of the book in the near future.
But with Facebook collapsing, I couldn't help but see a connection between Gilder's insights and today's news. Gilder's book has arrived at exactly the right time.
The book is a critique of the centralist model which applies to Facebook as well as Google (though Google is the prime mover). Facebook can’t seem to recover from its security issues, and as LAG pointed out, it’s an endemic and structural problem. The Googles and the Facebooks centralize data analysis -- that's their model: centralized collection of information about us which then can be put through 'big data' analytics. It's an economy of scale play. But with central data, you now have neatly gathered all that valuable information together right where hackers already know to look. So, hackers and manipulators hack and manipulate, then Facebook has to hire an army of coders/censors to spot fake news and look for a Russian under every bed. Costs money.
That's one of the things which is creating problems for Facebook as Bloomberg just reported:
"The company is also rapidly expanding its real estate around the world to accommodate a hiring spree, which includes thousands of new workers to help combat foreign election manipulation on the site. In 2016, Russia ran a campaign on Facebook to cause political unrest in the U.S. around the presidential election. The company said headcount was 30,275 as of June 30 -- an increase of 47 percent year over year." (Source.)
It's not just a matter of fighting real threats. It's also a matter of fighting perceived threats. Whether the current focus of mass media attention is a moral panic trying to discredit the election of President Trump or rather a healthy robust reaction to Russia having 'hacked our election' (and your answer to that question probably correlates with political alliances, the fact is that it is putting Facebook management on the defensive. It not only has to stop hacking, it has to be seen as going to painfully expensive changes to atone for having been hacked in the first place. That's a constraint on management which is hurting revenues:
“Chief Financial Officer Dave Wehner blamed “currency headwinds” and new privacy options for users for the shortfall but also revealed that new ad formats, such as those within Instagram Stories, weren’t pulling in the same amount of money as ads shown in the Facebook and Instagram feeds.” (Source.)
And it is also an expense:
"The company has been working to convince users it has their best interest at heart, after reports of Russia’s interference and disclosures that a political consulting firm gained access to private personal information. Zuckerberg in January said he was going to adjust the news feed to make sure people spend more time on Facebook with meaningful content from their friends and family members -- a move the company has said would decrease user engagement with the site.” (Source.)
Both of these -- reduced revenues and higher expenses -- hurt earnings. Now we're starting to see the earnings problems.
"Operating margins, Mr. Wehner added, would fall to the “mid-30s” from about 44% currently over the next few years, stemming in part from investments in security and safety that Facebook has discussed since last fall.” (Source.)
All of this is following the Gilder forecast like actors following a script. The centralized model of which Google is the Prime Mover, but Facebook is a fellow demiurge, is doomed. This is not a tweakable situation. The whole model of the world - central accumulation of data, users as product not customer (which I wrote about here last April).
What I said then (partly inspired by my reading of Gilder's early drafts) was,
"Let's face the fact that a big part of Facebook's problem is its business model. As Tim Cook, CEO of Apple, pointed out: Facebook’s users are not really its customers; they're its product. Now, of course, that's true of almost any media company, or at least any media company that lives by advertising. When you watch television, you are not the customer, you are the product. The advertisers are the true customers, and the media company is selling soap sellers access to your eyeballs. Okay, we're all used to that already. Social media like Facebook is different, though. Unlike TV, whenever you're watching social media, social media is watching you. And it sells what it sees to its real clients, its advertisers, which includes political campaigns. But people don't like to have their eyeballs and their personal information sold. There was bound to be some kind of collision."
The collision I spoke of is a slow-motion collision, the bumper hit the wall when the hacking scandal broke, but only now are the shock waves beginning to show up in an engine which has been bent enough to diminish the drive shaft. It might take ten years for all of this to be felt.
Now all of this might be wrong, or it all might be ten years ahead of us. My point as an investor is that with a PE of mid-30s before the call, the risk was just not worth taking. Sure, if FaceTwittGoog world was the inevitable future of mankind, huge data farms with AI hacking us and selling its download of our precious preferences to vendors, then it might have been necessary to pay 36 years' worth of earnings to own a share. But with inevitability very much in doubt and revenues flat and angry governments and the cost of security rising, investors start to turn their minds away from newfangled New Media valuation metrics (like revenue growth) and back towards fundamental things like earnings and price, and even to old-fangled things like leadership and character. And when that happens, the spell is over. Life After Google is the spell-breaker. The free-because-you-are-the-product-not-the-customer model, which allowed huge aggregations of market share (because what is apparently free is highly in demand), is being shown as not free at all (unless you value your time, attention, peace of mind, and privacy).
Now we did not need all this new analysis or these new revelations to be convinced that Facebook was not worth the risk. Both of our domestic stock indices, FLAGLSX and VCUSX (more info on both here) held Facebook at a zero weighting. Why? Significant leadership and corporate governance problems. The company has a culture which holds shareholders at bay and puts management’s interest ahead of an owner orientation. It had some problems with its accounting reporting as well, though the forensic accounting issues were not as large as the board governance issues. And then there’s valuation. It seemed to be priced well above its inherent value. Principles-based investing is not mainly about running away after the bad stuff gets revealed. It’s about spotting the leadership problems which tend to lead to bad stuff beforehand.