Seeking Alpha: How Facebook Created Its own Monsters

It's no secret that Facebook (NASDAQ: FB ) has tanked over the last six months. At present, it's almost hard to remember that the company was once part of the original FANG trade. History seems to always repeat itself, and as soon as a "can't lose" basket of stocks is identified, something goes wrong. Unfortunately for Facebook investors, what went wrong was pretty much the entire year of 2018. It's always easier to assume everything will return to normal and that Facebook will go back to being a great growth story once again. The bad news is Facebook doesn't want to face that it created its own monsters. Even worse for investors, according to the company's last conference call: Stories, security and video trends are problems Facebook doesn't seem to have answers for. The moral of the Stories The first monster created by Facebook is the idea of Stories. In 2017, Facebook introduced Stories to the masses in what seemed to be a direct shot at Snapchat (NYSE: SNAP ). Roughly seven months ago , Facebook decided it was time to attempt to monetize this new feature. The challenge for Facebook is getting users to accept the idea of advertising, in the middle of what is designed to be an impermanent slide show of personal experiences. Mark Zuckerberg said in the company's last conference call : "We're seeing the way people connect shifting to private messaging and Stories." The company said it created Stories because people share more, and feel more comfortable sharing, if they know what they share isn't permanent. Unfortunately, for investors, there were two very significant comments made about the Stories business that should worry them greatly. First, the company acknowledged multiple times that it would take time to attempt to monetize Stories to the same level of the News Feed. Mark Zuckerberg shared his thoughts around the move from advertising in Stories versus the advertising flow in News Feed. He said, "it will take some time and our revenue growth may be slower during that period." As if warnings about revenue weren't enough for investors to deal with, the second comment from CFO David Wehner should give investors even more concern. He said, "in terms of converging on Feed from any pricing perspective, that's a journey that's going to take years, not quarters." This seems to call into question some thoughts from Deutsche Bank that were shared just last month. The company said Facebook's valuation looked "extremely attractive" and that it expected "monetization in the Stories format to drive a potential re-acceleration in growth in mid-2019." With analysts trying to figure out when growth will return, and the company saying this conversion will take years, it seems reasonable for investors to take a hard look at the situation. To be blunt, Facebook created a product that it didn't know how to make money from. Investors can track the direct connection between the increase in the use of Stories and the company's declining margins. Last quarter, Facebook reported that its operating margin dropped from 50% last year to 42% this year. This negative trend is expected to continue well into 2019. CFO David Wehner said last quarter : "Over the next several years, we would anticipate that our operating margins will trend towards the mid-30s on a percentage basis." The ads Facebook is trying to implement would be 5 to 10 second spots during a user's Story. The problem is Stories can be very short or have multiple tabs and be minutes long. It's one thing to invade a user's experience with an advertisement that appears when scrolling through a News Feed. It's a whole different scenario to place an ad for 5 seconds in the middle of a Story that might only be 20 seconds long. The bottom line is Facebook says Stories are growing faster, yet this development will negatively affect both revenue and margins. If Facebook can't monetize this usage trend, the company's short-term challenges may not just be a bump in the road after all. The hits just keep on coming Facebook's security concerns are well documented, but it's possible investors are slowly coming to the realization that they've underestimated the risk. Pretty much everyone is aware of the issues surrounding Facebook and the Cambridge Analytica breach. What should scare investors to the core is a comment Mark Zuckerberg made last quarter, "we still have at least a year before our systems are at the level that we want." In September, the company announced it suffered a data breach of about 30 million users. A company that suffers a massive data breach and the reputational loss that goes along with it, then months later suffers another data breach of tens of millions, should make users and investors nervous. There was a study by Pew Research as recently as September that says some users are deciding the value of Facebook isn't enough to warrant the potential privacy issues. The study found "26% of users have deleted the Facebook app from their cellphone." More specifically, "44% of users between the ages of 18 to 29 have deleted the app from their phone." Of the users who aren't deleting the app, 54% adjusted their privacy settings last year. The cost of Facebook's security missteps is clear. In last year's second quarter , its expense growth was 33%. At the beginning of 2018, Facebook reported that its expenses grew by 39% year-over-year. By the end of 2018, it was aiming for 50% to 60% expense growth with security being a significant driver. The point is Facebook has moved from a site that was being used by more and more people to one that seems to already have everyone signed up. It's a simple decision to use Facebook if your information is safe and it allows you to stay connected. That simple decision becomes much more complicated once users start to question if their information is at risk. Like it or not, Facebook must now prove to users that the site is safe as opposed to being granted the benefit of the doubt. Telling users what they want is a mistake One of the core principles of most businesses is find a need and then create a product or service that fills that need. Facebook's core business is about making it easier to connect to the people you care about. However, as more users are choosing to share video, Facebook seems intent on telling users what they want rather than allowing the site to meet another need. Mark Zuckerberg said it best, "video monetizes significantly less well per minute than people interacting in feeds." In case investors aren't sure if this is a significant issue, he revisited the topic later in the conference call saying, "as video grows, it will displace some other services where we'd probably make more money." On the surface, this would seem to be a short-term challenge as video growth outpaces traditional sharing on the site. Over time, Facebook might make more money as video grows faster but monetizes at a lower rate. What's ironic is in the past Facebook seemed content to fulfill the role of social media facilitator. The bad news for investors is this time the company seems to want to control what users do instead of making money off their choices. If Sheryl Sandberg's words are the marching orders for Facebook, investors should be very worried. She said, "we see passive consumption of video displacing social interactions, that's not something that we've wanted." Though the company might not have chosen this path, there are worse fates than users finding more value in the site through video. However, what should really worry investors was her next statement, "we're the Internet service that people use to help connect with other people and we're not going to let passive consumption get in the way of that." Reading between the lines, Sandberg is essentially saying Facebook will push users away from passive video consumption because it doesn't know how to make enough money from this activity. Investors who thought they were investing in a social network who would make billions assisting users connect with each other now find they are investing in an entity that wants to control the conversation. Monsters are eating the stock alive Investors hoping to buy the significant dip in Facebook stock are probably trying to catch a falling knife. In the last six months, the stock has been nearly cut in half in value. The company may find a way to monetize Stories at an acceptable level at some point, but management has already admitted this will take years. Users may decide that they can trust Facebook again and decide to re-install the app. However, when users delete the app, they may find being disconnected is a refreshing change. Along with these challenges, the fact that Facebook is trying to control video consumption seems like looking a gift horse in the mouth. What the company cannot afford to do is try to drive users' behavior as they seem to already be questioning the value of the site. The last six months have seen Facebook's stock decline by 5% or more multiple times, then the shares would rebound, only to decline to a fresh low. 2019 seems to be a transition year, as the company invests in infrastructure and adjusts to the increased use of Stories and video. Facebook created its own monsters and isn't sure how to take them down. The stock may be a decent, long-term play. However, given the company's issues, investors should avoid the shares at least for the next six to twelve months.