Facebook (FB, Financial), the social media giant, is down around 9% since the unfolding of the recent data privacy scandal. Cambridge Analytica, a data mining company that was involved in the data driven campaign of President Trump was accused of violating Facebook’s data handling policy.
This has awakened the interest of several regulators in Facebook’s data handling practices across countries. The Federal Trade Commission of the U.S is looking into Facebook for potential breach of terms of services regarding the transfer of user data to Cambridge Analytica without users’ consent.
"The FTC takes the allegations that the data of millions of people were used without proper authorization very seriously," said FTC Commissioner Terrell McSweeny.
Facebook's top executive, Mark Zukcerberg, has also received a request to appear before the parliament in the U.K. to testify about user data. Moreover, British privacy regulators have stopped the auditors hired by Facebook, in order to conduct an on-sight investigation at Cambridge Analytica’s London office. EU lawmakers are also assessing the situation and will potentially investigate the situation, according to Antonio Tanjini, the president of the European parliament. To add to the problems, a class action lawsuit against Facebook has also been filed by investors, arguing that Facebook has misled investors and violated its own data privacy policy by allowing third parties to use data without proper consent.
It appears that regulatory scrutiny in tightening around Facebook. If Cambridge Analytica is found guilty of breaching data protection acts, Facebook will face the music. It is important to note that Facebook can be penalized by the regulators even if Facebook unknowingly breached its data privacy policies. As of now, both Cambridge Analytica and Facebook deny any wrongdoings.
What does it mean for Facebook’s business concern?
In the short term, Facebook potentially faces fines from regulators across the globe. Brian Fung, a tech reporter with Washington Post, tweeted that violations can cause Facebook up to $2 trillion in fines from the FTC. However, this claim is open to discussion. The FTC has the power to charge $40,000 per day for a single violation, noted Bloomberg. The amount of potential fines depends on the FTC’s definition of a single violation. If the FTC considers the collective breach per day as a single violation, then fines can only amount to $102 million assuming that FTC charges fines from 2011.
A fine of $100 million is immaterial to Facebook’s bottom line given that the company generated around $24 billion in operating cash during the trailing 12 months. On the other hand, if violations are to be considered on a user basis by the FTC, then the fines could swell up to $2 trillion. But this is just hypothetical because such an extent of fines threatens Facebook’s going concern. Wiping a $500 billion dollar company from the economy will most certainly have serious repercussion.
A more reasonable way to gauge the potential penalty for Facebook is past precedence. The FTC charged Google (GOOGL, Financial) $22.5 in fines for misrepresenting to users of Apple Inc.’s (AAPL, Financial) Safari browser that it will not serve targeted ads to those users. Around 5 million users were affected by the breach. In Facebook’s case, the information of 50 million users was shared without consent. Following the precedence, FTC can change Facebook around $225 million based on the number of users affected by the breach.
All in all, the FTC won’t charge $2 trillion of fines for several reasons. Firstly, Facebook is a $500 billion company, with a cash balance of $41 billion. The company can’t possibly pay a fine of $2 trillion. Secondly, the label of $2 trillion in fines will bring Facebook down alongside the tech market, which can potentially precipitate into a premature slump in the market and the economy. Therefore, the possibility of any amount of fines that can challenge Facebook’s going concern won’t be pursued by the FTC; an assumption of a $400 billion in fines is absurd, let alone $2 trillion. Of course, all of this is contingent upon conviction of Facebook in breaching data protection laws. The point is, Facebook might be penalized by FTC and others to the extent that won’t challenge Facebook’s going concern.
What about long-term prospects?
This brings us to the second point: Facebook isn’t affected by this scandal in the long term. Over the long term, the company might be subjected to additional regulation resulting in lower than usual margin. However, given the extent of gross margin (86% in the trailing 12 months), additional regulatory compliance doesn’t seem like a material concern for Facebook.
Skeptics of Facebook’s long-term prospects argue that users will turn away from Facebook in the backdrop of the current privacy scandal. This argument is flawed given that users primarily care for “individual direct impact” of a given breach, to stop using a platform. A credit card data breach will most certainly drive users away from a platform. But users tend to forget “collective and indirect impact” of some data breach. Therefore, Facebook's user base is not at risk from the recent scandal. Moreover, even if most users want to abandon the platform, there should be an alternative to fall back to. The lack of an alternative mature social media platform is the biggest barrier for Facebook users abandoning the platform.
The crux is that long-term prospects of Facebook are intact as the company is too big for regulators to challenge its growing concern without posing a threat to the economy, and users don’t have a fallback position in case they take a high road in abandoning Facebook in case the breach was intentional.
Facebook is a bargain: should you buy?
This brings me to the third point of discussion: Facebook is a bargain at current price; it’s an opportunity to get in cheap. Well, it looks cheap given the growth prospects of the company (27% earnings growth per annum is expected during the next five years). However, it’s not the time to get on the “cheap” bandwagon. The stock will certainly trend lower if regulators slap a fine on the company, or tighten the regulatory framework. Therefore, it’s better to wait for the smoke to clear, and get in at a lower price. The only reason not to sell the stock now is if you are convinced that Cambridge Analytica will get a clean chit from the authorities.
Final thoughts
The data breach scandal is blown out of proportion as far as Facebook’s long-term prospects are concerned. However, the company is at risk of fines and costly regulatory compliance in the short-term. From an investors’ perspective, it’s better to sell and wait for a better entry position.
Disclosure: I have no positions in any stocks mentioned and do not plan to initiate any positions within the next 72 hours.
