I’m the first to admit that I was skeptical about the long-term viability of Facebook Inc. (NASDAQ:FB). I didn’t see how it could be monetized effectively, but was proven wrong as advertising revenues started pouring in, and FB stock started heading to the moon.
Facebook has very little in the way of capital expenditures, so it became a big cash flow machine. I just found it hard to believe that people were actually clicking on ads in enough volume to make the ad spend worthwhile for advertisers.
I just remember the early days of CompuServe, which relied on advertisements for revenue, and how it never was able to sustain itself. As someone who almost never clicks on ads of any kind — figure 0.1% of the time — I just didn’t understand how this model could possibly work.
Yet, it does. Not just for Facebook, but for Alphabet Inc (NASDAQ:GOOGL) on the search side.
And Yet …
As an investor, I have two concerns when it comes to FB stock.
The first is immaterial as far as long-term investment is concerned. What happens in an economic downturn, when ad spend declines? What if it ad spend totally craters and doesn’t come back for a long time? Suppose we enter a long economic contraction. In the near-term, it would obviously mean large revenue and bottom line declines. One would expect Facebook to fall in this period due to uncertainty and a contracting valuation.
Because Facebook is stacked to the gills with cash, it would easily survive and eventually ad spend would pick up again. No big deal.
But the other concern I have could send Facebook plunging.
Since virtually all its revenue is ad-based, the question is what would happen if ad buyers had a reason to permanently reduce their ad spend. Even worse, what if ad buyers abandoned Facebook?
What do I mean? Look at Facebook’s latest earnings report.
- Daily Active Users (DAUs): 1.23 billion.
- Mobile DAUs: 1.15 billion
- Monthly Active Users (MAUs): 1.86 billion
- Mobile MAUs: 1.74 billion
- Average Revenue Per MAU: Grew from $9 in Q4 of 2014 to $13.70 in 2015 and $19.81 last year, up nearly 50%.
- Mobile Revenue: In Q4 of 2014, it was $2.5 billion. It’s now $7.2 billion.
What if these numbers weren’t accurate?
Facebook has admitted in its previous 10-Ks that there are fake and duplicate accounts. In it’s latest 10-K, there are several important sentences to note:
“The numbers for our key metrics, which include our daily active users (DAUs), monthly active users (MAUs), and average revenue per user (ARPU), are calculated using internal company data based on the activity of user accounts. While these numbers are based on what we believe to be reasonable estimates of our user base for the applicable period of measurement, there are inherent challenges in measuring usage of our products across large online and mobile populations around the world…we estimate that “duplicate” accounts may have represented approximately 6% of our worldwide MAUs.”
Hold the phone.
“These numbers are based on what we believe to be reasonable estimates of our user base.” Reasonable estimates? Says who? The fox guarding the henhouse?
Here’s another unsettling quote:
“We believe the percentage of accounts that are duplicate or false is meaningfully lower in developed markets such as the United States or United Kingdom and higher in developing markets such as India and Turkey. However, these estimates are based on an internal review of a limited sample of accounts and we apply significant judgment in making this determination, such as identifying names that appear to be fake or other behavior that appears inauthentic to the reviewers. As such, our estimation of duplicate or false accounts may not accurately represent the actual number of such accounts.”
This is a pretty gigantic disclaimer.
The truth sounds like Facebook simply has no clue just how many foreign accounts are real. There’s no possible way any human or computer can cycle through the hundreds of millions of accounts “that appear fake or [have] other behavior that appears inauthentic.”
But fake accounts and bot traffic are a large reason investors haven’t trusted Twitter Inc (NYSE:TWTR), so this is no small matter.
I’m not saying the Facebook is deliberately falsifying user numbers. However, I have a concern that FB stock reflects ad revenue that is based on user numbers that may have a mark larger population of fake/duplicate accounts. If this ever happened, especially if discovered by a third-party, that could blow up advertising sales.
If.
But if = risk. I just wonder if Facebook stock is priced for this risk. I don’t think it is.
Lawrence Meyers is the CEO of PDL Capital, a specialty lender focusing on consumer finance. As of this writing, he did not hold a position in any of the aforementioned securities. He has 22 years’ experience in the stock market, and has written more than 1,600 articles on investing. He also is the Manager of the forthcoming Liberty Portfolio. Lawrence Meyers can be reached at TheLibertyPortfolio@gmail.com.
