Facebook and the regulation of privacy

There are a lot of stories focused on Facebook coming out of the Cambridge Analytica scandal. I tend to believe Facebook will escape largely unscathed because of a lax regulatory environment in the US. Nevertheless, Facebook and other large Internet players still face a range of downside scenarios, particularly in the EU. I got into some of this last week. But the trouble for Facebook has now leaked into a loss of advertisers. Some brief thoughts below.

The 2011 FTC settlement mandates regulatory controls

All of this goes back to a settlement Facebook made with the US Federal Trade Commission in 2011. In the final settlement in 2012, the FTC found that Facebook had “deceived consumers by telling them they could keep their information on Facebook private, and then repeatedly allowing it to be shared and made public.”

The FTC set out guidelines that would make sure Facebook’s ability to stay in good standing:

The settlement requires Facebook to take several steps to make sure it lives up to its promises in the future, including by giving consumers clear and prominent notice and obtaining their express consent before sharing their information beyond their privacy settings, by maintaining a comprehensive privacy program to protect consumers’ information, and by obtaining biennial privacy audits from an independent third party.

At the least, it seems that Facebook has violated this settlement. Therefore, it faces potential fines. But it could also face regulatory controls that affect how it handles customer data. This will be expensive, and could potentially cause advertisers to seek other platforms.

Facebook’s value

Hence Facebook has lost well over $100 billion in market capitalization since the scandal hit. The company was down another 5% today to $152.22 from a record high in early February over $190 a share. That has Facebook trading for about 18 times trailing twelve-month cash flow from operations of $24 billion.

By comparison, Apple trades at only 13 times TTM cash flow and Google trades for 21x cash flow. Amazon trades for a gargantuan 40x trailing cash flow. The market is essentially valuing Facebook more like Apple or Google than Amazon. And it is treating Facebook more like a normal company than a high octane one. For example, Boeing also trades at 14x trailing cash flows.

How far down can Facebook go? Another comparison is GE. That company has been beaten up and has been setting new multi-year lows. Right now it is trading at about 11 times cash flow of $10.4 billion. If we set Facebook at that level, that’s another 40% downside.

So clearly, Facebook has a lot of incentive to get this problem under control.

Facebook’s problem is not just privacy but controls more generally

What concerns me personally is not just the privacy issue, but also the potentially exploitative nature of micro-targeting. Take a look at this excerpt from a recent Bloomberg Business Week post:

It was a Davos for digital hucksters. One day last June, scammers from around the world gathered for a conference at a renovated 19th century train station in Berlin. All the most popular hustles were there: miracle diet pills, instant muscle builders, brain boosters, male enhancers. The “You Won an iPhone” companies had display booths, and the “Your Computer May Be Infected” folks sent salesmen. Russia was represented by the promoters of a black-mask face peel, and Canada made a showing with bot-infested dating sites.

They’d come to mingle with thousands of affiliate marketers—middlemen who buy online ad space in bulk, run their campaigns, and earn commissions for each sale they generate. Affiliates promote some legitimate businesses, such as Amazon.com Inc. and EBay Inc., but they’re also behind many of the shady and misleading ads that pollute Facebook, Instagram, Twitter, and the rest of the internet.

Scammers on Facebook

The money quote: “They go out and find morons for me.”

Affiliates once had to guess what kind of person might fall for their unsophisticated cons, targeting ads by age, geography, or interests. Now Facebook does that work for them. The social network tracks who clicks on the ad and who buys the pills, then starts targeting others whom its algorithm thinks are likely to buy. Affiliates describe watching their ad campaigns lose money for a few days as Facebook gathers data through trial and error, then seeing the sales take off exponentially. “They go out and find the morons for me,” I was told by an affiliate who sells deceptively priced skin-care creams with fake endorsements from Chelsea Clinton.

So data has leaked to unauthorized third parties like Cambridge Analytica and potentially fourth parties too. But even the third parties with authorized Facebook access are engaged in dodgy practices. And apparently, Facebook so lacks controls that these scammers escape wholly unscathed.

Operating leverage will decrease… and not just at Facebook

It sounds feasible to deal with threats of privacy and unethical advertising through algorithms. But we’re seeing that it just doesn’t work.  The only way to deal with this problem is more human intervention. And that means lower operating leverage. Revenue won’t just fall straight to the bottom line as operations scale. Instead, Facebook will need more staff and more human intervention as it scales.

Moreover, as I wrote last week, the big risk is cross-platform regulation. Facebook itself may be in trouble because Facebook has been saving extensive call and text data made by Android users. But remember, Facebook companies like WhatsApp practically mandate access to mobile users’ contact data. So the data Facebook lacks on one platform is easily filled by the data on another platform. From an advertiser’s perspective, the ability to advertise across Facebook’s platforms is crucial in Facebook getting both higher spend and higher ad rates.

If the regulatory remedy is to set up Chinese walls between Facebook’s individual platforms, Facebook’s business units can’t share data – even in anonymized form. That’s bad for Facebook. It’s also bad for other cross-platform companies like Google, Microsoft, Apple and Amazon.

Is Facebook just a bad actor?

The question everyone is asking now: Is Facebook ethically challenged — a rogue actor. That question’s presumption is that we can trust other companies with our data but that specific remedies need to apply with Facebook.

But look at the fact that Facebook faces a lawsuit over discriminatory housing ads. This is entirely driven by micro-targetting, the ability to advertise to specific user segments at Facebook. Google can do that too. I’m inclined to say that it’s not Facebook that’s the problem. It’s a problem inherent in the micro-targeting advertising business model. And that means eventually there will be a regulatory fix. And that fix will apply to all competitors in this space.

For me, this means the problem is biggest for Facebook and then Google. Apple is not ad dependent, nor is Amazon or Microsoft. And so expect less regulatory risk for those companies.

Facebook users may finally turn their back due to a lack of privacy

As a user, I find myself once again asking myself whether I want to stick with ‘free’ products like Facebook or Gmail. Their revenue stream is based on selling very private, personal data to advertisers and other actors like ‘researchers’ Aleksandr Kogan, who sold the data he collected further on to Cambridge Analytica.

I think there are a lot of people like me out there. And so Facebook faces a crisis of confidence, not just from regulators and its paying clients, advertisers, but also from its ‘product’, its users.