What’s behind Facebook’s slump?

FACEBOOK has reset the growth meter for itself and other social media companies, which are facing changing user tastes and increased regulatory scrutiny in a world following the Cambridge Analytica scandal and Russian meddling in US presidential elections.

In its 2018 second-quarter earnings call on July 25, Facebook warned of decelerating revenue growth “over the next several years,” and of uninspiring trends in its user patronage in the US (flat at 185 million daily active users) and in Europe (down 3 million to 279 million daily users), where strict data privacy rules took effect in May. Facebook lost nearly $120 billion in market capitalization the day it announced its results, bringing down other tech stocks such as Amazon, Twitter and Netflix (although they have since recovered somewhat).

The social networking giant will likely need to reinvent its business model, even as it faces no serious threat to its preeminence in its industry, according to experts from Wharton and elsewhere. Those pressures also will be felt by Facebook’s rivals, including Twitter, they added. In particular, social media companies will find increased costs of regulatory compliance and decreased revenue opportunities from targeted advertising in the European Union with its GDPR (General Data Protection Regulation) rules. CHANGING MARKET EXPECTATIONS The drop in Facebook’s share price (from $217 to $166 before recovering to current levels of $171) “is a consequence of the market resetting prices based on a change in expectations,” said Erik Gordon, clinical assistant professor at the University of Michigan’s Ross School of Business. He noted that Facebook’s operating margins falling from first-quarter levels of 42% to the mid-30s in the coming years is “a huge drop.”

Mr. Gordon saw a related story with Twitter, which last Friday reported in its earnings release that it weeded out a million fake users. “These problems that a couple of the social media companies are having are hitting the bottom line, but are [also] hitting expectations about what these companies will look like in terms of growth and profits going forward,” he said. “And that killed their stock.” Gad Allon, Wharton professor of operations, information and decisions and director of the Jerome Fisher Program in Management & Technology, pointed out that Facebook’s expenses have also increased — they surged 50% year-over-year to $7.4 billion in this year’s second quarter. Some of that has to do with its increased head count on account of the extra policing it is compelled to do after the recent privacy scandals, he said.

Facebook’s employee count grew 47% year-over-year to more than 30,000, and part of that is because it has committed to doubling its safety and security staff to 20,000 by the end of this year. However, that is a thankless effort in some senses, according to Mr. Allon. “While it seems that the overall market or at least the citizen population would like them to continue getting to that [increased safety and security of user accounts], the market is not rewarding them for doing that,” he said

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BUSINESS MODEL CHALLENGES Facebook also faces pressures to change its business model, according to Duke University law professor James Cox. “[Its current] model is to induce people to find a lot of psychological rewards by being on their Facebook account [often],” and to monetize the information that those users generate by selling it to others,

he said. However, users concerned about their privacy “are now disconnecting from Facebook,” which hurts the company’s ability to earn revenues, Mr. Cox said. “At some point, these concerns – not just in Europe and America – are going to have to lead to big changes in Facebook.”

Messrs. Gordon, Allon and Cox discussed the future for Facebook and the social media industry on the Knowledge@Wharton show on Wharton Business Radio on SiriusXM. (Listen to the podcast at the top of this page.)

According to Mr. Cox, Facebook’s problem is that its market is saturated. He pointed out that it already has 2.25 billion users among the 3.5 billion people worldwide that are connected to the internet. “This is the old law of diminishing returns,” he said, noting that it would be more costly than in earlier years for Facebook to add the next million or 100 million users. “Those costs are skyrocketing because of largely political concerns, [which are] driven by concerns over privacy and fake news,” he added. Facebook’s costs in doubling its staff of safety and security personnel “go right to the bottom line,” he added.

Mr. Cox also thought Facebook could be impacted by what he saw as the “beginning of a growing awareness” among people that “it’s not good for their productivity, for their healthy lifestyles, to spend as much time on their phones as they’re spending right now.” He said if that trend gains traction, it could have an even bigger impact than privacy concerns on Facebook’s user base. “There are so many headwinds coming in right now on all the social media platforms that it’s very difficult to speculate about whether [these companies] will be the darlings six months or even a year from now that they have been….”

According to Mr. Gordon, a fundamental shift may be occurring in Facebook’s appeal to the younger generation. “Their tastes have changed. They actually associate Facebook with people my age – their parents,” he said. He has noticed changes in how young people use Facebook. Two years earlier, his students felt the need to be constantly checking their social media accounts, he said. “[Now], I don’t think they check as often. It turns out that they’re still on Facebook and they check it once in a while as a defensive measure – to make sure nothing bad was said that they don’t know about…. That’s the bad news for Facebook. The good news is they love Instagram.”

Mr. Allon pointed to China’s WeChat as a model for the future. “WeChat is a combination– it is a little bit of WhatsApp, a little bit of Instagram, and all of them together in small communities,” he said. “Maybe that’s where we are going, where we have smaller communities, slightly more civilized, slightly more community-based, more a reflection of offline communities rather than online communities. If you’re going to break Facebook, the competitor is not Twitter; it’s WeChat.”

EXTRACTING VALUE FROM INSTAGRAM, REGULATION

Mr. Allon pointed out that it is important to separate “Facebook the stock from Facebook the product and the firm.” Facebook the firm owns Instagram, and the company benefits overall if users flee from Facebook to Instagram, which currently has only a billion users, he added.

Mr. Gordon noted that Facebook of late has tried to boost advertising on Instagram, even as it earns less revenue from that than on its own site. But he was bullish longer term for Instagram. “You might see a dip [in advertising revenues] this quarter and maybe for a few quarters, but an investment in what might be more of a growth vehicle for Facebook going forward – Instagram.”

Contrary to conventional wisdom, Facebook may also be able to extract a competitive advantage from its investments in securing the privacy of its user base, according to Mr. Allon. He noted that for example, new entrants in social media cannot afford to hire 20,000 people to manage the security and privacy of their users’ data. Facebook could use that to its advantage. “They’re creating essentially a defensive mechanism,” he said. “If you’re a new entrant, you cannot handle GDPR the same way [Facebook] can, or Google can. All of these regulation changes and political pressures in the long run will benefit them unless people flee social networks completely. But in this case they may flee to one of the other firms.”

Mr. Gordon agreed with Mr. Allon about Facebook’s opportunity to use its regulatory compliance as a competitive moat. “Regulation is often liked by big incumbents as creating entry barriers,” he said. “Entrepreneurs – the innovators – often hate the regulatory burden. Regulation, which initially looks like it’s going to hurt you, might actually help you.”

Mr. Cox also felt that Facebook could pursue regulatory compliance activities “to be able to maximize its own value.” He also expected the company to play a big role in shaping the legislation governing its industry. “In a big way, that’s going to benefit it and probably harm competitors.”