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Tuesday, August 25, 2015

Do Not Underestimate The Legal Risks Of Facebook



Facebook (FB) operates under two distinct entities, Facebook USA, which oversees users from the US and Canada and, Facebook Ireland, which deals with users from Europe and the rest of the world. As many of you should know, Facebook does not respect the rights to privacy and data protection of its users. 

While Facebook Ireland falls under EU law, Max Schrems, an Austrian citizen, decided to sue the Ireland entity to protect the fundamental rights of EU citizens. Besides the altruism move, I do believe it put Facebook business at stake. In fact, the class action lawsuit could meaningfully impact Facebook revenues outside of the US and Canada because it will affect the business practices of collecting data and selling ads. It could literally lose "billions" in the case. In this article, I'm going to explain you why you should take into account that legal risk in your investment thesis.



"If it is free, you are the product"

Facebook business is based on its users and the data collected to sell ads. By doing that, the company generates impressive advertising revenues ($3.83 billion last quarter). Therefore, the tracking activity of its users is of utmost importance. Indeed Facebook can command higher prices to advertise on its network thanks to high data collection. But what could happen to the company top line if the business model is meaningfully impacted by a decision from the EU authorities to apply EU law regarding data protection and privacy? Let's have a look at some numbers.

Last quarter, the company generated total revenues of $4.04 billion, of which $2.075 billion came from Europe, Asia and Rest of World (for simplicity's take, we rename it as Rest of World). That's an impressive 51% of total sales. Daily Active Users (DAUs) from Rest of World amounted to 805 million, which represents 83% of total DAU. While the company generated more revenues per user in the US and Canada at the moment, RoW will represent an increasing size in the future. In fact, the US and Canada region is already saturated in terms of user growth. Future growth will have to come from RoW in order to sustain sales' growth and high multiples.

Potential damage and risk factors

The class action itself represents a drop in the ocean in terms of indemnity. Indeed the plaintiff claims an amount of €500 per participant (25,000), which amounts to €12.5 million. This is clearly peanuts in comparison to Facebook cash position of $14 billion. However, that's not the point. The problem lies elsewhere.

If EU authorities rule against the social network, the company will have to change its business practices regarding data collection. As 51% of total revenues fall under Facebook Ireland, the company could be well damaged. Future growth would disappear and the business prospects would appear darker than ever. Even if Facebook continues to capitalize on its users from the US and Canada to grow the business, the financial pain will be immediate for shareholders, as the RoW would be much more complicated to monetize due to stricter rules to protect privacy and personal data. Now, it is impossible to determine what could be the potential impact in terms of dollars. Will advertising revenues decrease by 10% or 50%? Honestly, I don't know. Nevertheless, Facebook's risk factors give us some hints. In Q2 2015 results, the company states:

"We are involved in numerous class action lawsuits and other litigation matters that are expensive and time consuming, and, if resolved adversely, could harm our business, financial condition, or results of operations".

"We have been subject to regulatory investigations and settlements and we expect to continue to be subject to such proceedings and other inquires in the future, which could cause us to incur substantial costs or require us to change our business practices in a manner materially adverse to our business".

"Our business is subject to complex and evolving U.S. and foreign laws and regulations regarding privacy, data protection, and other matters. Many of these laws and regulations are subject to change and uncertain interpretation, and could result in claims, changes to our business practices, monetary penalties, increased cost of operations, or declines in user growth or engagement, or otherwise harm our business".

"We generate substantially all of our revenue from advertising. The loss of marketers, or reduction in spending by marketers with Facebook, could seriously harm our business".

Obviously, a hammered company appears less appealing to potential marketers. If the EU authorities step in, the company will suffer from a loss of reputation, at least in Europe. As an advertiser you don't want your name attached to this kind of bad exposure. Moreover, it might prove difficult for the social network to target its users as effectively as it did before with ads, due to new regulations regarding data protection and privacy. Therefore, I could not imagine that advertisers will stick to Facebook. The financial harms could be meaningful even with a slight change to business practices.

Aside from the class action lawsuit, the company currently faces a lawsuit from Belgian regulator. Going into the future, it is easy to understand that Facebook will face more and more scrutiny from regulators. As a result, business practices will have to adapt to meet regulators guidelines. As new guidelines mean stricter rules, it will impact considerably the advertising business. As advertising accounted for 94% of total revenues in 2015, it is easy to see the financial pain coming. Therefore, the company must diversify its revenue stream accordingly. One way to do that would be to go head to head with Linkedin (LNKD) and Pulse+ from Jive Software (JIVE) in the enterprise space. Enterprise are generally more receptive to pay for a service than consumers. In my opinion, Facebook at Work is a step in the right direction and will become a major source of revenues in the future.

Conclusion

Facebook's legal risk should not be underestimated by any investors willing to put money into the stock. While the class action lawsuit has been rejected by the Vienna regional court on "not admissible procedural grounds", it will take a raincheck. In my opinion, Facebook's business practices will have to change in the future to respect the EU law. As a result, it could be disastrous for the company, if it does not adapt to new regulations. With the current market sentiment being very low, investors should be careful before betting on a company's future, which is already highly priced at $86.

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