Facebook stock fell 19% Investors call for Zukerberg firing

After all the controversy Facebook In. has generated in recent months, it was inevitable that, at some point, the social media giant would get the reality check it had coming. The July 25 disappointing earnings report and the July 26^th historic19% stock price fall appeared to be fitting conclusion to a difficult first half of 2018 for Facebook. To add to this Facebook has been sued by a shareholder for misleading the investor community.

What has hit Facebook?

Facebook Inc and its chief executive Mark Zuckerberg were sued on July 27 in what could be the first of many lawsuits over a disappointing earnings announcement by the social media company that wiped out about $120 billion of shareholder wealth.

The complaint filed by shareholder James Kacouris in Manhattan federal court accused Facebook, Zuckerberg and Chief Financial Officer David Wehner of making misleading statements about or failing to disclose slowing revenue growth, falling operating margins, and declines in active users.

Kacouris said the marketplace was “shocked” when “the truth” began to emerge on July 25 from the Menlo Park, California-based Company. He said the 19 percent plunge in Facebook shares the next day stemmed from federal securities law violations by the defendants. The lawsuit seeks class-action status and unspecified damages. Shareholders often sue companies in the United States after unexpected stock price declines, especially if the loss of wealth is large.

Facebook is already facing dozens of lawsuits over its handling of user data in a scandal also concerning the U.K. firm Cambridge Analytica. Many have been consolidated in the federal court in San Francisco. The July 26 plunge also hit Zuckerberg’s own wallet. Zuckerberg had been tied with Warren Buffett as the world’s fourth-richest person, but the Berkshire Hathaway Inc chairman’s current $83 billion fortune now tops Zuckerberg’s $66 billion, Forbes magazine said. Buffett now ranks third among the world’s billionaires, while Zuckerberg is sixth.

Considering how things stand now, Zuckerberg must consider himself lucky to be the sixth richest person in the world.

Why is this a bad time for Facebook?

Facebook’s stock price took a massive tumble this week after the company’s latest quarterly earnings revealed stagnating user growth in key markets and rising costs associated with tackling misinformation, election interference, and privacy issues. More than $118bn was wiped off the company’s market value and Mark Zuckerberg’s fortune took a hit of $16bn after the company announced its financial results for the second quarter of 2018, the company’s first full quarter since the Cambridge Analytica scandal broke.

The core problem appears to be decelerating revenue growth, fuelled by user base stagnation in Europe and the US, where Facebook makes the bulk of its advertising revenue. During the earnings call the company revealed that growth would continue to slow down throughout the second half of 2018, moving the company from a long period of “hyper-growth” (more than 40% year on year) to just high growth.

“We expect our revenue growth rates to decline by high single-digit percentages from prior quarters sequentially in both Q3 and Q4,” said the company’s chief financial officer, David Wehner. “It’s usually a slow progression going from hyper-growth to just growth. In this case, it’s a step function down. That’s why you are seeing more of an overreaction,” said Loup Ventures’ Gene Munster.

To a certain extent, this is also because of the Cambridge Analytica scandal. The platform’s investment in security on the platform, including tackling election interference, misinformation, and privacy problems is a major contributor to rising costs. Facebook’s privacy practices came under the microscope after the Observer revealed in March that the data firm Cambridge Analytica inappropriately obtained millions of users’ data without their permission. However, Facebook ramped up spending after 2016 US presidential election and has been warning about how that would affect profitability since November 2017 – well before the key Cambridge Analytica revelations in March this year.

Lynnette Luna, the principal analyst at GlobalData, put it down to an “amalgamation of weird things happening at the same time”. She noted that in addition to the slower growth and bad publicity over the last 18 months, Europe’s General Data Protection Regulation, was a significant factor, contributing to a drop of 3 million users between Q1 and Q2. “It’s an unfortunate market condition,” she said.

It’s the biggest ever one-day drop in a company’s market value, falling from a record high of $619bn on July 25 to just $501bn in early trading on July 26. However, the company’s valuation is still higher than it was after the US Federal Trade Commission confirmed it was investigating the company over its privacy practices following the Cambridge Analytica revelations.

When does Facebook seem to be in trouble?

What went wrong, and how much Facebook, its stockholders and the rest of the technology industry need to worry about the company that has been the biggest success in tech in the last decade. Here are four possible explanations for what happened, and how bad it is for Facebook:

A communications breakdown: This idea, articulated by Bloomberg analyst Jonathan Ferro, is that what happened on July 25 was a failure to adequately flag warning signs to Facebook investors. The explanations Facebook gave for an expected slowdown in revenue growth later this year — a drag from fluctuations in foreign currency rates, a shift in priorities to newer types of internet activity that generate relatively lower ad sales, and decisions to be less invasive in harnessing information about users — seemed to come mostly out of the blue. Sure, Facebook had been saying it’s hitting the gas on Stories, the photo-and-video diary formats for the social network and Instagram. Currency swings aren’t necessarily predictable, and CEO Mark Zuckerberg had been saying that changes to limit the mindless use of Facebook could hurt business. But the company wasn’t explicit before on the possible scale of impact from the changes it is intentionally making to its Internet hangouts. If the company could predict this, then management failed to properly set investors’ expectations.

Investors didn’t take Facebook’s hints: While investors could justifiably claim surprise at the forecast of a growth slowdown, perhaps they shouldn’t have been surprised about squeezed profit margins. The company has been saying for months that it was increasing spending drastically for a range of priorities, including hiring more people and devoting more technical resources to prevent its digital hangouts from being overrun by misinformation, politically motivated propaganda and incitements to violence. Facebook is also doubling down on programming for its web video services and for its global network of computer data centers. The company forecast that its operating costs would increase by as much as 60 percent this year compared with 2017, although analysts tended to dismiss that forecast as too high. It now looks as though that estimate won’t be far off. To defend investors, however, perhaps the most alarming thing in Facebook’s litany of alarms was a prediction of a sharp pinch on profit margins for the foreseeable future. The company forecast operating profit margins somewhere near 35 percent over the next several years. That is a stunning deceleration both from recent history — that margin was 45 percent in the first half of 2018 — and from investors’ expectations of profit margins around 44 percent in 2019 and 2020.

Facebook is being intentionally overcautious: Facebook is the boy who cried wolf on financial issues. Nearly two years ago, the company sparked a mini-panic when it cautioned that its revenue growth rate would “meaningfully” slow around mid-2017 because Facebook couldn’t keep shoving more advertisements into its social network. Investors worried for more than a year about those words. In the end, the growth rate barely ticked down by late 2017. It’s possible that Facebook on July 25 was again lowering the financial bar nearly all the way to the ground so it can easily surpass its own forecasts later. That doesn’t feel likely given the range of worrying financial and user metrics, but it’s possible. Michael Nathanson, a stock analyst with MoffettNathanson LLC, also raised the possibility that Facebook is talking down its prospects _“to stave off further regulatory pressure.” *The worse Facebook’s financial results look, the less likely it will be that all those mean politicians and regulatory authorities around the world will try to crack down on Facebook for being too successful and powerful.

Things are going unexpectedly wrong: Many believe Facebook was caught off guard because of the simultaneous deterioration of user growth, particularly in the U.S. and Canada, which generate most of its revenue; in its revenue growth rate and expectations for a further slowdown; and in its profit-margin forecast. Facebook also said the split of ads compared with other types of information on Instagram was nearly the same as that on its main social network. To many, that signals that Facebook was worried about a slowdown it saw in usage or revenue growth on its social network and therefore significantly stepped up the number of ads on the young and promising photo-and-video app. **That smells like fear.** Plus, Facebook warned about a possible second-quarter decline in the number of users in Europe after a significant change to privacy regulations in that market, but it didn’t predict the flat-lining of user numbers in the U.S. and Canada. That suggests Facebook didn’t see that user stagnation coming, and the company didn’t try to explain it away as the result of intentional decisions to focus on quality over quantity of people’s time on Facebook. Maybe Facebook is doing exactly what it’s been telling us for many months: The company is spending more and changing its priorities, to ensure its digital hangouts are happier and healthier places. Those decisions will be good for the world, and eventually for Facebook’s finances, too.

But many can’t shake off the belief that Facebook saw all this coming, and its pledges about *“ time well spent”* and cleaning up its act were defensive reactions to trends that weren’t obvious to the public until July 25: *Facebook was running out of steam. *

Note: Facebook has continued to adopt the “Time Well Spent” philosophy, removing click-bait news and crappy viral videos that lead to passive internet content consumption that studies say is unhealthy. Instead, Facebook is pushing features like *Watch Party*, where users actively interact with each other. Those might not produce as much time on site and subsequent ad views, but CEO Mark Zuckerberg said the changes are *“positive and we’re going to continue in this direction.”*

Where do hope and fear come from?

Prepare for the invasion of the unskippable. If the Stories social media slideshow format is the future of mobile TV, it’s going to end up with commercials. Users won’t love them. And done wrong they could pester people away from spending so much time watching what friends do day-to-day. But there’s no way Facebook and its family of apps will keep letting us fast-forward past Stories ads just a split-second after they appear on our screens.

We’re on the cusp of the shift to Stories. Facebook estimates that across social media apps, sharing with Stories will surpass sharing through feeds sometime in 2019. One big reason is they don’t take a ton of thought to create. Hold up your phone, shoot a photo or short video and you’ve instantly got immersive, eye-catching, full-screen content. And you never had to think.

Unlike text, which requires pre-meditated reflection that can be daunting to some, Stories are point and shoot. They don’t even require a caption. Sure, if you’re witty or artistic you can embellish them with all sorts of commentary and creativity. They can be a way to project your inner monologue over the outside world. But the base level of effort necessary to make a Story is arguably less than sharing a status update. That’s helped Storie's rocket to more than 1.3 billion daily users across Facebook’s apps and Snapchat.

The problem, at least for Facebook, is that monetizing the News Feed with status-style ads was a lot more straightforward. Those ads, which have fueled Facebook’s ascent to earning $13 billion in revenue and $5 billion in profit per quarter, were ostensibly old-school banners. Text, tiny photo, and a link. Advertisers have grown accustomed to them over 20 years of practice. Even small businesses on a tight budget could make these ads. And it at least took users a second to scroll past them — just long enough to make them occasionally effective at implanting a brand or tempting a click.

Stories, and Stories ads are fundamentally different. They require big, tantalizing photos at a minimum or preferably stylish video that lasts five to 15 seconds. That’s a huge upward creative leap for advertisers to make, particularly small businesses that’ll have trouble shooting that polished content themselves. Rather than displaying a splayed out preview of a link, users typically have to swipe up or tap a smaller section of a Story ad to click through.

And Stories are inherently skippable.

Users have learned to rapidly tap to progress slide by slide through friends’ Stories, especially when racing through those with too many posts or that come from more distant acquaintances. People are quick with the trigger finger the moment they’re bored, especially if it’s with an ad.

A new type of ad blindness has emerged. Instead of our eyes glazing over as we scroll past, we stare intensely searching for the slightest hint that something isn’t worth our time and should be skipped. A brand name, “sponsored” label, stilted product shot or anything that looks asocial leads us to instantly tap past.

This is why Facebook COO Sheryl Sandberg scared the hell out of investors on the brutal earnings call when she admitted about Stories that, “The question is, will this monetize at the same rate as News Feed? And we honestly don’t know.” It’s a radically new format advertiser will need time to adapt and perfect. Facebook had spent the past year warning that revenue growth would decelerate as it ran out of News Feed ad inventory, but it’d never stressed the danger as what it was: Stories.

That contributed to its record-breaking $120 billion share price drop.

By making some Stories ads unskippable, Facebook’s apps could charge more while making them more impactful for advertisers. It would also reduce the creative pressure on businesses because they won’t be forced to make that first split-second so flashy so people don’t fast-forward. Employing unskippable ads could also create an incentive for people to pay for a hypothetical ad-free Facebook Premium subscription in the future.

If Facebook makes the Stories ad format work, it has a bright future that contrasts with the doomsday vibes conjured by its share price plummet. Facebook has more than 5X more (duplicated) Stories users across its apps than its nearest competitor Snapchat. The social giant sees libraries full of Stories created each day waiting to be monetized.

Who else is having a tough time?

It’s not just Facebook, Twitter too is experiencing a slowdown.

Twitter shares have closed down more than 20% after the messaging platform reported a fall, inactive users. User numbers fell to 335 million in the second quarter of the year, down one million from the previous three months.

During the quarter Twitter deleted many fake accounts - a move that chief executive Jack Dorsey said was reflected in the results. The slide to just under $35 a share came despite Twitter reporting record quarterly profits.

It posted a profit of $100m, marking Twitter's third consecutive quarter in profits, with sales up 24% to a better-than-expected $711m. "Our second-quarter results reflect the work we're doing to ensure more people get value from Twitter every day," Dorsey said. "We want people to feel safe freely expressing themselves and have launched new tools to address problem behaviors that distort and distract from the public conversation."

Tech firms have been under pressure in several countries to be stricter over abusive content and misinformation, or "fake news", as well as political influence and protection of personal data. Dorsey later told an investor call the company had used machine-learning tools to identify and remove "bad conduct, not just bad content" from the social media channel. "We don't think the work will ever be done. It doesn't have an end point," he said.

Twitter recently removed or suspended a number of accounts, which the firm said was one reason behind the fall in active users in the second quarter. The company said it expected user numbers to continue to fall in the third quarter.

How does the way forward look for Facebook?

The reckoning has finally happened for the social media giant. The July 25 disappointing earnings report and the July 26 historic 19 percent stock drop appeared to be a fitting conclusion to an easy narrative.

But the story isn’t that simple. Yes, the privacy protections the company put in place after a series of scandals played a role in the dismal earnings. But the company’s bigger problem is that the main social network — the invention that made it a corporate behemoth — simply can’t grow much more. And the new dollars Facebook will mint in the next few years will have to come from businesses that are less certain, like ads in chat applications, virtual reality, television-like video content and social media updates that disappear.

Facebook’s winning strategy has centered on advertising in its news feed. People come to the social network, scroll through, and see the ads for their friends’ baby photos and news links. Whenever Facebook needed to make more money, it just dialed up the frequency of ads, or aggressively courted more and more people around the world to sign up for Facebook. But there are now 2.23 billion people using Facebook. That’s two-thirds of the world’s Internet-connected population. That’s about the same size as Christianity. Who else can the company sign up?

It doesn’t help that some of the folks who do use Facebook are mad at the company for its various lapses on data privacy and content moderation. The social network’s user growth in the second quarter was its slowest ever, and flat in North America. It lost some users in Europe. Meanwhile, it stopped cramming more ads into the newsfeed. Too many ads and people will be turned away. The only place Facebook can replicate its tried-and-true business model is its photo-sharing application Instagram, which also has a kind of news feed. The rest is still an experiment.

Another one of the fastest-growing Internet companies, Netflix Inc., has given investors a scare that the ride is coming to an end. The owner of the world's largest paid online TV network reported slower subscriber growth in the second quarter, and the company's stock has fallen nearly 10 percent since last week. As with Facebook, investors will need to decide if this is a short-term blip or a sign of a long-term problem. Netflix is coming off its best year of subscriber additions yet, but growth at home has slowed.

The transition to new lines of revenue didn’t have to be this dramatic for Facebook. The company acquired WhatsApp for $22 billion in 2014 and spun off its own chat app, Messenger, the same year. For years it told Wall Street it was just waiting for the right time to make money off of these properties. Zuckerberg said the company could afford to be patient until those apps reached 1 billion users. Now they are well beyond that level, but Zuckerberg says the company is still experimenting with potential business models.

All that puts Facebook under pressure because all these new initiatives “frankly aren’t big enough over the short and medium term to alter the decelerating growth,” Eric Sheridan, an analyst at UBS, wrote in an investor note. Investors have to decide how long Facebook should be given the benefit of the doubt.

The road to new business models involves another thing investors hate: narrower margins. A lot of the ways Facebook will make money in the future are more expensive, curbing profitability. Making virtual reality headsets involves manufacturing hardware and, in some cases, selling it at a loss in order to entice customers to a new product. Making a new kind of internet television has already cost Facebook hundreds of millions of dollars in content deals. And in the long term, Facebook plans to split the resulting advertising revenue with the content creators.

There’s also the cost of cleaning up Facebook’s problems.

The company is hiring thousands of people to work on investigating issues with fake news and foreign interference in national elections. And it’s investing in expensive engineers to build an artificial intelligence that can streamline that work in the future. “In light of increased investment in security, we could choose to decrease our investment in new product areas,’’ Zuckerberg said on the July 25 call with investors. “But we’re not going to, because that wouldn’t be the right way to serve our community and because we run this company for the long term, not for the next quarter.’’

Operating margins will trend in the 30 percent range, Facebook said, compared to the more than 40 percent investors had gotten used to. Facebook also said the company’s revenue was going to be impacted in part because it’s giving users more control over their privacy settings. Its advertising engine depends on user data to accurately target people with what they might be interested in. The company is rolling out stronger controls to users in light of Europe’s General Data Protection Regulation (GDPR), which went into effect during the quarter. But that’s not the biggest factor. Zuckerberg said that the vast majority of users actually didn’t take Facebook up on its offer to use less of their data.

Facebook is known for its obsession with growing at all costs. But maybe it’s been too good at what it set out to do. Now that it’s reached a saturation point in the world, it’s having trouble grappling with the responsibility that comes with such a size, and also with the prospects for its future. That’s opened up the company to more risks than Wall Street was bargaining for, said Brian Wieser, an analyst at Pivotal Research, in a note to investors. “The company has not managed its growth as well as most of us thought,’’ Wieser wrote.