Facebook's Dirty Little Secret
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Facebook unquestionably has fake accounts. Even they admit it.
We believe the company reports far more accounts than actually exist.
Investors are being asked to believe that roughly half the world's eligible population use the platform daily. We say that doesn't pass the smell test.
We merely raise this concern because it is an unseen risk. But if we are even partially right, the stock has significant downside.
Facebook (NASDAQ:FB) surprised many investors by not only attracting advertisers but doing it to the point where it sits atop the world as an advertising story for the ages.
That is both its strength and its weakness.
Facebook stock will experience occasional periods of weakness as advertising revenue declines in certain situations, such as a recession, which are not likely to jeopardize its long-term value.
That's not what concerns us as much as the ultimate black box that is Facebook's Dirty Little Secret.
That is, just how many fake users are there, when will we learn just how many there are, and what happens should this come to pass. Because we think there are a lot of fake users - more than Facebook claims - and advertisers don't recognize how bad it is.
Since advertising is 98% of Facebook's revenue, this creates significant risk that we think investors are not considering.
Who Is Real and Who Isn't?
Let's first get to reported metrics for the user base, as reported in the latest 10-K:
Daily Active Users (DAU) were 1.66 billion on average for December 2019. Monthly Active Users (MAU) were 2.5 billion.
Facebook addresses what it calls "duplicate" and "false accounts" in its 10-K (Page 4).
"In the fourth quarter of 2019, we estimated that duplicate accounts may have represented approximately 11% of our worldwide MAUs…false accounts may have represented approximately 5% of our worldwide MAUs."
Yet, Facebook also admits to investors that measuring fake accounts is difficult, and their estimates may not only be wrong but far worse:
"Our estimates also may change as our methodologies evolve, including through the application of new data signals or technologies or product changes that may allow us to identify previously undetected duplicate or false accounts and may improve our ability to evaluate a broader population of our users.
Duplicate and false accounts are very difficult to measure at our scale, and it is possible that the actual number of duplicate and false accounts may vary significantly from our estimates."
So, we're looking at 16% of accounts alone being potentially fake, although those are factored into the reported numbers.
The Financial Times points out that even Facebook's estimate methodology is a black box. There is no third-party auditor to check their work:
"Users and advertisers complain that Facebook does not offer the same sort of insights about itself.
In most industries - from financial services to oil and gas - independent auditors ensure that the assets the company holds are accounted for. But technology companies whose business models are built on gathering user data consider themselves an exception, citing privacy concerns and the technical difficulty of allowing others to look under the hood.
The way Facebook identifies fake and duplicate account numbers, for example, is not explained in detail.
There may be overlap.
All the company will say is that it involves an internal review of a limited sample of accounts and "significant judgment".
So, the first question that you, as an investor, should ask is "Does Facebook itself have any idea of the true numbers considering they have admitted their estimates may be off?"
That question creates additional risk in our minds.
From the same FT article:
"Exactly how many fake accounts Facebook has is open to debate. Mr Zuckerberg's former Harvard classmate Aaron Greenspan believes up to half are fake.
Giving evidence to a British parliamentary subcommittee on disinformation in June he called the company a black box.
"We routinely hear that Facebook has over 2bn users and I think that is not true," he says."
Greenspan may be biased, but this does suggest that investors at least do a rough "reality check".
So, let's do that.
Facebook claims its MAU is 2.5 billion. The world population is 7.77 billion. China, Iran, and North Korea block Facebook. That removes 1.38 billion, 81 million, and 26 million people, respectively, from the total, or 1.55 billion.
So, the total possible number declines to 6.22 billion.
8.8% of the world's population is over age 65. We'll assume a proportional distribution across the remaining countries and Facebook demographics, which means 4.4% do not have Facebook, or 270 million.
26% of the world's population is under age 15. 5.6% of Facebook's users are in that demographic, so we assume 20% of the remaining world demographic can be subtracted from the possible total.
That's another 1.2 billion removed.
The total number of actually eligible Facebook users is thus a hair over 4.75 billion.
Do You Believe?
So, Facebook wants investors and advertisers to believe that 2.5 billion of the 4.75 billion eligible users, or 52%, are monthly average users.
Facebook wants investors and advertisers to believe that 1.66 billion of the total, or almost one-third, are daily average users. So, we throw the question back to investors: do you really believe that a third of the world's possible population uses Facebook every single day?
And that half of them use it monthly?
We doubt these percentages. They seem almost impossibly high.
Yet, even if our own calculations are wildly off-base, even if we are only partially correct, advertisers are not reaching the number of eyeballs they think they are.
That's the reality check.
This alone introduces risk that most investors, we believe, have not factored into their valuation.
Suppose Facebook is completely wrong with its estimates and there are nowhere near as many users as they believe.
A quick and dirty calculation would suggest that, on a DAU basis and $70 billion in FY19 revenue, proportional revenue would decline by $420 million for every 10 million users that are not real.
That is, for every 0.6% additional fake accounts, that's a risk to $420 million in revenue.
Mind you, this might be true even if our reality check is completely wrong. Now, we're just focusing on missed fake accounts.
Net margins are 26%, so net income falls by $109 million for each 10 million users that are not real.
Let's just take Mr. Greenspan's claim that half of users aren't real. Facebook's net income would fall to $9.2 billion.
Based on Wednesday's market cap of $445 billion, the P/E ratio rises from 24x to 48x.
Suddenly, FB stock isn't so attractive at this market cap. Yet that would not be the only downside.
What matters is when and if advertisers finally wake up to this possibility.
Does a whistleblower step forward?
Does FB finally hire a third-party auditor who breaks the bad news?
Advertisers have a herd mentality. They tend to chase what's hot.
Facebook is hot. If you are an advertiser, you will have to answer to your boss (and that boss to his boss) if you decide not to put any spend into Facebook (or Google (NASDAQ:GOOG) (NASDAQ:GOOGL) for that matter).
So, does the dam break?
If it does, you do not want to be standing in the way of the ensuing flood.
What happens is a complete loss of credibility for Facebook. Every advertiser who thought they were getting X eyeballs for their money suddenly finds out that they were getting a fraction of that amount.
We think they'd be angry, wouldn't you?
That not only leads to countless loss of advertising dollars but lawsuits. That would crush FB stock's multiple even more.
Could we be wrong? Of course. For all we know, people in banned countries are accessing Facebook. t is certainly possible that, even though these numbers don't pass our reality check, they are entirely accurate. It's certainly possible that advertisers may have factored all of this information into their own calculations about how much they should spend on FB advertising, so as to account for errors.
It's About Risk
All we are proposing here is that there should be heightened scrutiny given to Facebook's claims regarding its number of users. On simply logic alone, we believe the numbers provided are not accurate.
That creates risk. That's what we're here to highlight: RISK.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.