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Facebook shares are down 20%, but investors aren't focused on the key issue

CNBC logo CNBC 7/31/2018 Timothy Seymour and Ryan Dodd

  • Almost a week after Facebook reported second quarter earnings, when it lowered its outlook on revenue and raised its forecast for expenses, the stock is still down 20 percent.
  • The Facebook discussion should be about corporate governance, specifically poor disclosure by management.
  • Facebook users are losing trust in the brand based on how Facebook manages its data. This is a problem that may not go away

Facebook founder and CEO Mark Zuckerberg© Provided by CNBC Facebook founder and CEO Mark Zuckerberg

Almost a week after Facebook reported second quarter earnings, when it lowered its outlook on revenue and raised its forecast for expenses, the stock is still down 20 percent. Nearly $120 billion in market value has been wiped away. And while slower revenue and higher costs are fundamental concerns for any company, investors are focused on the wrong issues here.

The Facebook discussion should be about corporate governance, specifically poor disclosure by management. The stock has been re-rated because management has been unable to articulate the "cost of production" of the company's primary product, personal data.

Investors are reminded that Facebook is not a platform, or a "community of sharing." Facebook is a data broker, and the costs related to procuring, managing and securing data are very different than those of hiring coders and programmers for a centralized platform.

Since inception, Facebook has been telling the market that its business model is an advertising platform unique in scale, precision targeting and number of views. Based on this story from the company, investors would believe that its primary capital spending, or "cost of production," include the cost to hire enough coders and engineers to keep pace with the growth of the platform and the cost of maintaining enough server capacity to support it.

The recent earnings call, however, and Congressional testimony by founder and CEO Mark Zuckerberg, revealed something different about Facebook's actual costs of production and why the company will face profit challenges long into the future.

In both instances, Zuckerberg said nothing about the need to hire new coders or to invest in new server capacity. Instead, he spoke of investments in security and privacy. Note: If the market ignored his warnings in Congress weeks ago, they started to sink in during last week's earnings call.

Investments in privacy and security are significant enough to affect sales growth in future quarters. How is that possible for a "platform" company? Corporate cyber security budgets —including the cost of data loss protection — are typically only a fraction of annual revenue.

Facebook's product is not a "platform for communities." Creating an online community is simply a feature to help cheaply extract more of their core asset: data (specifically, your personal data, including personality traits, habits and activities). We believe the potential for long-term decline in value is at stake because Facebook leadership has not been clear in disclosing this fact to the market.

Instead, the company's "your personal data is our primary asset" business model has become apparent in the wake of embarrassing scandals revealing the misuse of Facebook's core product.

The big reveal in the earnings announcement was not the "below expectations" growth rates. It was why the company expected a slowdown: The Facebook brand has taken a hit due to governance scandals it is still trying to figure out how to manage.

Facebook users are losing trust in the brand based on how Facebook manages its data. This is a problem that may not go away. Data is the new oil for the 21st century, and with Facebook, investors are seeing what happens when it is mismanaged.

Ultimately as investors we know that significant market value for any company is imputed from the perception of management quality, which is a function of many things including vision, execution and governance. Investors should ask themselves: How would you rank Facebook now versus a week ago?

Timothy Seymour is a CNBC contributor and the CIO of Seymour Asset Management. Ryan Dodd is CEO, Founder of Cyber Hedge.

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