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The privacy issue for tech companies

17 May 2019

No news or research item is a personal recommendation to deal. All investments can fall as well as rise in value so you could get back less than you invest.

Privacy is the biggest cloud hanging over tech companies. And it’s not going anywhere soon. But does that mean investors should be put off?

We look at how the issue impacts two of the world’s biggest companies.

Facebook

Facebook has drawn the most fire on the privacy front, as investors discovered to their cost last year.

The Cambridge Analytica scandal and a significant data leak in September meant 2018 was a difficult year, even before you factor in the impact of a strategic review in July that saw earnings forecasts slashed.

While it’s easy to focus on the negatives, the numbers suggest Facebook isn’t losing its touch.

Google data shows the searches for Facebook’s privacy settings are falling over time, albeit with a couple of spikes. This tallies with the fact active user numbers are rising everywhere. The group’s average revenue per user is increasing too, a sign Facebook’s pricing power over advertisers is as strong as ever.

But there are still challenges around.

Facebook has helped people connect with friends, communities, and interests in the digital equivalent of a town square. But increasingly we also want to connect privately in the equivalent of the living room.

Private messaging and small groups are by far the fastest growing areas of online communication. In time, Zuckerberg thinks these type of interactions will become even more important than today’s open platforms.

So Facebook has adopted a new strategy – shifting focus onto things like the Stories video sharing service, rather than traditional wall-based user interaction. And it isn’t stopping there. The WhatsApp and Messenger services, both of which have been growing in popularity, will be central to the group’s future.

Doing more of what your users want is clearly sensible (all else being equal), but it’s not a one-way bet.

While traditional public social networks are a perfect canvas for advertisers, as things stand, messaging and video content is harder to monetise. How do you advertise effectively when the content of messages is encrypted? Facebook is exploring using AI and chatbots to enable companies to better interact with potential customers via Messenger. Initial results from partnerships such as that with LEGO have been positive, but it remains early days.

There are also extra costs to contend with, such as setting up extra servers. That means revenue and profits will be lower than analysts had hoped for a year or so ago.

However, there are still reasons for optimism. The public business remains a major draw for advertisers – which means it’s the pace of growth, not growth itself that’s under question.

Analysts still expect operating profits to rise by close to 50% by 2021. Facebook’s total active users continues to rise, and with average revenue per user in Asia trailing behind that of Europe and the US, there’s exciting potential to increase profits in emerging economies too. This continued progress should relieve pressure on Facebook to deliver transformational change immediately.

Facebook earnings before interest and tax ($bn)

Scroll across to see the full chart.

Past performance isn't a guide to the future. Source: Thomson Reuters Eikon, 7 May 2019.

Investors can also take comfort in the fact the group has shown excellent judgment in the past, and we can’t think of a company better placed to manage the transition.

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Alphabet

Alphabet is another with data at its core. And, also like Facebook, it hasn’t always been a smooth ride for investors.

Alphabet was fined €50m for breaking data laws in January this year. The fine focused on two infringements – making it too difficult to find out the terms around its data use, and enabling targeted ads without a user’s specific consent.

That figure looks like pocket change compared to the £3.8bn penalty it racked up for abusing its dominant market position. But it’s potentially more significant because further data breaches could see the EU levy penalties as much as 4% of Google’s turnover, which was over $136bn last year. Clearly, toeing the line is required from here on.

While the reams of data crossing Alphabet’s bows mean regulators have a close eye on it, this is precisely what makes the company so attractive to investors.

As we spend more and more time online, the internet becomes an ever more important resource for advertisers. Google controls what appears where in a search and can offer bespoke advertising space. Customers are happy to pay – after all, Google is so dominant in its space it's commonly used as a verb.

That means we think the core business is in good shape, while the more speculative pipeline of future projects, which includes biotech companies Verily and Calico, as well as driverless cars unit Waymo, looks promising too.

The group’s valuation currently sits at 24.8 times expected earnings.

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A connected party of the author holds shares in Alphabet.

Unless otherwise stated estimates, including prospective yields, are a consensus of analyst forecasts provided by Thomson Reuters. These estimates are not a reliable indicator of future performance. Yields are variable and not guaranteed. Past performance is not a guide to the future. Investments rise and fall in value so investors could make a loss.

This article is not advice or a recommendation to buy, sell or hold any investment. No view is given on the present or future value or price of any investment, and investors should form their own view on any proposed investment. This article has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is considered a marketing communication. Non-independent research is not subject to FCA rules prohibiting dealing ahead of research, however HL has put controls in place (including dealing restrictions, physical and information barriers) to manage potential conflicts of interest presented by such dealing. Please see our full non-independent research disclosure for more information.

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Investment notes
No news or research item is a personal recommendation to deal. All investments can fall as well as rise in value so you could get back less than you invest.
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