The biggest risk to Facebook (NASDAQ:FB) is that its numbers are a lie. This is a strong statement to start an article off, but it is the truth. As of January 28, we are at the one-year anniversary of my article on YouTube (NASDAQ:GOOG) (NASDAQ:GOOGL) and Facebook where I mentioned freebooting was a serious problem.
If you aren't aware of what freebooting is, freebooting is when a video is downloaded from YouTube and re-uploaded to Facebook using its native video player. The videos are preferred in Facebook's algorithm because FB wants to keep users on its site. Therefore, stolen content is preferred over original content and Facebook is profiting off of it.
Consider the following chart via Duke University. As you can see, the natively uploaded content received about five times the reach as the YouTube video. The first star indicates YouTube views from Facebook, and the second indicates play clicks on Facebook. The policy to keep users on FB is smart, but using stolen content is what makes it wrong.
This latest quarter, Facebook announced that 100 million hours of video per day is watched on its site; 500 million people watch video on FB every day. Much of this content is stolen. In the first quarter of 2015, 725 out of the top 1,000 videos on Facebook were stolen as you can see from the slide below. This amounted to 17 billion total views. Video has been so important to Facebook's results that the term was mentioned 42 times on the conference call, so clearly this is an issue worth reviewing.
I was naïve to think last year that because Facebook was new to video, it just needed time to create the infrastructure to start supporting individual content creators. As a video creator myself, I am passionate about this issue, but was willing to give Facebook a pass because of the programming it takes to create a proper Content ID system like YouTube has. Unfortunately, for me and every other creator, FB has made no effort to stop this freebooting from occurring. This makes Facebook a company that is unsustainable because theft always catches up to the thief. Alphabet already is aware that Facebook is its biggest competitor. There will be a time in the future where Alphabet decides to sue Facebook for its stolen views. I think we are getting closer to that time.
When I first heard about this issue, I was very angry that Facebook would build its new ecosystem off of stolen videos. This is much more difficult to do than encouraging independent creators to come onto its platform. YouTube has already existed for over 10 years, so it is ingrained into potential creators' minds to head to it first to upload a public video. Facebook decided to go the easy/unethical way when it continued to allow stolen content to grow on its platform.
Facebook said in August that it was working on a Content ID system that would prevent this from occurring in the future. I believed Facebook was sincere in its efforts. I was misguided. FB dragging its feet on this change is emblematic of what happens when a content creator flags stolen content on Facebook. Facebook drags its feet and takes the video down after all of the views already occur. The company rakes in the money and doesn't pay the original creator any money. There aren't any consequences for Facebook or the person who uploads the stolen video.
Moving on to what has been happening lately, on November 12, Hank Green wrote a piece on Medium where he expressed his frustration while making the point that he doesn't have the time to sue Facebook. He said that Facebook has a system in place to take down copy-written content from major corporations such as Disney (NYSE:DIS), but doesn't care about individual creators. This lack of care is consistent with its monetization efforts, which only focus on partnering with major content creators. This is because individually each creator is powerless. Hank Green says Facebook doesn't deal with this issue because independent creators won't sue and because it would be difficult to create and monitor a Content ID system.
On November 10, the channel called "In a Nutshell" uploaded a video detailing freebooting. It received 2.6 million views. Its video had been freebooted on Facebook causing it to miss out on thousands of dollars in ad revenues. The "Ethan and Hila" channel uploaded a video that received 700,000 views where he showed Facebook actually refusing to take down his video, which was stolen. The stolen video received three million views. This is how Facebook has been making its money from the expanded video initiative it has unveiled in the past few quarters.
I have laid out the argument quite clearly. If you don't care about copyright issues or the fact that a $300 billion firm is stealing from small entrepreneurs to enrich itself, you still may be wondering how this will affect the stock. I can debate with you in the comment section about this issue, but what matters the most is what will end up happening. I believe this method of profitability is unsustainable for Facebook. It cannot survive in the long term by basing its traffic off of stolen content.
If you noticed both the video by "In a Nutshell" and the article by Hank Green were published in the middle of November. This is because that was when Facebook announced it had eight billion video views. Every single announcement of how great FB's video platform is doing encourages new complaints by creators. This latest announcement should be no different. The best solution for this would be either a class action lawsuit or for Alphabet to sue Facebook.
This situation has "game theory" written all over it. Facebook is making the bet that it can keep stealing money from content creators without any consequences. It can take its time slowly creating a Content ID system, and when it gets big enough to be a threat to YouTube, it will change its policy. I'm not sure if Facebook is this nefarious. It may just not have any reason to care, so it continues with this unethical policy. The problem with the nefarious situation is if a class action lawsuit does take place, it will have to change its policy and pay the money owed to individual creators.
Judging by the litigious nature of our society and the virality of the videos that discuss freebooting, I am expecting the shoe to drop this year. There was literally a crowdfunded kickstarter that raised $55,000 for a guy to make a potato salad. I think the Internet will eventually rise up and fight Facebook. FB has stolen from the most powerful people on the Internet. I think the creators don't understand their own power in this situation. If Internet stars such as Hank Green and Jenna Marbles who have tens of millions of subscribers wanted to get together, they could end this problem.
There are many problems Facebook faces besides the amount of money it will pay out to the affected creators. The first will be it will have to spend money to actually build a Content ID system. It will have to work properly or else there will be a renewed scrutiny on the platform. The one announced in August was supposed to be in beta version. As you saw from the video in December by Ethan and Hila, the system is not working.
Another problem with this potential lawsuit is the amount of video content on the platform will decline substantially. The company's stock is supported by the potential growth of video and Instagram. A shift to reality would hurt the potential growth investors see for the company. Facebook is being valued at over 18 times sales, so this growth has to come to fruition or the valuation must compress. Vanity metrics such as monthly active users anger critical investors. I believe the video views are worse than vanity metrics because they aren't Facebook's views. The entire value of a video platform is the intent of creators to publish on the site, otherwise known as the network effect. Facebook's network effect is not as strong as it has let on. If Facebook had so much confidence in its network effect, why wouldn't it stop the theft of content?
Another problem Facebook will have to face is it will have to start paying out the money it makes to content creators once the system changes. YouTube would effectively double its profits if it got to keep all of the money earned on the ads shown in front of videos, instead of only taking a 45% cut. Facebook will lose half of its earnings on the freebooted content when this policy is changed.
FB has garnered the hatred of content creators, so they may not want to work with Facebook to create a sustainable platform. The counterargument to this would be that these creators may hold a grudge against the company, but will still post their content to the site because it would be in their best interest. My response to this counterargument is that monetization via ads isn't the permanent solution to monetization of content online. It is only one solution. The other solution is monthly subscriptions, as is the case with YouTube Red. No content creator will want to work with Facebook to create a monthly subscription network that would compete with YouTube Red after FB has screwed creators out of their hard-earned dollars. Because of this, the company has less monetization potential than analysts and investors think.
I am very biased in this situation because I have a YouTube channel that I plan on growing substantially this year. Facebook investors are biased to believe the firm is doing nothing wrong. Putting these biases aside, there is a chance Facebook's stolen chickens will come home to roost in 2016. Stealing content is not a sustainable business practice.
On the other side of the coin, Facebook has been successful at managing the change in consumer tastes by shifting its focus to mobile. This was the driver of the excellent user growth numbers reported in the recent quarter. Analysts discussed the possibility of FB having its own separate video player application on the call. Facebook cannot do this with stolen content. However, if it does decide to improve its business practices and support independent creators, the opportunity to truly rival YouTube is there for the taking.
Disclosure: I am/we are short FB.
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.
Additional disclosure: I have a YouTube channel and anticipate making money from Adsense in the future. I don't want my videos free-booted to Facebook.