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The One Thing That Can Destroy Facebook

|About: Facebook (FB)

Summary

While Facebook’s fundamentals and growth prospects are strong,downside risk is high.

Studies have shown that the number one reason people use Facebook is for entertainment value. The number one way people entertain themselves is by viewing other’s profile.

A large portion of Facebook’s revenue comes from third party advertising. Breaches in privacy would reduce active users and lessen time spent on the social network, leading to reduce demand.

While Facebook has many people working to prevent this specific breach in privacy, it is still a legitimate concern. Regardless of the odds, the consequences are large enough to warrant.

In the midst of every bull market there are a few companies that remain untouchable. Like the "nifty fifty" during the early 70s and the high-tech stars prior to the dot-com bubble, these companies are often fresh off an IPO, progressive and popular among day traders and institutions. While today there are many companies that share similar characteristics, none seem as bulletproof as Facebook (NASDAQ:FB).

Since its record-breaking IPO in May 2012, which valued the high-tech company at over $104 billion, FB has experienced well above average price appreciation (with one exception in the summer of 2012). Today, FB is trading close to $80 per share, about 190% over its market price at the end of the week following its IPO. For comparison, the S&P500 is up about 56% over that same span.

Facebook's performance isn't unwarranted. Since their IPO, Facebook has monetized their service in ways that the market never expected. Even more so, it seems that the Company is at the forefront of the mobile computing trend that many believe to be the prominent source of high-tech growth in the future. While I tip my hat, this article isn't about Facebook's profit potential or its future plans but instead, about a risk that investors are ignoring. In the midst of all of this optimism, the one risk that investors ignore may turn out to be the most crippling.

A few years ago I overheard several students talking about how there was a computer program that allowed Facebook users to see who visited their profile. A few days later, I saw an advertisement on my news feed for a program that would do just that. My curiosity got the best of me and I clicked it, but instead of finding out my secret admirers, I found a Trojan horse virus on my hard drive.

While I was initially disappointed, I quickly realized that it was for the best. Allowing users to see who was visiting their page would reduce Facebook's entertainment value significantly. In a recent study called "The Influence of Computer-Mediated Communication Apprehension on Motives for Facebook Use", Professors from Yale, University of Connecticut and Newbury College found that people primarily use the social media website for its entertainment value and that the number one form of entertainment was spying, or in some cases, voyeurism.

I think that it is safe to say that Facebook users would tone down, or possibly discontinue using Facebook for entertainment purposes if their spying habits were uncertain to remain confidential. If this was the case, a good portion of Facebook users would spend much less time on the website.

According to Facebook, 864 million daily active users spend an average of 7 hours per month online. A program where users can find out who has viewed their page would most likely reduce demand for the social network, leading to a large drop in average hours and daily active users. Less hours spent on the website would reduce third-party advertising sales, which according to Facebook's 2013 annual report, make up 89% of their revenues. I have not spent time calculating specific losses because it is unnecessary. Understanding this risk is however, critical.

While this scenario seems unlikely, it isn't exactly farfetched. Even though users don't know who is watching them, Facebook does. In their data use policy, Facebook writes that

"We receive data about you whenever you use or are running Facebook, such as when you look at another person's timeline, send or receive a message, search for a friend or a Page, click on, view or otherwise interact with things, use a Facebook mobile app, or make purchases through Facebook."

In fact, they use this data to create a more personalized user experience. How else did you think your newsfeed is so perfectly fits your interests?

I am certain Facebook understands the consequences of this breach of privacy, which is why they are trying hard to keep it secret. Throughout their 10-K, the word "privacy" is mentioned 31 times, but only once in regards to violations. Even more so, information about costs arising from privacy violations are almost totally ignored in section 1.A Risk Factors. Instead, management spends more time informing investors about risks relating to declining user growth and monetization, two factors that are most likely already priced in to FB shares.

While the odds that someone will come up with software that allows users to see who viewed their site and posts may be slim, Murphy's Law suggests otherwise. Facebook pays some very smart computer scientists and programmers a lot of money to protect individual's privacy. Is this enough to prevent hackers? What about competitors or large investors with ulterior motives who may not mind devoting resources to exposing this threat? Only time will tell. However, putting the odds aside, the heavy consequences alone are enough to make a shrewd investor skeptical. Regardless of it's upside, such a clear, critical and ignored downside risk is critical when deciding whether to invest in Facebook.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.