MARKET WATCH
Google recently was fined $57 million under Europe’s new General Data Protection Regulations (GDPR), the first major fine imposed under GDPR. The fine signifies mounting troubles for Google and Facebook, the once-vaunted Big Tech stocks which have found themselves in hot water with investors and regulators alike. In the wake of a tumultuous 2018, many analysts assume that the troubles are over. But this is a mistake. Google and Facebook must contend with significant headwinds over the coming years and decades that threaten to upend their way of doing business.
Since we last covered Google and Facebook (see: “Danger Ahead for Google and Facebook?” and “Google-Facebook: No, Don’t Buy This Dip”), the long-term outlook has worsened for these firms in several important ways. Let’s start by re-examining the three growth “dynamics” we laid out in our earlier piece. As a reminder, these dynamics, should they take place—Google and Facebook squeezing out all of their digital competitors; digital ad spending rising rapidly as a share of total ad spending; and total ad spending rising rapidly as a share of GDP—would enable Google and Facebook to meet their revenue projections. Overall, these dynamics have shifted in an awkward direction. We remain dubious.
- Dynamic #1: Google-Facebook Growing as a Share of All Digital Ad Revenue. The outlook here looks much worse than it did previously. In 2018, according to eMarketer, the two companies owned a combined 57.7% of the market—down significantly from 2017. Google’s share alone slid by more than 2 percentage points from 2017 to 2018.
- Dynamic #2: Digital Ads Growing as a Share of All Ad Revenue. Luckily for Google and Facebook, a worsening outlook for Dynamic #1 was made up for by an improving outlook for Dynamic #2. Digital ads gained a whopping 6-plus percentage points of market share within the total U.S. ad universe, up to 49.7% today by eMarketer’s count. But in our opinion, this growth rate in digital share cannot possibly be repeated for several years in a row—as it would need to in order to justify the consensus projections.
- Dynamic #3: Ad Spending Rising as a Share of GDP. Even in a year that had everything going for it in terms of ad spending, 2018 saw U.S. ad spending account for 1.08% of GDP, up only +0.04 percentage points from the year prior. In fact, adjusting for cyclical events such as the 2018 midterms, ad spending last year remained flat as a share of GDP.
Other long-term headwinds have also worsened over the past year. One is consumer tech-lash. Excessive screen time has been implicated in everything from the erosion of impulse control to rising rates of loneliness and depression (see: “All the Lonely People”). New NIH research even shows that screen time may be altering the structure of developing brains (see: “Is Excessive Screen Time Changing Children’s Brains?”). States are rethinking the wisdom of allowing screens in the classroom (see: “Maryland Considers Legislation that Limits Children’s Screen Time”). And we haven’t even mentioned yet the biggest news of the last summer and fall: the data-privacy scandals and politicized disinformation campaigns. These scandals have culminated in genuine fatigue and distress among many users, which will ultimately turn up in brand rankings.
At the same time, Google and Facebook are contending with growing political threats at home.
On the left, the tarnishing of Google’s and Facebook’s reputation only starts with the possibility that their paid-for disinformation, in part funded by Vladimir Putin, may have put Donald Trump in the White House. Much worse is the Democratic Party’s post-election drift leftward on most policy issues (see: “The 2018 Midterms: A Tale of Two Americas”), which has given new clout to progressives who were never comfortable with Obama’s and Clinton’s friendship with Big Tech. To them, both Google and Facebook are precisely the sort of gargantuan duopolists that the Sherman and Clayton antitrust acts were supposed to destroy or prevent. So why are they still around? Progressive think tanks are now working overtime to customize and perfect the legal arguments that would deal a death blow to each of them in turn.
In the Republican party, meanwhile, the news is hardly any better. And that’s because the GOP’s strengthening populist wing has its own reasons for hating Big Tech. For starters, populists on the right accuse Big Tech (and Silicon Valley more generally) of liberal bias: They charge Google in particular with suppressing conservative voices and biasing its search results toward left-leaning publications. Like all populists, moreover, they are deeply suspicious of big business and market power and are hardly more inclined to defend these firms than the firebrands on the left. One thing is clear: When both MSNBC’s Rachel Madow and Fox News’ Tucker Carlson both start inveighing regularly against the same companies, watch out.
If anything, the United States has been late to the party when it comes to being tough on Google and Facebook. Europe has long been the standard-bearer in the battle against U.S. Big Tech firms. In May, Europe implemented its sweeping GDPR, which among other things mandates that companies gain opt-in consent before sharing consumer data. On the first day of enforcement, Google and Facebook were hit with lawsuits totaling $8.8 billion over their noncompliance. That’s not all. Last year, EU regulators hit Google with a record $5 billion fine stemming from its dominance of the smartphone OS market. The EU also has been asked to open an inquiry into antitrust activity in the digital ad market.
But the biggest threat for these firms going forward may be the Internet’s continued transformation into an infinite number of closed-loop “walled gardens.”
Over the last decade, both Facebook and Google have repeatedly been described by economists as firms with infinite economies of scale. Which means, thanks mostly to the “network effect,” that the larger they are, the more profitable they are. This is what gives them pricing power. This is what makes them so incredibly attractive to investors. This is what makes them such obvious targets of antitrust enforcement. But what if the economists are wrong? What if it turns out, in our emerging post-globalist era, that most people don’t actually want to be connected to Zuckerberg’s “billions”—nor do they want to be microscopically pored over by every marketing firm on the planet? In other words, what if bigness comes to be regarded by most consumers as a negative?
To be sure, Google and Facebook will continue to be growing and profitable firms for many years to come. Their deep pockets will enable them to invade whole new industries overnight. But if sheer size is no longer their ally, that growth rate will inevitably start inflecting down—and those new businesses may be no more profitable after they are purchased than before. And that possibility will affect valuation premiums today.
TAKEAWAYS
- Understand that the troubles aren’t over for Google and Facebook. Much has happened since we made our bearish call the two firms last February. In aggregate, these firms are worse off today than they were nearly a year ago. Google and Facebook face a number of worsening long-term headwinds that threaten their growth potential. In the coming years, the two firms will bear the brunt of an unforgiving U.S. advertising market, a lasting consumer tech-lash, and regulatory threats at home and abroad. A more existential threat is the continued evolution of the open Internet into an infinite number of walled gardens, which could lead to declining economies of scale.
- Expect the Q4 2018 earnings reports to carry more bad news. Each firm faces challenging comps set by a strong Q4 2017. Let’s start with Facebook. Though the company’s revenue is projected to rise QoQ to $16.4 billion in Q4 2018, this figure would represent a declining YoY revenue growth rate. Moreover, $16.4 billion would mark the third consecutive quarter of slowing YoY revenue growth for Facebook. The dead-ahead danger is even bigger for Google. Mean consensus estimates put Google’s total revenue at $31.5 billion in Q4, which would represent a decline both on a QoQ and on a YoY basis. Although Google’s click rates have been rising, its total revenue per click has been plummeting.
- Watch for these firms’ troubles to continue into the medium-term. When we look past the Q4 print to CY 2019, our biggest concerns shift from Google to Facebook. In 2018, Facebook attained operating margins of 44.2%, which the consensus expects to decline to 36.6% in 2019. Google, by contrast, is expected to grow its margins slightly from 2018 to 2021—an impressive feat for a company of Google’s size and maturity. Facebook’s problems boil down to effective market saturation: Its usership has stagnated in its most profitable region. Facebook’s Q3 earnings report shows that the company has 242 million monthly active users in the U.S. & Canada, virtually unchanged YoY.
- Realize that a “walled garden” Internet harms both Google and Facebook. Walled gardens are obviously a nightmare scenario for Google, which thrives in a free and open Web where everyone starts their search on Google.com. But it is also bad for Facebook for the following reason: Today’s consumers are insisting, ever more loudly, that they want their walled gardens to be exclusive, intimate, small-scale experiences. At its outset, Facebook was this type of place—but years of trying to “make the world more open and connected” have de-emphasized personal connection, transforming Facebook into a humming borderless throng where you are just as likely to see posts from strangers as from friends.
