Facebook isn't the worst example of financial shenanigans that need investigation by the SEC, but I've chosen to give it attention recently because the general public can easily understand the mechanics of a stock pump and dump.
Facebook's underwriters currently face allegations that at its May 2012 initial public offering (IPO), they gave downward earnings guidance to select investors while other investors were uninformed. Giving downward earnings guidance during an IPO is alarming and extremely rare. Facebook's insiders and officers sold stock.
As I've mentioned before, Facebook officers have been selling stock this past month, but that should mean that none of them had knowledge of Facebook's negotiations with Zynga. Perhaps Mark Zuckerberg handled the negotiations himself, because meanwhile, Facebook and games-maker Zynga have been revising the terms of a five-year deal they struck in 2010 to make the terms more favorable to Zynga. Now newly launched Zynga.com won't have to use Facebook as the only way for gamers to log in. Moreover, Facebook took 30 percent of Zynga's sales through Facebook's virtual payment system via Facebook ads, but now Zynga.com isn't obliged to use Facebook's system. Facebook will still get a new game at the same time as, or shortly after, Zynga launches it elsewhere, but Zynga isn't required to use Facebook as its non-Zynga platform.
The contract negotiation was material insider information. How do I know this is material information? Facebook told us so. In its 10-Q for the period ending 9/30/12 and filed with the SEC on 10/24/12, Facebook stated the following in original bold italicized letters:
In the first nine months of 2012 and the full 2011 year, we estimate that up to 13% and 19% of our revenue, respectively, was derived from Payments processing fees from Zynga, direct advertising from Zynga, revenue from third parties for ads shown on pages generated by Zynga apps, and Facebook ads and Sponsored Stories displayed on Zynga.com. If Zynga does not maintain its level of engagement with our users or if we are unable to successfully maintain our relationship with Zynga, our financial results could be harmed.
Facebook emphasized this because it is required by law to do so. That was one little month ago.
Meanwhile, the PR narrative from analysts and from so-called financial "reporters" has often dismissed the new threats to Facebook's mobile revenues strategy -- again it was Facebook itself that said "sponsored stories" was key to its strategy and now "sponsored stories" are in trouble due to a California lawsuit. Now that this strategy is in peril, there's been hype about all the money Facebook will make from gifts, even though a similar strategy failed a couple of years ago. Even worse, its "sponsored stories" and "suggested posts" that are supposed to deliver the gift message in News Feeds are in trouble with regulators. More than that, Eyeo, developer of AdBlock Plus, just announced new software that will block ads on Android phones, the phone Facebook is urging its employees to use. Eyeo's app will block Facebook's ads.
Remember, just a month ago, Facebook warned us about the threat to user engagement if its relationship to Zynga should change.
Decelerating and Possibly Declining Number of U.S. Users
In my November 26, 2012 report, I mentioned that overall user growth is decelerating. The deceleration problem is most pronounced in the U.S. and Canada. From September 30, 2011-12, the number of Daily Active Users (DAUs) grew from 124 million to 132 million -- by only 8 million or 6 percent. Monthly Active User (MAUs) grew from 176 to 189 million -- by only 13 million or 7.3 percent. Should you rely on those numbers? Given Facebook's own estimation of its percentage of fakes, the number of users may have actually declined.
You'll also recall that relative to the December 31, 2011 Facebook reported a 64-97 percent increase in fake users (69-104 percent increase in fakes if Facebook netted), or an increase of around 168-287 percent in fake users on an annualized basis (185-319 percent increase in fake users on an annualized basis if Facebook netted). It reported worldwide 8.7 percent fakes which translated to 83 million fakes (91 million fakes if Facebook had already netted out the fakes before reporting its numbers).
By having poor controls and leaving the door wide open for fraud, Facebook can claim that -- in its opinion -- users in the United States are increasing, but that's not really clear at all. Facebook's poor controls and the shakiness of its numbers have other plausible interpretations not found in its SEC filing. It's also likely that U.S. users are declining. Facebook doesn't really know.
I've bought and monetized puts on Facebook since they became exchange-traded shortly after the IPO. ("Investors Bet on Facebook Fall," Kaitlyn Kiernan and Jonathan Cheng, Wall Street Journal, May 19, 2012.) I'm currently long other puts on Facebook.
See also: "Facebook: Soaring Fraud and Decelerating User Growth" (pdf) - TSF - November 26, 2012
Endnotes added December 3, 2012
When it comes to desktop usage, Facebook's had a double-digit loss of its U.S. audience from October 2011-12 ("Myspace grows as Facebook Slows" - by Kevin Sablan, Orange County Register, November 27, 2012.) It was down 10.2% according to ComScore. Desktop usage had been down for five months in a row, but this is the first report of a double digit desktop year-over-year decline.
From October 2011-12, Facebook's U.S. desktop visitors declined from 166 million to 149 million or 10.2%. That trend might be explained away as a growth in mobile as opposed to loss of market share, except for Myspace's numbers. (Facebook users are also said to be migrating to Twitter) Three years ago, Myspace was the most popular U.S. social network, and while Facebook was down double digits, Myspace's U.S. audience increased by 1% to 28.8 million in the month of October. This may be more than a desktop migration-to-mobile phenomenon, since Facebook's desktop numbers are crashing while New Myspace is seeing an improvement.
Facebook's Controls are Still Lax (This section was added on December 3, 2012)
On November 27, 2012, Bianca Bosker, Executive Tech Editor for the Huffington Post, wrote that the previous week she discovered an account set up by someone impersonating her: "After being 'friended'" by myself on Facebook, I set out to learn as much as I could about who had created the bizarre--and unsettling--Bianca Bosker impostor account, a profile created under my name, with my profile photo, my cover picture, my personal information and even my most recent status update." (See: "Hunting My Facebook Impostor," November 27, 2012.)
Since she was already on Facebook, she was able to get Facebook to pull down the fake profile. But when she asked Facebook for the information it collected about the fraudster, she had to scan her driver's license and provide a notarized statement verifying her identity. Her independent investigation with Alex Horan of Core Security revealed IP addresses appeared to be in Ahmedabad, India, and he said it seems to be the source of lot of fraudulent Facebook accounts. But there are ways to make it only appear that way, so the source could be anywhere.