Revenues, dreams and The Social Network

Now that Facebook has filed for its IPO, it is possible to look at the hard numbers. And Facebook will need to work hard to keep up with the market’s expectations, argues Jon Collins.

It may be the most anticipated market debut for almost a decade, but Facebook’s IPO is now a reality.

And while there has been more than enough speculation about the company’s valuation, less has been said about how it will achieve the quoted numbers, and its potential impact on the market. These questions are inextricably linked.

Calculations linked to Facebook’s SEC filings suggest a “worth” of $5bn. However, trading on the controversial private exchange Sharespost implies a valuation of $80-85bn – understandably creeping up, given the suspense – and the general line in the markets and the industry is that the company could be worth as much as $100bn.

But the term “worth” should be used guardedly; share value is a construct existing entirely in the minds of investors. Some companies achieve the dubious distinction of a valuation that is less than their actual net assets – the stock broking equivalent of being worth more if you were melted down for scrap.

So just how much of Facebook’s valuation is actually grounded in reality? The company turned over $3.7bn last year, and made a profit of $1bn. In other words, to pay back investors, it would take 100 years at current rates. So, there has to be more than it than that.

By way of comparison, Google reported revenues of $10.6bn in the last three months, and profits were up 6.4 per cent to $2.7bn. Even with unforgivably shoddy maths, that equates to a return an order of magnitude greater than Facebook. Google is currently valued at $180bn, which is twice as much as the suggested value of Facebook.

Intriguingly, at the time of its own IPO (at $85 a share), Google was valued at 121 times annual sales. But now it trades at around 20 times revenues, six times less. This is roughly the same over pricing, you could say, that Facebook now enjoys. In other words, based on existing considerations, Facebook shares are quite likely to end up at about 20 per cent of their initial offer price (based on annual sales).

Where’s the growth?

Let’s go with the former scenario, for the moment. Additional revenues could come from three places: growing the subscriber base from the current model, providing additional services to advertisers, or selling additional services to subscribers. Facebook currently earns about a dollar a year per subscriber in terms of revenues.

So to grow organically from its current base it needs to expand to five times as many users. That is about four billion: roughly everyone on the planet who has the capacity to read and write.

Advertising is the company’s biggest revenue stream. But while advertising revenues are increasing, the advertising rate hikes needed to achieve a 500 per cent uplift in revenues would result in a commensurate increase in advertisers’ expectations.

It is only possible to speculate how that would go down, even if the quality of click-throughs could be increased to reduce advertisers’ acquisition costs per lead. Note: ad pricing increased 18 per cent in 2010 and the number of ads increased by 42 per cent.

It is difficult, too, to see how this could happen without further erosion of individual privacy. The Facebook Open Graph, for advertisers, is predicated on the idea that not only are people prepared to give up their privacy on the premise of “free stuff”, but also that they will shop their mates. (Or, as Facebook puts it, “Helping brands connect with your friends.”) You’ve had a Starbucks or bought a pair of Levis – perhaps your pals would like to do the same?

So, what about selling additional services? Facebook’s biggest area of growth – up five-fold in 2010, to $557m – is currently “payments”. These are “freemium” apps such as Farmville, where you can pay for additional stuff such as a rake or a bale of hay. The explosion in the gaming market overall suggests this could be an area of considerable growth to Facebook – but, as the company itself mentions in its 22 pages of risk factors in the IPO prospectus, much of this growth could be outside of the online platform’s control.

Speaking of the prospectus, the company is a lot less verbose when it comes to future strategy. The model is the model – and indeed, many of the company’s announcements (such as Open Graph) do, with hindsight, look as if they have been implemented in order to give the IPO a bit more meat. But the model is the model, the plan is to grow by continuing to do what the company is already doing, and there are no hints of other rabbits to pull out of the hat.

“More of the same” includes mobile, possibly the most intriguing area for the company. Facebook is the most downloaded app on smartphones today, which is great news for the company’s footprint. Not so great for advertisers, nor for developers, as the mobile Facebook client doesn’t support ads or apps. Indeed, this is quoted as a risk for the company. The IPO filing suggests incorporating sponsored stories into the mobile news feed, but again, this is untested.

Facebook on the market

What, then, of the IPO’s impact on the wider market? The evidence so far suggests that if Facebook is to grow, it will need to start eating the lunches of other companies. Ruling out the unlikely scenario that existing punters have even more time to spend on social networking sites, Facebook’s required gain will require a level of pain from other providers, in particular Twitter and Google. Twitter, which is probably Facebook’s biggest contender for eyeballs, is not going anywhere, and Google is arguably the most creative of the three.

If the majority of Facebook’s revenues are from advertising meanwhile, the company will have other online advertising models in its sights. Like Google, Facebook operates a walled garden approach. While both offer a more attractive, “joined up” proposition to advertisers than conventional online publishers, given the wealth of information they are building (rightly or wrongly) about their subscribers, the broader advertising world is also evolving. Examples include web beacons, and retargeting of ads.

Advertisers are currently investigating every potential way to connect with customers. Whether people like such models is a moot question – the important thing right now is that they work, and that advertisers will be clinical in how they assign their budgets, according to detailed analysis of Cost Per Acquisition (CPA) and other metrics.

Which brings us, inevitably, back to the question of privacy. You might be of the “Privacy is dead, deal with it” school of thought, but this makes some quite dramatic assumptions about both forward behaviours, and the fickleness of youth. Generation Z, we are told, doesn’t give two hoots about privacy. But equally (and following the same, misguided stereotyping logic), it doesn’t give two hoots about anything. Brand loyalty is everything, but loyalties change very quickly.

Where else could Facebook have an impact? The answer to this question returns to developers. As things stand, Facebook offers a highly scalable, globally accessible, advertising-funded application platform, suggesting the real battleground for the company is more with Platform-as-a-Service companies such as Microsoft, Amazon and indeed, Google than with social networking providers. The latter have been targeting corporate apps and standalone start-ups, whereas Facebook’s offer is decidedly consumer (with undertones of the Apple versus Microsoft battles of old).

Developers lead to start-ups, and whatever comes out of the IPO, Silicon Valley is likely to gain a number of angel investors with positive attitudes about the future success of the company, and hence the platform. Start-ups lead to diversity, and diversification could well be the key to Facebook’s future. But as the current model goes, the firm is more likely to bask in the reflected glory of those building on its platform. Imagine, perhaps, a “Facebook Inside” marketing campaign in a few years’ time.

Diversity, destiny?

Given Mark Zuckerberg’s mission statement, “To make the world more open and connected,” there is no reason why Facebook-the-company needs to stop with Facebook-the-social-portal. The idea of Facebook smartphones, or indeed, Facebook SIM cards has already been suggested.

However, to spread its wings Facebook will need to enter areas of the market where it lacks first-mover advantage. It has not succeeded in winning over email and messaging; it is not a player in videoconferencing; it doesn’t have a (software) stack play; it has no enterprise offering. And to put it bluntly, the grudging acceptance of the Facebook consumer brand is unlikely to translate into the corporate space.

Perhaps, quite simply, Facebook’s future remains inextricably tied to the future of social networking. The company was always a bet, and it remains one. So far it has paid back in spades. Mark Zuckerberg and his merry men discovered a seam of gold that nobody had yet spotted – whether it was luck or judgment is irrelevant. The real question is whether that seam of gold goes even deeper, or whether Facebook will have to compete more directly with other prospectors.

For a generation, together with Twitter, Facebook is social networking. But while the company has achieved a staggering level of success and defined a whole new method of global communications in the process, the company’s ambitions in terms of the future of social remain relatively paltry.

Somewhere along the way, Facebook seems to have confused personal interaction with genuine, emotional engagement. Equally, if the company doesn’t set out a more solid (meaning revenue-earning) mobile strategy, someone else will.

The future in all its reality-augmented, near-field, sentiment-analysed glory will be device-independent, and Facebook’s business model (while not its reach) is still very dependent on the computer browser, which, we are told, is in its twilight years.

So, will Facebook’s IPO have an impact? About the only thing we can say with any certainty is that a handful of people are going to become very rich indeed.