Facebook’s big gamble

Jason Hesse dissects Facebook’s IPO, analysing whether the company will be able to live up to the hype.

Today’s the big day. Facebook is going public with an expected market capitalisation of $104 billion, the biggest flotation since Google went public in 2004 with $23 billion.

Facebook’s float price of $38 was raised at the last minute due to high demand, and it’s widely expected that Facebook shares will soar when the public get its chance to buy. If other big floats, which have seen first-day closes explode past the initial price, are anything to go by, we’re in for a big day.

Kernel contributor Mark Riley, chief executive of Mallard Digital, thinks that Facebook’s stock price will be a good indication of the industry’s health: ”If stock goes through $40 on day one, that’s good pricing and everyone will be happy. If stock goes through $50, then caveat emptor, institutions are cleaning up and feeling frothy.

“But if stock climbs and then heads south through $35 and towards $30, it will be deeply embarrassing and the Web 2.0 bubble cynics will be proven right. There would be red faces all round. VCs will need to go back to the drawing board and Silicon Valley will go into a prolonged existential crisis.”

The numbers

No matter how you look at it, Facebook is huge. Engagement, users, revenue: it’s impressive. According to its latest S-1 filing, there are 125 billion friendships, 2 billion likes a day, 901 million monthly active users, 526 million daily active users and 302 million photos are uploaded every day.

The company had just over $1 billion of revenue last quarter, half of which is from the US and Canada, $328 million from Europe, $118 million from Asia, and $87 million from the rest of the world.

Let’s put that revenue into context. Microsoft went from zero to $1 million of revenue in three years. Facebook went from zero to $150 million in three years – a 40-fold acceleration in real terms.

Of Facebook’s revenue, 82 per cent comes from advertising and 18 per cent from payments. Yet despite advertising being Facebook’s primary revenue source, it isn’t actually very good at it.

Facebook doesn’t publish an average click-through rate (CTR) for its advertisements, but analysis from Webtrends on more than 11,000 Facebook ad campaigns shows that the average CTR in 2010 was 0.051 per cent. The industry average is generally considered to be 0.1 per cent. Google’s CTR average is above 0.4 per cent – almost 10 times as high as a Facebook ad.

This could be interpreted in two ways: first, that Facebook ads simply don’t perform very well and therefore are a potential liability in the future, or that there is an opportunity for the company to improve its ad performance significantly. If the latter, then revenue should grow accordingly.

A research note by Frost & Sullivan explains: ”While Facebook is already mature in terms of the number of social media users, and facing growing competition from Google in this area, it is still relatively immature in terms of its advertising model, which is where the vast majority of its revenues currently come from.

“Facebook is currently finding it difficult to compete with Google’s more mature and more developed advertising platform. To gain full industry confidence, it will be critical that Facebook spends a lot of time and resources developing its advertising model further.

“On the flip-side, Facebook’s immature online advertising model, combined with its massive global reach, gives it huge potential to grow for very high revenue growth over the longer term and compete head on with Google in terms of advertising revenues. Google, on the other hand, while still displaying solid growth in online advertising revenues, no longer has the potential for such rapid growth due to its more mature advertising platform.”

Everyone knows that mobile is “the next big thing” – it’s the next frontier. Yet this is a big question mark for Facebook, which makes almost nothing from mobile, despite having more than 488 million monthly active mobile users:

“We believe that mobile usage of Facebook is critical to maintaining user growth and engagement over the long term, and we are actively seeking to grow mobile usage, although such usage does not currently directly generate any meaningful revenue.”

There is no doubt that Facebook is first and foremost a web product, but it seems absurd that a company with nearly half a billion monthly mobile users is not monetising them. Facebook’s recent $1 billion acquisition of Instagram is obviously attempt at changing this: the acquisition of a company specialised in mobile content creation is a good asset for the social network.

Display advertising doesn’t work on mobile, however, so the company needs to find a new route.

As investor Chris Dixon notes, Facebook has no choice but to change how it monetises. ”Can they find another business model that generates significantly more revenue per user without hurting the user experience? (And can they do that in an increasingly mobile world, where display ads have been even less effective?)”

The jury is still out on the recently-introduced sponsored feed entries. “I have trouble seeing how insertions into the feeds aren’t just more prominent display ads. You still have to stoke demand and convert people from non-purchasing to purchasing intents. A more likely outcome is that Facebook uses their assets – a vast number of extremely engaged users, its social graph, Facebook Connect – to monetize through another business model. If they do that, the company is probably worth a lot more than the expected $100 billion IPO valuation. If they don’t, it’s probably worth a lot less.”

Potential other revenue streams could come from enhanced services to companies. This would be a logical step. Facebook is already part of every consumers’ life, why can’t it become the main engine for employee-to-employee or business-to-business communication? Yammer, which operators a private social network service for business, is a good model for what Facebook For Business could look like.

Facebook will be, without a doubt, the biggest flotation of 2012, if not of the decade. But is it worth more than $100 billion? To make an unfair comparison, while Google’s market capitalisation is double that of Facebook’s, it makes 10 times more net profit and revenue.

What does this mean? Either investors expect Google to stop growing, or they expect Facebook to grow at a much quicker rate than Google. Can Facebook meet those expectations?

Mark Riley believes the price is right: “It seems to me to have been priced in a mature way that reflects the latent demand, which means the institutions are not cynically pricing for a day-one bounce.

“The question is, is Facebook a LinkedIn or a Groupon? In other words, does it have legs for a long-term revenue growth strategy, or is it a hyped-up momentum stock? Personally, I think Zuckerberg is on a mission, and it will become a permanent feature – a communication and transaction ‘thing’ that will be bigger than people can see right now.”

Facebook is “hot” today, but there is no shortage of big technology firms who were once considered the leaders and subsequently fell hard, such as MySpace and AOL.

A recent study by Greenlight Research shows that 30 per cent of internet users “strongly distrust” Facebook with their personal data, while 44 per cent say they would “never” click on its sponsored ads. The issue of privacy is not one to be ignored – while Facebook is pervasive today, it wouldn’t take much for the public to turn against it should it try to push privacy boundaries too far.

The issue of privacy is also intrinsically linked to revenue. Facebook is considering placing ads on third-party websites and targeting the ads to specific web users based on their interactions on Facebook. While this is an opportunity to massively scale up the amount of ads served to users by Facebook, it could also lead to significant privacy concerns by consumers and regulatory bodies.

Facebook’s flotation is certainly an exciting moment, but the real question is: what will Facebook’s shares look like in a year’s time? Beyond the financials and monetisation, Facebook has some major issues to contend with.

Is Zuckerberg ready to grow up and deal with them? Riley says his dress code today will indicate a lot about his mindset: “If he’s wearing a hoodie, it means ‘I’m in charge and Wall Street can go hang’. But if he’s wearing a suit, it signifies that he’s a grown-up and will attend quarterly calls.”

Let’s hope for the latter.