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What if Facebook isn’t so special after all?

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As the fateful day of Facebook’s initial public offering draws closer, the giant social network’s financial results are attracting more and more attention. And while there are some blockbuster numbers in its recently updated securities filing — including a mind-boggling 900 million active users, half a billion of whom use the site daily — there are also some potential red flags, including rapidly rising costs for marketing and other expenses. All of this raises the question that investors will need to answer before too long: Is Facebook unlike anything we have seen before, or is it just another modestly profitable Web business?

There’s no question that Facebook is huge — possibly the largest digital-only social enterprise that has ever existed — and it is still growing at a fairly rapid rate. Just a few months ago it crossed the 800-million-user mark, and now it has passed 900 million, which suggests it will probably rack up a billion active users sometime later this year. And more than half of that user base visits the site at least once a day, a level of engagement other Web services would likely kill for.

A revenue drop and a net income decline

That’s the good news, that and the fact that Facebook’s revenue for the first quarter of 2012 hit $1 billion, up more than 44 percent from the same period a year earlier. And the bad news? Well, for one thing, revenue actually fell compared to the previous quarter, something that doesn’t look particularly good coming from what is supposed to be a growth company. And net income (in other words, profit) also dropped by 12 percent compared to the same quarter of 2011. In fact, Facebook’s profit was lower in the most recent quarter than it was in the previous five quarters:

While the quarterly dip in revenue could be just a seasonal blip in an otherwise-growing advertising business (although Facebook’s payment-related revenue also flattened), the fall in net income is a bit more worrisome. Running a Web business without making a profit may be taken for granted when it comes to startups like Instagram, which Facebook just acquired for $1 billion. But when you get to be the size Facebook is — and you ask the public markets to value you at close to $100 billion — investors and analysts are going to want to see some money flowing to the bottom line, and lots of it.

According to Facebook’s filing, which is embedded below, the main reason for its lower profit was higher costs, particularly for marketing: Costs related to marketing and sales more than doubled to $159 million from $68 million a year earlier — almost as much as the company spent in all of 2010. In total, Facebook’s cost of revenue climbed by more than 65 percent compared to the same quarter in 2011.

How much can it squeeze out of its existing users?

It may be stretching things somewhat to compare Facebook to Groupon, another highly anticipated public offering, but one of the main criticisms of the group-buying service — and something that has helped push the stock down by close to 50 percent since its IPO — is that it has to continually spend more on marketing than it can ever hope to recoup in profit. Like the Red Queen in Through the Looking Glass, the company has to run faster and faster just to stay in the same place, because users leave and it has to spend to acquire new ones.

Facebook’s problem is somewhat different: It has close to a billion active users, but it makes a remarkably tiny amount from each one: about $5 per year. That’s not a lot, considering over half of those users visit every day. And while the amount Facebook makes from the average user rose in the most recent quarter, it only grew by 6 percent. Some of the marketing costs it is racking up are no doubt going toward increasing that number. But how much more can Facebook squeeze out of its existing user base?

As I tried to describe in a recent GigaOM Pro report on Facebook’s IPO (subscription required), the biggest question about the social network is whether it can grow in any substantial way from its already massive base. With almost a billion users currently, the upside for the company is likely relatively limited, unless you assume Facebook will eventually be used by everyone on the planet. So growth then has to come by increasing the revenue it gets from each user. But what if it has to spend increasingly large amounts of money in order to do that, either to market itself or to acquire new avenues for reaching users such as Instagram?

In a recent essay on Facebook’s prospects, investment advisor Josh Brown called it a “red giant” — a star that, having grown too large, starts to consume its own resources and eventually implodes and becomes a white dwarf. Investors who are looking for a meteoric return on the company’s initial offering should consider the fact that they may wind up with shares in something very different.

Facebook Amended S1

Post and thumbnail images courtesy of Flickr users Jinterwas and Jinterwas

21 Responses to “What if Facebook isn’t so special after all?”

  1. Chris Lau

    There’s another architecture for social networks that does not require more servers as the network grows. As Facebook’s costs get strained, and are not matched by users who click on ads or buy facebook credits, perhaps that will be when the site truly becomes a red dwarf.


    1) Yes, FB is trying to pump its share price via advertising in anticipation of the IPO. We should expect advertising higher costs as the public awareness of FB’s income limitations increases.

    2) Even if FB produces only 1B a quarter in revenue or only $5 per user, the costs of running that company are very small in practice, and marketing expenses are controllable.

    3) If FB solves mail and search and duplicates the Google advertising tools, it can improve its value to advertisers even if its knowledge of customers is not as thorough as they hope, because customers will prefer less noisy searches to Google’s noisy and dirty searches. This is probably the strategic internal error they are making. They are very likely overvaluing the data about the individual in pursuit of mass advertising dollars instead of accurately valuing the desirability to the user of the interface and the protection from ‘noise’.

    FB will not become another Google. Google profits from the fact that its results are BAD. Because its results are bad, it can sell advertising to small business. FB however, can profit from the fact that its search results CAN be GOOD by narrowing acceptable advertising and therefore increasing advertising rates over those of google. The problem google has is that it CANNOT ATTRACT TOP BRANDS. The virtue of FB is that it CAN if it creates a walled garden. FB can strategically create a flight to quality for good brands just as Google has created a flight to opportunity for small and weak brands. “FB is television, and Google is the yellow pages.”

    4) THE QUESTION FOR INVESTORS THEN is whether FB will pursue the short term trend, and continue to overvalue customer information — which looks bad but may not indicate anything other than an issue of timing — or whether FB will pursue the long term opportunity, of creating a less cluttered garden on the internet which converts their perceived weakness into a strength that is both desirable for users, consumers and for brands, and one which can rival google’s revenue, but rival it with UPMARKET revenue. The important point here, is that investors can INFLUENCE THAT STRATEGIC DIRECTION.

    I have no idea whether this strategy is commonly understood inside the company or without. But as one of the few people who has built a large scale technology and marketing company (Top 25 Digital Agency), and who has worked with other strategic Fortune 100 technology leaders to try to solve this problem, the business opportunity is obvious to me since Google’s challenge at attracting top brands due to its all-encompassing aspirations is legion. Google helps small business. FB can help large brands. And advertising large brands requires a bit of a garden. And FB has it. But the client interface for that business model is not Google’s. It’s more intimate. It has to be.

    That is what I suspect FB’s strategic error is: they’re looking in the wrong direction. That direction can be fixed however. And investors should invest in the OPPORTUNITY to create that wealth even if FB’s numbers look depressed because of timing.

    Curt Doolittle

  3. I’m curious what they consider marketing since I wasn’t aware that Facebook did any marketing at all, certainly not enough to put a dent in its earnings. Do you have any info about how those costs break down?

  4. GuyClapperton

    The other area nobody’s mentioned is F-Commerce. Companies are starting to sell goods from their Facebook pages. Now, it’s a bit of a long shot, but what if FB were to start going for this in a big way – aiming to be as trusted an e-seller as Amazon? There’s no obvious vacancy for a dominant player in that market, but if FB *could* start positioning against Amazon as well as other social networks then the potential for increased profits increases dramatically.

  5. Jonathan Gebauer

    The main problem with evaluating Facebook is, that no one knows how the average Facebook user will react when Facebook really starts squeezing them. Will they stay on board, when Facebook bombards them with ads? Will they pay for some features?

    The moment Facebook starts monetizing in an aggressive way, we will find out what Facebook really is worth.


  6. johnnyrocket

    Is anyone considering the simple fact that ‘social networking’ is a commodity? Seems a simple open network could come along at any time, and folks could switch or join up to this new network, with a snowball effect.
    I just don’t see the massive value in FB, and I see it’s perch as very precarious.

  7. I totally agree with you Josh. With open graph Facebook is creating the next world wide web (the semantic web) just as it was imagined by tim berners-lee.
    That’s why Facebook has an unimaginable potential: it can be the next big search engine plus the social layer of the web.
    I have no doubt that this is a company that will make history: social layer + search engine + incredible detailed user database = the biggest ad retailer of the world.
    Google should be scared.

  8. Any Internet service that asks for a user’s credit card series is already dead. The real problem is double: paying would force many people to leave, especially in third world countries. Facebook is a worldwide phenomenon that enjoys being the biggest Internet thing ever. The second problem is security. Where I live, all my passwords seem to be public stuff.

  9. Pierre Augustin

    I’m not too sure FB increased valuation will necessarily have a linear relationship with its users’ growth. Surpassing the 1 billion+ users is more an iconic threshold than anything else, I suppose. Facebook inherent increased valuation depends more on its ability to monetize its platform than amassing more users. Arguably the more users FB has the more money it may charge per display ads. But, no company can survive long term by drawing most of its revenues solely from advertising. Google understands this very well as it is diversifying from the Ads business and is also becoming an hardware company. Facebook has so many ways to monetize its platform: e-commerce, search engine for Ads-click, apps store, display Ads, mobile Ads, and not least broadening the use of the FB currencies. Facebook has announced their plans to add at least 6000.00 more employees on their payroll that undoubtedly will work on something other than those aforementioned means of revenues. I predict Facebook as one company will be part Apple, Google, Amazon, Microsoft, and Social network.

  10. Screwed by facebook

    Facebook as a company has no ethics. As a small startup that’s screwed badly by their lies, i’m pretty sure most of the stuff they tell are big lies. In the long run everybody will find out what kind people are behind fraudbook.

  11. I believe FB so far has stayed inside the box, it’s like if Google would have used display ads. I would look into data organization, context and interaction to build some businesses. Google has a guess about context from intent, I think FB could do better. Sharing could be a data provider like web crawling for Google, except with already applied filter and basic organization.
    The question is if they could pull a two/three money making business instead of a one trick only show. Focus doesn’t have to be “1” thing only,it can also be business structure.
    It’s not about friends telling you what to buy for example, it’s about data friends “provide” to make a “better” decision.

    PS: I’m not a user. So there is some growth in the user base possible :-)

    • cryptblade

      What you are talking about has been pondered and pontificated for about 5 years now, especially since the rise of Facebook in 2007.

      It started off as more of a wishful thinking by Google-haters. It has since grown, thanks more to the entrance of Twitter than Facebook alone, and now search engines use social link-sharing as a trigger to help rank pages in search engine queries.

      This is an attempt at using social signals. About 2-3 years ago, there was excitement over FB’s “Open Graph” and a lot of hopefuls thought it would kill Google and make it so that people would use social search forever and ever.

      Fast forward to today and OpenGraph and Facebook social search is anything but realized.

      What media pundits and greedy IPO underwriters who then hire stock-pumping charlatans like Henry Blodget forget is that PEOPLE love using Google and search engines because it gives them a sense of “anonymity” this is why people were infuriated with Google when they found out that Google, in cooperation with the gov’t, could specifically identify you based on your keyword queries, ISP, and so on. The demand for privacy protection was huge and helped to chip into Google’s mighty armor.

      Now Facebook, from nearly the get-go, has faced a severe privacy issue. It has lasted so long that users of FB will not so easily allow FB to use their data.

      Savvy FB users are creating multiple accounts and treating FB profiles like emails – creating JUNK profiles for public use – and then creating private profiles.

      What this means is that FB cannot build a trustworthy open system with which to use, even accurately, the social-linking profiles for anything related to search or for display ads.

      The new and young users are the ones creating multiple profiles while old heads, 35+ are the ones still using 1 profile.

      This paradigm will nullify anything and any value from your social-graph and therefore, nullify any commercialization that FB can gain.

      People silo their friends into spheres of influence. You have your core friends. You have your work friends. You have your gym or rec-club friends, you have your alumni or frat bro friends. But each has a place and sphere of influence.

      Now if people segment more and more and create multiple profiles, there is no way to create a usable social graph for FB or for advertisers’ profit

  12. Josh Davis

    Two areas of growth are obvious for Facebook and will dramatically expand their value per user. Facebook will leverage their social graph data to launch a 3rd part ad network (similar to Google Ad Words). Facebook is also likely to create their own search engine or at a minimum work with a partner to combine the social graph data with the intent that comes with search.

    I can’t say search will happen, but I would bet heavily on the fact that Facebook will launch 3rd party ad network.

  13. Ric Sansand

    Facebook has indicated clearly where it is going and what its future will be like. The AOL patents is a sure sign of its walled garden aspirations and the instagram knee jerk acquisition shows it has little confidence it its own mobile strategy. In my mind just another Web company covers it.

  14. I see Facebook’s profitability facing at least two key risks. The first is the tradeoff between ‘lightness’ and profit. Offering a simple free service makes it difficult to ear a lot per user (just ask Twitter). An “everything-and-the-kitchen-sink” service has more advertising opportunities, but becomes a pain to use. Facebook today already elicits from many people all the joy that MS Office does.

    The second is the tradeoff between privacy and profit. Facebook wants more data than users are happy to share. So it continuously resorts to various ‘nudges’ for revealing more data. No one appreciates being continuously nudged.

    Take the two together, and if anyone were to create some nice set alternatives that were easy to switch to, many users would abandon Facebook in a heartbeat (and more so when it would actually have to act to earn high profits). The number of people who love Facebook-the-service is falling and will likely continue to fall.

  15. My, my — is that the emperor without any clothes on?

    Thanks for raising this great question. I think we’re all amazed by the growth of Facebook, but I’ve been wondering a lot lately about tech companies with disappointing (or no) revenue, and also about the “we’ll pay for our free service with advertising” model that everyone seems to be jumping on. In some ways it’s brilliant, but it’s interesting how infrequently the model is questioned — surely we can’t ALL make billions by selling ad space. Is anyone out there studying this with any kind of hard data to see what the ad market will actually bear?

  16. GuyClapperton

    Don’t forget there’s also the issue of what constitutes an “active user”. Some reports I’ve seen suggest FB considers you “active on its site” if you click a ‘like’ button somewhere. Now, if I give you a ‘like’ on this page that’s one thing from me to you; it’s useless, however to Facebook’s advertisers as I’m not actually on the site. The nature of FB’s ‘active users’ will undoubtedly have an effect on the advertisers’ willingness to pay large amounts for their participation.

      • Ciarán Norris

        But what it does do is add to the data that Facebook has on you. Whether they can do something with that is still up for debate, but I don’t think it’s an entirely unreasonable definition of ‘active’. It doesn’t necessarily matter that much anyway, as advertising is generally bought on CPM or CPC, or, with their new tools, am agreed audience.