Facebook

with one comment

Saturday marked the three-month anniversary of Facebook’s IPO. Its stock price is down nearly 50%, while the S&P500 has risen by over 9% over the same period and the NASDAQ-100 index (which Facebook hopes to join later in the year) is up over 12%. This past week alone saw Facebook shares decline more than 12%, hitting an intra-day low of $19.00 on Friday (suggesting that limit orders are kicking in at that level). Commentators have suggested that the drop can be at least partly attributed to the expiry of the first lock-up period on Thursday but one would expect that the market would have anticipated and priced in the impact of insiders and early investors liquidating a portion of their holdings. The fact that the price still dropped suggests that the post-expiry sell-off may have been greater than expected and doesn’t bode well for the lock-up expiries that are due over the coming months. Facebook could end up rivalling Zynga and Groupon for the title of “largest decline in stock price since IPO” (Facebook, of course, has already won the gold medal for “Largest decline in market capitalisation”).

How can a company that was valued at over $100bn just a few months ago now be worth barely half that?

Well, the scary fact is, it could get worse. Jan-Frederik Kobus came up some valuations for Facebook stock based on the methodologies commonly used on Wall Street. The results aren’t pretty, ranging from $6 to $10.

The only way Facebook is worth $19 a share, let alone $38, is if investors believe that it can generate far greater revenues than it does at the moment. So, let’s take a look at some of the risk factors that could affect its revenue growth.

User Growth

Facebook’s growth has been phenomenal. It rapidly eclipsed the previous generation of social networks and looks set to reach a billion users in the next couple of months. However, if Facebook adoption mirrors the standard technology adoption S-curve, subscriber growth will begin to slow at some point. Every Wall Street analyst covering Facebook will be adding newly-announced subscriber numbers to their graph and looking for any hint that the slope is flattening out, at which point we’re likely to see a rash of headlines and more downward pressure on the stock price.

Competition

The biggest threat to Facebook’s dominance of social networking is that a new entrant will disrupt Facebook in the same way that Facebook disrupted Myspace. Most people believe that the network effects that allowed Facebook grow so large, so quickly, present a massive obstacle to any challengers, but the fact is that, in an era of accelerating technological development, network effects are a double-edged sword.

Bear with me while I draw an tenuous analogy from the financial sector.

In the mid ’90s, the majority of trading in German government bond futures happened on the London International Financial Futures and Options Exchange (LIFFE, pronounced “life”), an open outcry exchange, where all trading occurred between traders shouting and gesticulating furiously at one another on a physical trading floor in London. Its closest competitor, the Deutsche Terminbörse (DTB), had managed to capture the local German banks’ dealflow but it wasn’t until it introduced screen-based trading (which allowed traders outside the trading pit direct access to the market, instead of having to place their orders through brokers who had seats in the pit) that it managed to challenge LIFFE’s dominance. Once DTB captured 50% of trading volume, a tipping point was reached and, within months, the vast majority of trading shifted from LIFFE to Eurex (DTB’s successor), where it remains to this day.

The worst-case scenario for Facebook is that a new entrant builds enough momentum to become the hot new way to keep in touch with one’s friends. Mobile presents the most obvious opportunity in the short- to medium-term but the obvious candidates to exploit it – Google and Path – have failed to make any inroads thus far.

In the longer term (which, to be fair, is probably a time horizon too distant to affect Facebook’s stock price today), the threat is likely to come from a generational shift, in which the children of today eschew the social networks their parents use, in favour of newer, trendier, more fashionable alternatives.

Business Model 

The lion’s share of Facebook’s revenue comes from advertising, which is a zero sum game – on the whole, companies don’t start spending more on advertising when presented with new advertising channels; they simply re-allocate their budget to the most effective channels. That means that Facebook must compete against other channels for every dollar of advertising revenue it earns, and the competition for advertising dollars is only set to intensify. The next big development in this area is likely to be targeted promotions, personalised by users’ location, demographic, personal preferences and their friends’ preferences and recommendations. However, this is a space which Google, Groupon and Foursquare are as well-positioned as Facebook to exploit.

The other key revenue stream for Facebook is what it refers to as “Payments and other fees”, the majority of which comes from Zynga, which hasn’t exactly been impressing the markets recently. While Zynga was content to leverage Facebook’s network to grow rapidly, there’s no guarantee that the next generation of social gaming companies (which, chances are, will be founded by disgruntled ex-Zynga employees) will be as keen to fork over 30% of their revenues to Facebook.

Zynga, like Groupon, surfed a wave of hype and explosive growth to rush to IPO, allowing the founders and early backers’ to cash out before it dawned on investors that the business model’s half-life was on the verge of expiring. Google, on the other hand, having triumphed over AltaVista, Northern Lights and Inktomi, found a viable business model and then proceeded to diversify beyond its core search-driven advertising business into apps, maps, videos and mobile phones, and continues to expand into driverless cars, glasses and fiber.

Facebook’s first attempt to expand its business beyond the confined of its own website was an unmitigated disaster and there has been little indication since that the company has either a strategy or the capability to diversify beyond its existing revenue models. Even if it starts tomorrow, it will be doing so while grappling with the challenge of maintaining its existing revenue stream while its subscribers shift to mobile.

Structural Shifts

In a sector as fast-moving as the Internet, the most dangerous threats are the ones that aren’t obvious or even visible – Rumsfeld’s “unknown unknowns”. Yahoo! never imagined that a PageRank’d search engine could replace its Internet directory. Sun Microsystems never imagined that a free, open source operating system running on Intel hardware would triumph over Solaris on UltraSPARC in the enterprise. Microsoft never imagined that Apple would rise from obscurity to rule mobile operating systems and Nokia never imagined that a company with 0% market share would come to dominate the mobile phone market. Back when I started using the Internet in 1993, I never imagined that, 19 years later, I’d be accessing the ‘Net from a handheld, wireless device, with bandwidth exceeding a T1.

Nobody knows that may appear out of leftfield over the coming years but one thing worth remembering is that the most successful communications and media technologies – from the original telephone, thru GSM mobile phones to 3G, from fax to email, from cassette tapes thru CDs to MP3, from VHS to H.264, from Ethernet to the Internet itself – have all been based on open standards and platforms. It seems unlikely that, in ten years’ time, we’ll still be logging into http://www.facebook.com in order to send friend requests, organise parties and share photos.

Facebook’s ability to foresee an recognise such changes, to pivot and adapt to them, will determine whether it follows in the footsteps of Google or Yahoo!

Leadership

The single, overriding factor affecting Facebook’s long-term success, is the company’s leadership. Ultimately, the buck stops with the CEO.

Back in 2001, when it became apparent that Google had discovered a viable business model in the form of AdWords, its investors (led by John Doerr of Kleiner Perkins and Mike Moritz of Sequioa) insisted that Page and Brin hire a professional CEO. They chose Eric Schmidt, who presided over a successful IPO followed by steady growth. By the time he handed the CEO’s baton over to Larry Page in early 2011, Google was generating annual revenue of $29bn.

By contrast, Mark Zuckerberg has held onto the Chairman/CEO role at Facebook. In theory, Sheryl Sandberg brings the managerial expertise that Zuckerberg lacks but, through Facebook’s dual-stock structure, he controls the majority (57%) of shareholder votes, despite owning just 28% of the shares, which makes his position and authority unassailable (as evidenced by his unilateral decision to acquire Instagram). It also gives him the ability to stack the Facebook board with yes-men, if he chooses to do so.

In effect, buying Facebook stock means that you’re betting that Zuckerberg has the ability to lead the company through the challenges detailed above.

The scandal over Facebook’s “selective disclosure” of reduced revenue forecasts to a select group of Wall Street analysts just before the IPO  will have dealt a blow to the market’s confidence in Zuckerberg’s. It will also have served to remind them of the controversies over how Facebook was founded and how Zuckerberg tried to screw his first investor. Investors don’t want to invest in a company ruled by a CEO who does whatever he wants – they want to invest in a company led by a CEO who delivers unto them a return.

Zuck successfully built the world’s biggest social network but it remains to be seen whether he can steer it through the challenges it faces, to retain that position.

Update – 20th August 2012, 14:53

Less than 24 hours after I wrote this, news emerged that Peter Thiel has sold the majority of his shareholding in Facebook, which can only add to the downward pressure on the stock price.

Written by jackgavigan

August 19, 2012 at 6:54 pm

Posted in Bubble 2.0

One Response

Subscribe to comments with RSS.

  1. I wonder if advertising is in fact “a zero sum game – on the whole, companies don’t start spending more on advertising when presented with new advertising channels; they simply re-allocate their budget to the most effective channels”

    Part of Google AdWords’ success is from bringing new advertisers into the market, such as small businesses, because of the ability to be so specific in when their ad appears. Certainly lots (probably most) of this advertising was redirected spending from “old media” like yellow pages, etc., but I think there is some money here too.

    Mark Gavagan

    April 15, 2014 at 9:51 am


Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s

%d bloggers like this: