Harnessing Facebook's raw talents

Facebook has filed for its IPO and while it is impressively profitable, the social media network's business model is still a work in progress.

The much-anticipated Facebook filing for an initial public offering that could value the dominant social network at between $US75 billion and $US100 billion has been made. It reveals a business model that, while impressively profitable, is very much still a work-in-progress and aware of its vulnerability.

The filing showed that Facebook made, at $US1 billion, profits last year that were materially less than had been anticipated and revenue that, at $US3.7 billion, was slightly less than the market expected.

Nevertheless, with revenue up 88 per cent on the previous year and earnings up 65 per cent, the eight-year-old company is definitely experiencing remarkable growth.

Even more impressive, it now has 845 million monthly users worldwide, a 39 per cent increase on the number it had at the end of 2010 and rapidly approaching the billion mark which, given its own estimate that the number of internet users worldwide is about two billion, says something even more dramatic about the extent to which Facebook has captured the online community.

Despite the litany of extraordinary numbers in the filing, however, the company makes it clear that there are still a host of uncertainties and risks confronting it.

An obvious issue that the filing raises is that, while there has been phenomenal growth in its revenues and earnings, the rate of growth has been steadily slowing and has been out-stripped by the rate of growth in the group’s cost base. Revenues might have grown 88 per cent last year but costs more than doubled, with a 169 per cent increase in marketing and sales expenditure and a 169 per cent increase in research and development spending.

In the filing the company itself says that it expects its rates of growth to decline in future. Revenue growth has historically been driven by user growth and, as it says, both will inevitably slow as its market penetration rates – already at quite dizzy levels – rise.

About 85 per cent of Facebook’s revenue comes from advertising. Another 12 per cent flows from a single company, the social network game developer Zygna, which currently distributes its products purely via Facebook. If Zygna’s products cease to be popular, or it shares them with or shifts them to other platforms, that would be damaging.

The key to Facebook’s future, and to whether or not it can live up to its expected market valuation, is whether it can attract more advertisers and extract better yields from them. While its user base is approaching one billion, self-evidently Facebook is achieving less than $US4 of annual revenue from each of them and only just over $US1 of profit.

The selling point to advertisers is that Facebook has almost unprecedented levels of engagement with its users and depth of data on them and their locations, activities and interests that allows advertisers to very effectively and efficiently target them. It should be able to attract more advertising, bigger advertisers and better yields.

There are delicate and potentially dangerous privacy issues involved in monetising that data, however, both in terms of the legality (Facebook has already had one settlement with the Federal Trade Commission) but more importantly in the users’ reactions if they believe Facebook is overly exploiting their personal information for commercial gain.

There is also always the possibility that Facebook loses its ‘’coolness’’ – and Mark Zuckerberg is clearly concerned that listing could alter the internal culture of the company – and users move onto something else.

That’s what occurred with MySpace when, after News Corp acquired it, it became ‘’corporatised’’ and too obvious and insensitive to its user in its attempts to monetise them. They deserted MySpace for the newer, cooler, Facebook. The pressure from investors to grow revenue and earnings would be acute if Facebook were valued at anything like $US100 billion.

Another opportunity/vulnerability for the company raised in the filing is that about half its users use its mobile products, a proportion that it expects to continue to grow.

While a majority of the mobile users also access the site on personal computers, Facebook generates no meaningful revenue from its mobile products. Unless it can find mobile revenue streams, the growth in mobile use is going to undermine its overall economics. If it does crack the ad market for mobiles, of course, that could be a significant incremental revenue opportunity.

When a business has such high penetration rates – in countries like Chile, Turkey and Venezuela it estimates it has penetration rates above 80 per cent of internet users and in the US and UK still-impressive rates of about 60 per cent – its rate of growth is destined to slow.

The thing that makes Facebook fascinating, however, is that while it is possible to see the growth in its numbers of users taper off, the commercial elements of its model are quite crude and very immature.

If Zuckerberg can reconcile his ‘’social mission’’ to make the world more open and connected with making money for his investors – without destroying Facebook in the process – it is conceivable that it might eventually be worth $US100 billion, or more.

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