Much ado about Facebook?

The build up to the Facebook float is reaching near-hysterical levels, but huge question marks remain over the company's revenue model.

The Facebook float has become something of a phenomenon. Demand for the stock has been so strong that its promoters have raised the price range for the IPO from levels that already had sophisticated technology investors scratching their heads.

With reports that the Asian tranche of the offering already over-subscribed 25 times, and US newspaper reports of 11-year-olds wanting a piece of the action, there is a sense that the float has become more of a social event, one with cultish undertones, than an IPO.

The original plan was to sell around 10 per cent of the company to new investors at a price of between $US28 and $US35 a share, valuing Facebook at between about $US77 billion and $US96 billion. Yesterday the range was shifted upward and narrowed to between $US34 and $US38 a share, lifting the valuation to between $US93 billion and $US104 billion. The listing will now raise about $US12 billion.

That’s clearly a response to demand rather than fundamentals. Facebook’s first quarter results showed revenues and earnings actually falling relative to its fourth quarter numbers last year. While the company cited seasonality, a stock valued with the levels of growth that the Facebook IPO numbers imply shouldn’t be materially affected by seasonality.

There are other disconcerting trends within its business. Even as its numbers of users, and its advertising revenues have grown – it has about 900 million users and had $US3.7 billion of revenue and $US1 billion of earnings last year – the growth in its revenues per user has slowed and its margins have been shrinking.

That’s partly a function of its size – it has grown such a large user base so quickly that it can’t grow its advertising base fast enough to keep up with them – but there is a structural element to it to.

More than half Facebook’s users access through its mobile application and Facebook itself has conceded openly that it hasn’t yet worked out how to monetise that mobile usage. Unless it can crack that conundrum the continuing surge in mobile usage will undermine its economics.

It has been trying to beef up its mobiles expertise and understanding through a series of acquisitions, most notably the $US1 billion it spent recently to acquire the mobile photo-sharing app group, Instagram. Instagram is popular, but essentially has no revenue. A reality is that smartphones aren’t great vehicles for conventional advertising.

Another potential issue, unless Facebook can devise ways to increase its revenues per user, is the network’s sheer size. It appears inevitable that it will have more than one billion users soon. Given the number of internet users worldwide is estimated at about two billion, there is a ceiling on its eventual size.

If Facebook is to justify the heady price-tag being placed on it, it will need to get better yields from the advertising that generates almost all its revenue, which means it has to better exploit the extraordinarily deep user engagement and the user data it holds to enable advertisers to target their advertising.

That is a very sensitive issue, however, given the existing concerns about Facebook’s attitude towards its users’ privacy. Facebook isn’t the only social network out there and the My Space experience illustrates how quickly and destructively a social network can fall out of fashion, although Facebook is enmeshed deeply into its users’ lives.

The other reason to be sceptical about the valuations being placed on the group is that Mark Zuckerberg has made it very clear that he is more interested in improving the user experience than in building earnings and he will retain control of the group.

There is no reason to disbelieve him, which means that it is likely that he will continue to build Facebook’s cost base regardless of whether it translates into greater revenue and margin growth. In a listed company, that’s a recipe for tension between management and the market.

Facebook is, in terms of a business, obviously immature, with a crude revenue model. That suggests there could be significant upside if and when Zuckerberg and his team focus more attention on the commercial potential of the remarkable platform he has built.

Once listed, he is going to have to do that quite quickly and creatively – whether he likes it or not – because otherwise Facebook is definitely not going to be worth more than $US100 billion, at least not for long.

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