Saturday, September 8, 2012

Why Facebook Will Falter

After all the intensive hype and then disappointment over the IPO, Facebook $FB went through another rite of passage by giving its first set of results as a public company. The market wasted no time in savagely marking the company down. Whilst the numbers hit estimates, I think there is a growing consensus that the company is not really articulating a strategy for how it can generate the kind of earnings growth in order to justify such a high valuation. In summary, I think there are a number of challenges here which are not being accounted for in the market price of this stock.

In a sense, this was an opportunity missed by Facebook. It had the perfect opportunity to outline a clear strategy for mobile and allay market fears over its direction but instead Zuckerberg in particular appeared more interested in promulgating Facebook’s ‘mission’ to connect the world. I suspect most investors are more interested in getting Facebook’s huge user base ‘connected’ with the bottom line of its profit and loss sheet.

Users Create the Value Not Facebook

This sub heading may seem a statement of the obvious but sometimes it’s hard to see something that is staring us in the face. Just as a lot of analysts were behind the curve with the speed of the shift to mobile internet usage, so I think many of them will be missing this key point.

Users create the content that ultimately is the value for the company. It is the content which gets people to use the site and it’s the content which creates the data which allows marketers to be more efficiently targeting and understanding their marketplace. Facebook itself does not create this content; it merely acts as a conduit.

Why is this point so important? I think there are three key reasons.

How Mobile is Changing Content and Value

Well firstly, if Facebook usage is going to shift to mobile then the content created for it (by its users) will start to evolve in a different way. It is wrong just to think of the shift to mobile as being a pc site now being downloaded on a mobile, especially when the content on the site is being created by someone using a mobile phone.  I doubt Tolstoy would have written ‘War and Peace’ on his Android phone but he might have swapped the odd picture of himself holding up a shot of Vodka with Victor Hugo. Of course, if the content changes then the way users engage with it will too and this has implications for mobile can be monetized.

Secondly, Facebook seems to be making a play of the fact that it wants to become the platform of choice for applications developers. Moreover, much is made of the opportunity to share applications activities with your friends. Again, I think Zuckerberg and co are rather over estimating their brand leverage and the fact these apps (usually games) became popular as a consequence of a group of people playing them on pcs. You only have to ask Zynga $ZNGA shareholders about how fortunes can change with this kind of stuff.

Facebook simply doesn’t create content the way that BMW adds value by manufacturing a car. There is no reason for anyone to be ‘loyal’ to Facebook in the way that I am loyal to BMW engineering. No one is obliged to ouse an app just because it’s available on Facebook. I may enjoy learning to speak German or following the Tour de France but I surely don’t feel the need to buy the app via Facebook and encourage my friends to do so.

And finally, if we accept that the content will morph in ne ways due to mobile being a different type of viewing than the value inherent in the data created out of this new online interaction will be different too. I doubt it will be as comprehensive. By definition pc usage is more ‘lean forward’ than mobile and this has a lot of consequences for the kind of data created. It also has repercussions on the type of advertising that can be integrated into the site. If I am discussing wine from Italy, I might appreciate an add from a wine distributor. If I am merely looking at a pic of a friend drinking wine in Italy, it would be a different story.

Mobile is a Game Changer

I think it’s time to reflect on what Facebook is and take Zuckerberg at his missionary word. It is an incredibly successful website that has in a way ‘connected the world’. However, if this is its mission then making money has been more of a by product of its success rather than its aim.

Indeed, even before the market started to realise the seismic shifts being created by mobile, questions were being asked about how Facebook would monetize its user base. Whilst Google $GOOG is leading the way in managing this shift, it comes from a proven background in generating advertising revenue. If anyone knows how to do it, it will be Google. I'm not sure the same can be said for Facebook.

So where does this leave Facebook?

Facebook has a huge user base and has had a genuine and lasting impact on society, yet the challenge remains to manage the migration to mobile whilst generating the earnings growth to justify a very high evaluation. Even with the recent fall, the stock still trades on 47x forecast  earnings for 2012 and its EV/Ebitda multiple of 25.4 would inspire vertigo in a high wire circus act.

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