The Facebook IPO post

Facebook finally filed its paper work for a forthcoming IPO and I was asked for my impression on it by David Moth, you can read his full article here.

DM: Facebook’s revenue was less than $4bn last year. What justifies a $75bn – $100bn valuation?
GC: The valuation is based on people’s perception of future earnings. It reflects a confidence in the investment and that the investors think the business has a substantial amount of potential for growth.

The question is what are those limits to growth and what is the financial glass ceiling that Facebook has ahead of it. I don’t know what that will be but I have some ideas about the limiting factors:

Context: one of the great reasons why Google is successful is because we are looking for something when we are on there, so chances are if you are looking for a plumber in London on Google you may want to click on an advert for a 24-hour call-out emergency plumbing service. More contextual data can be derived from mobile search: specifically location and further data could be mapped on top by plugging into other services – temperature, weather conditions, propensity to use facilities in that area  to offer more precisely-targeted content.

Contrast with Facebook which is very much about a social context; you can do a greater degree of targeting based on profile data (marital status, job title, stated location, age etc); I am not likely to click on job ads, mobile phone deals, get a new credit card or move over to a cable broadband provider when I want to see photos of a friend’s night out or details of their new-born child. You could map mobile information on top of all this, but because of the basic lack of context advertisers would have to work harder to earn a click and turn that into a business action. So given this, I would propose that Facebook inventory isn’t likely to fulfil its full revenue potential in comparison to Google.

Geographic expansion: a simple law of math is that Facebook will find it harder to continue to grow at the same pace as it has done already. The company is the social network for much of the western world, so it needs to grow next in China and the developing world. In China, Facebook would have to do a lot of work to comply with government regulations and it would face fierce competition from established local companies who continue to innovate and evolve at a great pace. The only reason why Facebook did so well recently in Korea was because of hacking attacks by an alleged state sponsor on Cyworld and other Korean web properties that stole critical information including national ID numbers. Prior this Facebook found Korea slow going due to hyper-competition from entrenched domestic players. In Japan, its a similar story. Mixi, social gaming company DeNA and other domestic players are making Facebook work very hard for each customer.

Facebook’s real identity principle made it very hard for the site to be accepted by a number of different cultures: Japan being a prime example.

Finally in terms of geographic expansion, not all consumers are created equal. Advertisers are more likely to pay more to get clicks from consumers who are likely to spend more money, so consumers from the developing world are likely to reduce Facebook’s ARPU (average revenue per user), whilst the cost of hosting their profile is likely to be comparable to a member from a developed country. Financial growth means harder work and greater expenditure.

Engagement: there are already some indicators that consumers maybe active on Facebook but may not be that engaged, how will this filter down in terms of how much advertisers will be prepared to pay and what they likely click-through rates are they likely to enjoy? Brand sentiment towards Facebook in mature markets shows that consumers are dispassionate about the brand and like it less than companies like Microsoft.

Legislation and regulation: As Facebook has gotten bigger it has undergone increased legal scrutiny. The European Union are already concerned about privacy issues relating to Facebook advertising, these issues are only likely to increase over time.

None of this takes into account things that may disrupt Facebook’s business like say Zynga losing its game mojo, risks that Facebook addresses in their IPO filing paper work.

DM: In your opinion, is it a good investment? Why?
GC: Well I won’t be looking down the back of the sofa to find money to invest. This IPO is likely to be aimed at and bought by large financial investors, they won’t be letting it go to ‘Joe Public’ until they have made a decent return from their investment.

Many of Facebook’s major investors like DST are locked in for at least 12-18 months so there is likely to be an under-supply of shares to meet likely market demand. In this case, large institutional shareholders will be at the front of the queue, it just isn’t a viable investment opportunity for smaller investors.

DM: Are we headed towards a new tech bubble?
GC: I don’t think so. Since Sarbanes Oxley, an IPO is no longer the easy step it used to be for technology companies. In many ways tech CEOs would find it far less desirable. Look at the way Amazon goes up and down on share price as Bezos makes long term investments.

Sarbanes-Oxley: Back in the day, technology companies used to go to IPO with small (tens of millions of dollars in market capitalisation), with Sarbanes-Oxley the increased compliance overhead was estimated to cost upwards of 5.1 million dollars per year back in 2004 and increase the costs of going public by 130 per cent. If you were a company that was barely profitable because of a focus on growth or wasn’t yet profitable like Netscape; those compliance costs could be better spent elsewhere within the business or saved to reduce the company’s burn-rate.

Competitive advantage: Secondly, not going public for as long as possible can provide a competitive advantage. When Google finally went public rivals were bowled over by their profitability and the cost efficiencies that Google was managing per search – information that Google had sought to mask for as long as possible from rival Microsoft. They managed to achieve a cost-per-search that is a third of that achieved by Microsoft, provide a better consumer search experience and do a better job at monetising its audience.

If we are going to see a bubble it is likely to be in secondary equity trading areas like SecondMarket.

DM: Which other companies will Facebook’s IPO affect the most?
GC: Zynga is the one that stands out because it accounts for something like 12% of Facebook’s revenue. Its share price bottomed out post IPO and only recently reached the floatation price again.

Since many people won’t be able to pick up Facebook stock, Zynga might be viewed as a good proxy, but there are flaws with this argument for various reasons.

I was surprised how right I was in this call. Zynga’s share price went up by 20 per cent.  I don’t think that Zynga is a particularly good proxy for Facebook. Zynga’s business is selling virtual goods; though it does some brand promotions inside the likes of Farmville. By comparison, the bulk of Facebook’s revenue comes from advertising. Zynga could lose its gaming mojo and go down in flames. Whilst this would hurt Facebook it wouldn’t affect 80 per cent of Facebook’s revenue; unless another games company was luring Facebook users to another platform for social interaction.

A change in Facebook’s advertising business will not reflect in a corresponding rise in Zynga’s revenues

More information:

Ed Cotton: Facebook’s Dangerous Game @PSFK
Facebook’s Real Problem in Just 44 Words
Zynga Shares Jump On Facebook IPO Connection | TIME.com
What Facebook isn’t telling you about its risky ad business | VentureBeat
Analysis: A sobering look at Facebook | Reuters
Here’s The Real Problem For Facebook’s Stock Valuation
Is Facebook peaking in the US? – FT.com
Why Facebook is a dead man walking
Why Facebook is a dead man walking part II?
Why Facebook is a dead man walking part 2.5?
Risk Reduction Strategies on Facebook – danah boyd
Teens Find Innovative Ways to Control Their Facebook Presence – All Facebook
On Facebook deactivations – Jillian C. York
Is Facebook peaking in the US? – FT.com
Facebook (Kinda) Disputes Slowdown Estimates, But Declines to Give Actual Stats – AllThingsD
Facebook Is Losing Users In The Countries Where It Took Off First
If growth in the US is flatlining then where is Facebook’s growth going to come from? « excapite
Report: Facebook Grew Only 1.7 Percent in May, Dragged Down By Losses in Oldest Markets – AllThingsD
Has Facebook Peaked? | WebProNews
Thoughts on Facebook’s apparent decline in the developed world
Facebook, privacy and consumer behaviour
Facebook fatigue