January 16, 2013 – Facebook: Stuck in the Friend Zone

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Facebook has a LOT of users, a LOT of unique information about them, and a large scale, sophisticated data processing infrastructure, with “big data” capability second only to Google.  FB has a good start in applying those assets, taking its share of internet ads from 5.4% to 5.8% YoY.  The rapid growth of on-line advertising, the growing appreciation of advertisers for the precise targeting and wide reach enabled by FB’s unique assets, and the rich set of innovative ad formats being introduced by the company give ample reason for enthusiasm.  However, there are risks.  As web access moves relentlessly to portable platforms, iOS and Android will offer integrated alternatives to many parts of the FB experience and require substantial payments to allow Facebook’s apps onto their platforms.  More focused rival apps may also siphon usage, as FB’s one-stop platform approach is less suitable to the app-driven portable environment.  Finally, FB is unusually vulnerable to possible privacy regulations and/or shifts in user behavior that could reduce the quality of the data that it is able to collect.  In this context, consensus expectations that FB can sustain its current 30% YoY sales growth for the next 5 years, while expanding operating margins by an average 1600 bp, may be optimistic and the assumptions embedded in the current price are likely even more so.

 

Detailed profiles on 1 billion active users, and a near state-of-the-art distributed data processing infrastructure to boot.  The bull case on Facebook is easy to grasp.  FB’s billion users are more than double the number of registered iTunes customers or Gmail subscribers, and FB’s user engagement is greater than any other site on the web.  Its business concept and its super aggressive privacy policy have yielded a unique information asset, with extensive demographic and usage data tied by name to individual consumers.  The company has invested billions on a powerful data center infrastructure that is second only to Google in sophistication and performance.  Just eight years after its birth in a Harvard dorm and less than a year since its IPO, FB is now squarely focused on monetizing its extraordinary assets.

 

A good start on advertising revenues.  FB delivered an upside surprise in 3Q12 with 20% of revenues coming from mobile ads just 6 months after entering that market.  Strong growth also came from the launch of Facebook Exchange, which allowed advertisers to match FB’s browser cookies and target previously engaged consumers.   FB’s share moved to 14.4% of display ads, and 5.8% of the total internet advertising market.  Given that mobile feeds are far from saturated, investors are appropriately enthusiastic about the prospects for further growth in the seasonally strong 4Q.  Moreover, FB is expected to roll out additional advertising products, such as Instagram ads and a 3rd party ad network in direct competition with Google and Yahoo, with ambitions to expand its presence in media distribution, gaming and e-commerce. 

 

The power of the platform.  FB does not have its own portable device platform, posing several risks.  First, FB must pay to play – Apple and Google ask 30% of all revenues for apps on their platforms, and Apple charges Google billions of dollars to remain its default search engine.  FB is undoubtedly paying for access now, and the platform owners’ leverage will increase with time and future renegotiations.  That leverage also allows the platform owner to favor its own solutions, a la Apple’s new Maps or the integration of Google+ into Android.  FB is already butting heads with Apple and Google on many of its growth initiatives– e.g. social readers, streaming media, games, e-commerce, etc..  Finally, the platform owners may have control over valuable user data, such as location, mobile payments purchase history, media preferences, etc., that could give them advantage over FB in competing for future ad spending.

 

Search me.  The torrent of FB data is overwhelming for users, prompting it to launch Graph Search to facilitate finding relevant content. Graph search cannot rival Internet search for the queries most valuable to advertisers, and the random posts and likes of hundreds of “friends” or even tens of thousands of “friends of friends” are insufficient to adequately answer the most common types of searches.  Furthermore, mobile users are unlikely to bypass the convenience of the integrated search box in favor of seeking limited answers by clicking all the way into FB. 

 

Too much information.  FB’s growing roster of tangentially-related, yet fully integrated activities suffer in a mobile context, where more focused alternatives for specific functions are available with a single click, rather than the two or three necessary to navigate FB.  Moreover, ads lack context as users navigate their streams for a panoply of purposes, many of which may not be conducive for the advertising being served.  We believe FB will need to subdivide its monolithic service into an archipelago of more focused apps – giving users more focus and allow advertisers to reach them at more context appropriate moments.

 

Privacy and engagement.  FB has a history of pushing the privacy bar far past industry norms, drawing condemnation from consumer advocates.  Thus far, users have shown little concern as FB uses more and more of their presumably private personal information to expand their social graph.  Nonetheless, the din of complaints has a sympathetic ear with governments, which could act to regulate FB and constrain its use of personal data.  Moreover, there are anecdotal signs that a FB consumer backlash could gain momentum – catalyzed by privacy, advertising density and the clutter of the FB news stream – possibly leading to reduced engagement and reduced willingness to share personal data.  Any deterioration in the quality of user data that FB is allowed and/or able to collect would greatly diminish its usefulness to advertisers.

 

The cart is ahead of the horse.  The 5 year consensus expectations for FB forecast continued 30% growth and a 1600 bp improvement of operating margins to a 45% average for the period.  We are concerned that these estimates to not adequately the real risks that the company faces.  The current market price implies growth and profitability well ahead of consensus, a valuation that we believe is extremely vulnerable to possible future downward revisions.  The one saving grace is that current year expectations appear relatively reasonable, although Mark Zuckerberg’s well-known distain for quarterly reporting leaves the stock unusually vulnerable to quarterly surprises.  We suspect that FB will be available to interested investors at a significantly lower entry point in the future.

For our full research notes, please visit our published research site.

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