Facebook: Stuck in the Friend Zone

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SEE LAST PAGE OF THIS REPORT Paul Sagawa / Artur Pylak

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January 16, 2013

Facebook: Stuck in the Friend Zone

  • 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.

Facebook – Like, NOT Love

Facebook’s big announcement was a let down. Graph Search will be a great tool for asking “What do my friends like?”, but will provide a wholly inadequate answer to the commercially relevant question “What should I buy now?”. Our friends perspectives will not be comprehensive or consistent, and may not be well articulated or even a reasonable proxy for our own tastes or needs. For the query categories that drive the vast majority of Google advertising revenues, Graph Search is not a viable alternative. Moreover, mobile users are unlikely to click through into the Facebook App to initiate a search when the Google search bar is sitting right on the boot screen of their device. The fanciful speculation of multiple billions of dollars in near term addressable revenue for Graph Search is just that, fanciful speculation. This speaks to the big question on the table for Facebook. It has those billion global users active on its site for an average of 6 hours per month contributing reams of personal data while Facebook tracks their behavior both on and off the site as long as the application is open. It has a data processing infrastructure and skill set that is the envy of any company not named Google or Amazon. What it hasn’t demonstrated is a clear path to the $25-$30 Billion in future revenues with expanding margins needed to justify its share price.

Extrapolating Facebook’s 3Q12 performance – 32% sales growth, a jump to 29% operating margins, 20% of ad sales from mobile – would get there in 5-6 years, but sustaining that pace is a tall task in the face of considerable risks. First, Facebook’s plans conflict with interests of the portable platforms that are becoming the main internet access for consumers. Apple, and Google can step in front of Facebook, integrating analogous capabilities directly, capturing unique usage information, and demanding a tribute from all revenues generated by Facebook’s apps. The growing complexity of Facebook’s feed is another major risk. The tide of photos, updates, links, discussions, messages, games, social media notices, sponsored stories, likes, and ads is already so great that user news feeds must be aggressively edited. The volume and diversity of the flow dilutes its value, creates a confusing context for placing ads, and moves the point of ad saturation closer. Moreover, the cacophony of the feed plays into the platform owners’ hands by requiring multiple clicks to find functions that are more easily used directly from the platform. This Facebook monolith should separate into multiple focused apps, streamlining the experience for users, opening space for more advertising, and improving the context for placing ads. Unfortunately, there is no sign that Facebook is moving in this direction.

The final area of major risk is privacy and engagement. Facebook pushes the envelope on privacy – anything communicated within the web site is fair game for the social graph and its cookies follow you as you navigate away to websites with “Like” buttons and mine other programs on your computer for information. To date, consumers haven’t cared about the increasingly aggressive policy, but consumer advocates, governments and advertisers are far more circumspect, and all could force policy changes to the detriment of the social graph. Furthermore, Facebook’s reign as the world’s default social network is vulnerable to alternatives with critical mass – there are more than 500 million Android users and Apple brags of having more than 450 million credit cards on file – and to focused rivals like Twitter, Pinterest, Tumblr and Quora siphoning off valuable engagement from the Facebook monolith. In the mobile environment, Facebook may cease to be the coolest and most convenient way to waste time on line.

Assessing the risks brings us back to expectations. Consensus forecasts Facebook to grow its revenues better than 30% per year for the next five years, while expanding operating margins to an average of 43% over the time. The current market cap seems to assume considerably better performance than that – at consensus margins and constant relative capital spending, FB sales would need to grow almost 45% per year to nearly $30B in 2017 to justify the current share price. While this growth is certainly possible, we are concerned that it is not likely, given the risks. Furthermore, given Facebook management’s apparent disinterest in managing for profit or for providing visibility to investors, quarterly disappointments are likely a matter of time (Exhibit 1).
Exh 1: Facebooks Iso-Curve

Billions Served

From its well documented birth in Mark Zuckerberg’s Harvard dormitory room, Facebook has been the rock star amongst its generation of technology companies. An early obsession with subscriber growth and faith in the willingness of ordinary consumers to share the details of their lives, paid off in a truly global critical mass of active users, shredding the would-be rivals My Space and Friendster in the process. Monetization was back-burnered for years, while Facebook built out data processing infrastructure, rolled into new geographies and broadened the scope of information that could be stored and shared on its system.

Today, Facebook boasts of more than one billion active accounts spread over more than 200 countries, including 20 users living in The Vatican. The US accounts for about 170 million of those accounts, and those users are rated as visiting the site nearly 1.5 times a day and spending a phenomenal 6.5 hours per month using the site (Exhibit 2). Those billion users have uploaded more than 240 billion photographs to be stored by Facebook. Almost all of them have provided their real name, and most have provided accurate demographic details, like their birth date, relationship status, family composition, home town, educational affiliations, and employer. Importantly, each user also identifies a list of their friends, all of whom have also provided demographic information. Moreover, Facebook is able to glean further information – e.g. life milestones, attendance at events, travel plans, general interests, and “likes” etc. – from postings and from participation in the many applications integrated into the site. Furthermore, Facebook grabs data from any web site that a user grants permission via an integrated login or even by clicking on a “like” button, giving it a view into user activity on those sites as well. All of this information is stored by Facebook until it is explicitly deleted by the user, and even then, it may remain if friends have reposted it to their own accounts. This is the basis of the vaunted Facebook Social Graph and no other company has it, or anything like it.

Exh 2: Facebook Monthly Active Users, by Region Q3 2009 Q3 2012

For users, those uploaded photos, posting history and extensive friend lists are the glue that ties them to the site – uprooting to a competitor would be trouble and getting all of one’s friends to move along would be nearly impossible. These switching costs, on top of the unique ability to facilitate sharing and communicating with a nearly comprehensive circle of friends and acquaintances, yield an enviable stickiness that keeps those billion users coming back and coping with the evolving nature of the service.

Building a Cloud

All of those users and all of that data require enormous information processing and storage capacity. Early on, Facebook understood the IT challenges posed by its business plan, investing in both infrastructure and talent to stay ahead of the curve. Facebook also benefitted from Google’s pioneering work in data center design and “big data” software technologies, much of which had been contributed to the open source community through published white papers. Today, Facebook operates from three massive data centers and has transitioned from buying commercially available systems to specifying its own custom designs, again following Google’s lead. In a play to close the gap with Google, Facebook has been aggressive in sharing its work with the Open Compute Project, an open source community formed around data center design, thus leveraging the contributions of academic and commercial partners in driving better costs and performance.

While we believe that Google remains in a class by itself with its proprietary hardware and software architectures, Facebook has established itself as the best of the rest. On at least one measure, Facebook may have even nosed ahead of the leader – its North Carolina data center recently posted a PUE ration (power usage efficiency) of 1.07, beating the Google average during an unusually hot summer. This commitment to data processing excellence is critical to Facebook’s ambitions, but enormously expensive. The company spent $0.6 B on capital items in 2011, and is on track to grow that number by 150% in 2012. Given its massive data processing needs and continued investment in infrastructure, there is no reason to believe that Facebook’s capital spending will drop off significantly in the future.

Now a Word From Our Sponsor

Once the critical mass and the social graph had been started, Facebook turned its attention to advertising, experimenting with a wide range of formats. Display ads were inserted to the right of the feed of posts from each user’s friends. Companies were invited to set up sponsored Facebook pages. The “Like” button allowed users to register their feedback to advertisers, and to cue the site to disseminate that feedback to their list of friends. Social readers and listening apps automatically notify a user’s friends when they read an article or listen to a song, an encouragement paid for by the source of the media. Sponsored stories interpolate media judged to be an appropriate match directly into user news feeds. Recently, Facebook introduced its Exchange, which gave advertisers the ability to match their own internet cookies with Facebook cookies, in order to match ads to users who had previously visited their sites. Facebook has also begun selling ads that are interpolated into user news feeds on mobile devices.

Mobile advertising is the most interesting growth opportunity on Facebook’s plate. Almost half of Facebook’s US usage now comes from portable platforms, vs. just 20% of its advertising revenues (Exhibit 3). Overall advertising spending on mobile platforms has lagged the extraordinary growth in adoption and usage of these devices, leading some to prematurely conclude that the smaller screens rendered mobile less attractive for advertising. We believe that the previous sluggishness of mobile has been entirely a function of the newness of the format and the conservative nature of advertisers, and that longer term, mobile advertising demand will exceed that of the classic web site. New analytic tools, including those provided by Facebook’s exchange, a growing track record, and the inherent immediacy of advertising to a portable platform should continue the mobile momentum. Anecdotally, we believe that the typically user’s mobile news feed is far from saturated with advertising now, leaving ample room for volume growth to supplement improving ad pricing.

Exh 3: US Facebook Ad Spend / Usage by Platform, November/December 2012

All in, Facebook’s browser and mobile app advertising will hit around $5B for 2012, up 60% vs. 2011, although much more difficult back half compares slowed the pace to 36% for 3Q12. This performance puts Facebook neck and neck with Google in the US Display Advertising Category, with both rivals surging well past the formerly number one Yahoo (Exhibit 4). The 3Q12 results showed surprising growth for mobile ads, now 20% of total ad revenues just two quarters into the program, a spur to a stock that had languished since its widely criticized IPO. With this backdrop, investors are justifiably optimistic for 4Q12 sales growth to continue the strong trend.

Exh 4: Net US Digital Display Ad Revenue Share at Major Ad-Selling Companies, 2010-2014

Outside the Garden

The success of Facebook Exchange suggests that the concept could be expanded to place ads outside of Facebook’s own site. Exchange works by allowing advertisers to match a user known on their own site to their Facebook account and engage them with advertising as they use the social network. An external ad network could follow those users as they proceed to sites willing to exchange cookies with Facebook. Facebook would place ads onto those 3rd party sites, taking a portion of the revenues as a fee for the placement. Google, currently the leader in this arena, generates more than $12B annually from its external ad network AdSense. Facebook has not announced specific plans to enter this market, although it is widely believed to be planning to do so and its social graph would be a considerable asset in competing for a share of this growing opportunity. We note that some advertising professionals have cautioned that Facebook’s aggressive stance on information privacy may lead some advertisers and 3rd party web sites to approach such a relationship cautiously.

Exh 5: Global Search Market Share (November 2012)

The Secret to Comedy is … t…Timing

Still, Facebook’s overall advertising revenues are just a tenth of its arch-rival Google’s. This is attributable to two major things that Google has that Facebook does not. First, the large majority of Google’s ad sales come from its dominant global internet search franchise. Search is inherently valuable to advertisers because it delivers its message to consumers at the precise point that they are making purchase decisions, in the context of data that they are seeking to inform their purchase. This value proposition is well established and well appreciated, while Google’s near 90% global market share gives them considerable power to influence the market (Exhibit 5). Second, Google’s fastest growing category is on-line video advertising, driven by the company’s YouTube business – easily the largest internet video streaming platform in the world. Consumers, habituated by decades of commercial broadcast television, accept the premise that video ads run in advance of free video programs are a fair trade off.

In contrast, Facebook suffers a bit from context. When consumers visit Facebook, they may be looking to communicate with friends, post photographs, or kill time reading their new feed. In many of these instances, advertising can be viewed as at best a distraction and at worst, a nuisance. At other times, users may be far more open – coming soon trailers interpolated into film discussions or restaurant recommendations when checking in from an unusual city. Unfortunately, for the most part, Facebook does not know a user’s purpose for coming until well after they have arrived, spoiling the timing for the delivery of ads. Delivering that relevant and timely context remains Facebook’s biggest challenge.

What if My Friends Don’t Know?

The quest for context is the impetus for the Graph Search product Facebook announced on Tuesday. Yes, it is a boon for users, who have struggled to cope with the fire hose of information available on the site. Long ago, Facebook added automatic filters to keep the torrent of status updates, comments, posted photos, linked articles and videos, likes, social media notifications, sponsored stories and newsfeed ads to a manageable stream, making a call whether or not to add items to the feed based on explicit and inferred preferences. Graph Search helps you find stuff that you lost in the flood, and to parse the information provided by your friends. Facebook broke it down into People, Photos, Interests, and Places, but ultimately it is about finding needles in the haystack and getting answers to questions about your Facebook friends.

Exh 6: Top 10 Keyword Categories and Top CPCs on Google Search

Facebook hopes that these searches will create context for advertising (Exhibit 6). If a user asks for the restaurants most liked by her friends, ads for area restaurants can be interpolated into the results. If a user wants to know what movie his friends have seen and liked, trailers for similar movies can be returned along with the answer. There are several problems with this. First, how important is the input of my friends to these decisions? In many cases, not very, particularly without further context – How far away are these restaurants? Are they open for lunch? What’s actually on the menu? What does the restaurant look like? What are the prices? Are tables available at noon? Graph Search is NOT going to provide that type of input. Second, the quality of Graph Search results to these sorts of commercially relevant queries will depend on whether or not a user’s friends have provided the information – the sample size will be limited to the friends you have and the range of input that they have provided. The knowledge that two of your several hundred friends have bothered to click a “like” button for something may not be particularly useful. Third, it is easier to use general Internet search – just begin typing into the search bar and click as soon as Google figures out what you are looking for. In contrast, Graph Search requires me to open Facebook first, a minor issue on desktop browsers where Facebook is already open in a tab but a major one on mobile platforms.

All of this leaves us quite skeptical that Graph Search will be more than a small increment to Facebook’s overall advertising business. While it is possible that Graph Search might be a stepping stone to a broader and more commercially relevant internet search product, the technical and market hurdles to compete with Google are extraordinary. Microsoft has spent over a decade and billions of dollars trying to make a dent and has just 10% of global search market share, including the searches that it processes for others, to show for it.

Happy Birthday … Please Enter Your Home Address to Receive Your Present

Late in 2012, Facebook launched a new business area – Facebook Gifts. Partnering with an armful of retail partners, the service enabled users to buy gifts for their friends, taking a undisclosed fee off of the top. Given that Facebook was already in the business of reminding its users of their friends’ birthdays, it had the ideal context for spurring impulse gifting. Facebook Gifting is easy – pick a present and enter the payments information, Facebook then sends a message to the recipient who enters their address to receive delivery. The retailer ships the product to the recipient using Facebook approved packaging, and Facebook walks away with their fee, the senders credit card on file and the recipient’s home address appended to the social graph. This is a great business for Facebook.

The real question is how big can Gifts become and can it be leveraged into a broader e-commerce platform. As to the first question, we see Gifts as a premium price service, more akin to Gilt Groupe than to Amazon without Gilt Groupe’s angle of liquidating inventory. Not only is Facebook taking its fee off of the top, but it is requiring special packaging, and working with relatively upscale retailers, so prices will be high and purchases driven by impulse rather than careful shopping. Noting that Facebook will almost certainly book only their fees as revenues, the margins will be very high but the sales impact will be modest. 2012 Gilt Groupe revenues are believed to be about $1B. Assuming Gifts can generate 15% fees on top of a similar volume nets Facebook a $150M business that is mostly margin – nice to have, but not a game changer for investors (Exhibit 7).

The short answer on the second question is no. The 2000 pound gorilla of e-commerce, Amazon, is a cruel taskmaster for on-line retailers looking for outsized margins. With comparison shopping just a click away, it is very hard to see the value that Facebook would bring to the on-line shopping, even with the ability to check with your friends for recommendations or encouragement.

Exh 7: Simpified e-Commerce Profitability Breakdown Amazon v. Gilt Model

Joe Schmo Just Bought a New Tractor!

A big piece of Facebook’s early monetization was social gaming. Users would “buy” virtual items for use in games like “Farmville” or “Mafia Wars” using real money on account with Facebook, which shared the proceeds with the game developer. Zynga, the publisher of the aforementioned Farmville, was responsible for more than 12% of Facebook’s $3.71B in 2011 revenues, with total non-advertising revenues (mostly games) of roughly $600M. However, in recent quarters, Facebook’s non-ad revenues have stagnated with signs that the social gaming craze may have peaked (Exhibit 7). Moreover, gaming companies, including Zynga, appear to have shifted focus to delivering games to portable platforms as apps, vs. tying them to Facebook. This trend appears tied to dissatisfaction with game notices being filtered out of newsfeeds and the perception that fee structures were more generous off of the Facebook platform. As social gaming remains a meaningful piece of current Facebook sales and profits, weakness could put future earnings at risk.

Exh 7: Facebook Revenue Exposure to Zynga

Lost in the Shuffle

The frustrations of game developers seeing their notifications filtered out of newsfeeds is evidence of a broader risk for Facebook, particularly as it looks to expand the range of activities it facilitates for its users. Initiatives like sponsored stories, social readers, and social media streaming have increased the already unmanageable river of data, relegating most of it to a real time ticker to the far right side of the web site and not present at all on mobile apps. Specific apps, riding Facebook as a platform, find it increasingly difficult to rise above the din. This is particularly troublesome in the mobile environment, which now accounts for more than 40% of the time spent on Facebook globally.

Exh 8: Active Facebook Usage in the US, Last 3 months

Filling the void, a number of more focused apps have arisen to provide a narrower, and thus, more satisfying user experience, while also creating a more consistent context for advertisers. Examples include LinkedIn for professional networking, Twitter for news dissemination, Pinterest for sharing “likes”, Tumblr for casual blogging, Reddit for discussion forums, Quora for tapping expert advice, and YouTube for video sharing and publishing. Many of these sites have driven their active users above 100 million with strong and increasing engaging metrics. Meanwhile, Facebook’s engagement numbers have been stagnant and its US monthly active user count actually ticked down by 1.4M in December, the first ever decline (Exhibit 8). It may be that the Jack-of-all-trades approach is losing traction.

We have been vocal in advocating that Facebook break its monolithic site into more focused, and thus, more engaging apps. Since acquiring photo sharing site Instagram in September, Facebook has kept the app discrete, looking to tie it to the mothership’s user rolls and social graph under the surface. Using Instagram as a model, Facebook could launch an archipelago of related apps – one for social gaming, one for “2nd screen” TV discussion, one for media streaming and sharing, one for local check-ins and reviews … you get the picture. Management has shown no inclination to this path, but we would be enthusiastic supporters if they did.

The Elephants in the Room

Facebook has always thought of itself as a platform, on which an infinite array of applications might run, all informed by the social graph. This was reasonable in the era when its users kept Facebook open all day long in a browser tab, returning with a quick mouse click to pick up on whatever they were up to the last time they stopped in. Portable platforms are different. Apps on an iPhone, iPad or Android device do NOT stay open all day long. Users open Facebook for a reason, do their business and close it again. This makes using Facebook as a platform – opening Facebook, then clicking through to an application – a bit of a nuisance compared with using an alternative app directly.

This is amplified when the platform owners – Apple and Google – can favor their own solutions by making them defaults that ship with the product or even by integrating the functionality directly into their operating systems. This happens with EVERY release – Apple famously ditched Google’s Maps for its own poorly received alternative, Siri crowded out a host of 3rd party voice control apps, Google is squeezing sites like Yelp and Expedia with its integration of local reviews and travel services. Many of Facebook’s ambitions involve functions that will butt heads with the ambitions of the platform owners. Facebook applications like streaming media, news distribution, photo sharing/archiving, local check-ins and reviews, messaging, video conferencing, discussion groups, and gifting, are all vulnerable to future integration by the platforms. Furthermore, the platform owners also control unique location and usage data that could help them chip away at the advantage of the social graph.

Exh 9: Platform Advantage – iOS versus Android Apps and Features

Adding injury to insult, Apple and Google will also charge Facebook for the privilege of having a disadvantaged seat at the table (Exhibit 9). Both the iTunes App Store and Google Play ask for 30% of the revenues generated by the app – including the price of the app itself, any subscription revenue associated with the app, any physical product sold via the app, AND any advertising revenue generated by the app. By virtue of its powerful user base, Facebook has undoubtedly been able to negotiate better terms, but it is almost certain to be paying something now and will be asked to pay more in the future as it looks to add new revenue sources to its app. Should Facebook’s relative negotiating power wane for any reason, the deals on the table will be markedly less attractive.

The Fabled Facebook Fone

Platform advantage is the reason that Amazon pushed hard to move from e-readers to full-fledged tablets, and why the rumors persist that it will bring out its own smartphone. Jeff Bezos is smart enough to understand that Google and Apple will cut him out of the game if they can, and an Amazon-centric platform is a great hedge if they try. The same logic applies to Facebook, only about 3 years later. Unfortunately, in electronics, 3 years is a lifetime. Amazon sells its tablets at cost from the world’s most powerful on-line retail platform and has gained roughly 8% share of the US tablet market for its hundreds of millions in investment. The road for Facebook, which lacks device development skills and has no obvious distribution platform, would be harder. A previous attempt at a Facebook optimized phone – a Android-powered HTC model with a dedicated Facebook button – was a significant flop, but rumors persist that HTC will be coming back with another try in 2013. It is not clear how different the user interface might be from HTC’s other Android phones or how such a product would benefit anyone other than Facebook or perhaps HTC. Given HTC’s 5% share of the global smartphone market and the fact that the rumored Facebook model would be just one of many, this story seems to be a yawn no matter if it is true or not.

Privacy

Facebook has a storied history of user privacy controversies. In 2007, it launched Beacon, which automatically posted notifications of purchases made on e-commerce websites to users’ walls without permission, but had to shut down the service under heavy criticism from consumer advocates. In 2009, it abruptly changed its default privacy settings, allowing anyone to see user demographic information and their friend lists. Later that year, it was cited by the Electronic Privacy Information Center (EPIC) for “Unfair and deceptive business practices” including adding a “friends only” privacy mode that nonetheless allowed 3rd party applications to access all of a user’s information. The forced adoption of Facebook’s Timeline interface in 2011 made public older posts and photographs that had previously unavailable Facebook is also reputed to have more than 5 million users under the age of 13, in violation of the Children’s Online Privacy Protection Act. Reports that Facebook is working on an external ad network to track Facebook users onto 3rd party sites is being met by concerns from advertiser groups asking that such ads be labeled as deriving from Facebook internal data. Finally, last month, Facebook released changes to the privacy policy at its recently purchased Instagram business, asserting that it reserved the right to use user photographs in advertisements on its sites, that it would share user information from Instagram with advertisers and other partners and that future advertisements might not be clearly labeled as ads – in clear violation of industry norms – with no way to opt out without leaving the service.

This aggressive flouting of on-line privacy standards puts a bulls-eye on Facebook’s back with consumer advocates around the world. It is possible that governments, particularly in Europe where privacy concerns are generally given greater attention, could intervene in ways that could damage Facebook’s ability to leverage its Social Graph for commercial gain. It is also possible that publicity around these privacy issues could lead to a user backlash against Facebook.

Exh 10: Average Monthly Time Spent Per User, September 2012

Begin the Backlash

Social media monitoring company SocialBakers reports that Facebook’s US base of monthly active users dropped by 1.4 million in the month of December. While a one-time drop of less than 1% does not establish a trend, it is the first such drop that has been measured. There is also likely little room for Facebook’s 1 billion strong user count or 6 hours and 40 minutes of monthly average user engagement to go up (Exhibit 10). There are several factors that could catalyze a backlash.

Privacy concerns are an obvious issue. Facebook users have been famously blasé over the years in the face of the company’s litany of aggressions, but consumer advocates are indefatigable and an unexpected, emotionally charged breach, perhaps tied to underage users, cyber-stalking or some other socially radioactive topic could push the public sentiment against it. Users may also be tired of the confusion – constant changes to the interface and the torrent of information – and move their interactions to more focused and user friendly venues. The growing barrage of advertising could also become off-putting to users, particularly if Facebook follows through with its idea of serving ads into newsfeeds without identifying them as such. On the American Customer Satisfaction Index, released in July, Facebook’s rating dropped from 69% approval to 61%, placing the company in the bottom 5 of the 230 companies rated (Exhibit 11).

Exh 11: Internet Social Media Customer Satisfaction Index July 2012

A real consumer backlash could sap the ranks of consumers most valuable to advertisers and reduce the currency of the social graph, perhaps strengthening alternative services like Google+, Tumblr and Twitter in the process. It would also shift the perception of the company amongst advertisers to the detriment of business momentum and with investors to the detriment of share price.

Is it Worth it?

Sell side analysts have high hopes for Facebook – consensus expectations are for sales growth to average 30% over the next 5 years and for operating margins to expand to a 45% average for the period. Given 3Q12 YoY growth of 32% and 29% operating margins, and the risks posed by platform owners, privacy issues and consumer backlash, these forecasts seem better labeled possible than probable (Exhibit 12). Based on the current market cap, investors are even more optimistic. The iso-curve of 5-year sales growth and operating margin assumptions consistent with the share price is nearly 1500 basis points above those rich consensus expectations. While this juxtaposition of consensus and embedded assumptions offers solace if the expectations are reasonable, it is a serious problem if there is risk of a miss.

While the 2013 consensus is not particularly aggressive, we remind investors that Facebook does not have a good track record of delivering against quarterly expectations or of communicating effectively with investors. Mark Zuckerberg has not earned the market deference accorded to Jeff Bezos, and a quarterly miss would not likely be treated kindly by investors.

Exh 12: Facebooks Consensus Estimates

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