Tuesday, February 07, 2012

The Facebook IPO

Facebook: Short term hype play, long term mistake

I've been asked what I think of the upcoming Facebook IPO. Here are my thoughts, with the usual caveats that I am not responsible for any decision you take, I am not a qualified adviser or anything of the sort, etc...

With that out of the way, let's get to the core of the matter.

+ Huge user base (850MM)
+ Powerful ecosystem and developer environment
+ High switching costs

- Mature concept
- Huge user base (how much more can you grow it?)
- Growing early adopter fatigue
- High valuation
- Small floatation
- Expected exodus after lock-in period

From a purely financial perspective, the problem is that FB has a high valuation (up to $100B), a huge user base (850MM people) and a small floatation that artificially creates scarcity. FB can't go any lower than $75B valuation, but at the same time it's very tough justifying it due to very low revenues ($3.7B) and even lower profits. While Google did go public at 100x profits, its valuation was much lower and allowed for 7x growth. In this case, a potential investor only needs to look at the upside. How much can he expect? If he buys at $100B valuation, more than 4x upside is wishful thinking. I'd assume about 2x upside within a couple of years at best, at a $200B valuation (similar to Google currently, after 6 years of floatation).
So an investor would look at a highly volatile and risky investment for a 2x upside at best, knowing that the user base won't grow that much more. The other reasons to grow FB's valuation are:
1- increased monetization of users through additional products and services
2- better profit margins
3- speculative bubble

I contend that FB's current massive reliance on advertising is a dead end. Advertising on FB goes completely against FB's value to users (better communication, reduced friendship friction) while for example advertising is perfectly aligned with Google's value to users (finding relevant information). So comparing FB to Google in valuation based on the advertising model is totally flawed and Facebook is hugely overvalued. All advertisers today on FB want to believe that things will get better and that they'll find a way to monetize those FB "likes" but that's just wishful thinking. Conversion rates are abysmal and they will stay that way.
So the only way to really increase monetization is through new products such as in-app purchasing (IAP). It is clear that this is what FB is betting on, but that hasn't been validated yet as a good long term revenue line. Most of the current profits here stem from Zynga (and others) that sell games, and we all know how quickly fatigue settles in. FB has maybe 3 years to find better use of IAP than FB games before that too fizzles.

As for better margins, I think that when FB gets better margins this will be a red flag: it'll mean that people are using less of FB's services, necessitating less computing power per user. True, computers always get cheaper and faster, but FB constantly has to innovate to keep the users excited, thus negating that advantage.

in my opinion the real fundamental achilles heel of Facebook today is the perfect storm of early adopter exit (like myself), regular user fatigue looking for the next fun thing to try, and emergence of highly targeted small social networks with high added value competing for user time.

To sum up, investing in the short term in Facebook is akin to playing the lottery, hoping that most people expect to win and drive up the valuation. But in the long term investing in Facebook is a very bland proposition that in the absolute best of cases will yield a 100% ROI given non-negative market conditions.

Personally I'm going to pass. At $30B I would have considered it.