If Facebook is such a good investment why did Zynga’s second quarter profits drop 90%? To understand how Zynga is relevant to Facebook’s success one needs to read FB’s prospectus (oh joy).* There we learn that FB’s success is based on creating “value” for 3 types of customers.
The “user” group is the 845 million people who post on FB each month. Half of them are grandparents posting pictures of their grandchildren, the other half are people posting pictures of their dinner (sorry, couldn’t help myself). The second group are “advertisers and marketers” who post personalized ads based on information FB harvests from the user group and sells to the advertisers/marketers. This explains why I get ads telling me about the 50 things I should do in Calgary before I die while my hairdresser gets ads promoting the best gay bars in town.
The third group are “developers” who use FB to launch applications (often games) and drive traffic to their sites. They also access FB’s payment structure to get paid for “visual and digital goods”. What? A “visual/digital good” is the bale of virtual hay you buy to feed your virtual cow on the virtual farm you’ve bought from Zynga’s Farmville.
The FB business model is dependent on the user group as a source of personal information which can be sold to the advertising/marketing and developer groups. Unfortunately the needs, desires and legal rights of the user group frequently conflict with the economic drivers of the advertising/marketing and developer groups, resulting in a business model is fraught with knotty contradictions.
The biggest irritant to the user group, aside from a lack of privacy, is advertisements. Some FB users simply ignore the ads, other install ad blockers to eliminate them altogether.
The advertiser’s lack of exposure is exacerbated by the fact that FB users are accessing FB on their cell phones. In Dec 2011, approximately half of the 845 million monthly users accessed FB through their mobile devices. There are no ads on a mobile phone—the screen is too small. Ad revenue is dropping. In 2009 advertising revenue accounted for 98% of all revenue, in 2010 it dropped to 95% and in 2011 it dropped to 85%. This hole in the revenue stream must be replaced by increasing the size of the user group, developing ways to put ads on to mobile devices (and further irritating the user group) or developing alternative revenue sources. And there lies the rub.
FB’s business model is based on FB’s unimpeded ability to sell personal information from its users to advertisers, marketers and developers. This ability is under attack here and abroad. In 2009 the Canadian Privacy Commissioner ruled that FB breached Canadian privacy laws by sharing users’ personal information with developers (such as Zynga). The recent dust up with German data protection officials demonstrates that this problem won’t go away anytime soon—German federal agencies were ordered to take down their FB pages and disable the “Like” button on their websites.
FB fought these decisions but recognizes that evolving US and foreign privacy and data protection laws could seriously harm its business and that it is powerless to do anything about it.
So, is FB a good investment? The fact that FB’s IPO roared out of the gate at $42.05, sputtered and settled gently at $38.23 (just 23 cents above its “reserve price”) does not engender investor confidence. Particularly when one takes into account the fact that the FB IPO was a “bought deal” which required Morgan Stanley, JP Morgan and Goldman Sachs, as underwriters, to step in at the 11th hour to prop up the share price to prevent it from sinking below $38.
There are two explanations for why the IPO shuddered. The first is that the investment bankers did such a good job pricing the investment that everyone knew that $38 was the right share price (tell that to the underwriters now holding millions of FB shares on their books). The second is that a market capitalization of $104 billion—a multiple 100 times earnings—FB will require “bold new revenue streams to justify the mammoth valuation”**and FB’s contradictory business model doesn’t outline a clear way to get there from here.
The correct explanation will emerge in the fullness of time, in the meantime I’m keeping an eye on Zynga.***If Zynga says goodbye to FB, I’ll pack my virtual cow into my virtual truck and mosey over to an investment more closely tied to the real world.
*Facebook, Inc. Form S-1 Registration Statement filed Feb 1, 2012
**Constine and Cutler in TechCrunch Online May 17, 2012
***Zynga provided 12% of FB revenue in 2011. If Zynga reduces its use of the FB platform, launches games on competitor platforms or becomes dissatisfied with its relationship with FB then FB’s financial results will be adversely impacted. Registration Statement p 18.