This is Part 1 of a report on Facebook’s business opportunity. In Part 1 we analyse Facebook’s various business engines and try to figure out whether and how they can grow. In Part 2, published next week, we will draw on this analysis to provide our revenue and earnings estimates for Facebook over the next few years.
Photo: CIA World Factbook, International Telecommunications Union, BII Estimates
The conundrum of analysing Facebook’s business is that it is an amazing business by any standard—except the once-in-a-lifetime standard Facebook has set itself.Facebook earned about $1 billion dollars last year on about $4 billion in revenue, 7 years after its founding.
But, Facebook’s growth, while still very strong, is decelerating, which will make it hard for it to justify its $75-100 billion IPO valuation.
Photo: Business Insider
If it wants to be an era-defining company, and not “just” an excellent business, Facebook is going to have to generate a LOT more revenue and a lot more profits in the years ahead. (See chart)Can it?
This is what we’ll be exploring here. In this note, we’re going to evaluate Facebook’s current and future businesses, and whether and how they can grow. In a future note published next week, we’ll put some numbers to our analysis and provide revenue and earnings estimates for Facebook.
So, what are Facebook’s current and future businesses? There are basically five, which we’ll look at in turn:
- Display ads. This is what brings in the bulk of Facebook’s revenue today and will always be an excellent revenue engine. Hundreds of millions of people visit the site every day, and view tons of pages. Given all those page-views, even cheap rinky-dink ads add up to billions of dollars of revenue.
- New, “social” ads. This is a business that Facebook is still experimenting with, and it is hoping that this is what will get Facebook from being a “merely” excellent business, to becoming an incredible, category-defining business like Microsoft, Amazon, Google and Apple.
- Mobile ads. Facebook is just starting to monetise mobile, and it is doing it in a very clever way—by bundling it with the rest of its advertising.
- Facebook Credits. Facebook Credits are Facebook’s virtual currency, which is mostly used to pay for virtual goods inside Facebook games, and on which Facebook takes a 30 per cent cut.
- An ad network. Facebook has said repeatedly that it’s not planning on doing an ad network, but most people, particularly big investors, expect it to introduce an ad network at some point. This makes sense because of all the data on its users Facebook has, and because most Facebook users are already identified on third-party sites through products like Facebook Connect and the “Like” button.
Let’s dive in, shall we?
On almost every single page on Facebook there are ads. They’re best understood as regular display ads: They are sold at CPM (sometimes CPC) rates, and don’t have the magic capacity of Google’s search ads to generate clicks that lead to sales. (For more info on Facebook ads and how they work, read our explainer.)
Facebook display ads don’t look like the banner ads you see most everywhere on the web, and they use Facebook’s unique demographic data set for targeting. But for all intents and purposes, they basically function the same way. And display ads are basically the oldest form of advertising online, so they’re not exactly some exciting new advertising paradigm.
Photo: Facebook S-1
They do have one advantage, though: They work. They’re generating billions of dollars of revenue for Facebook (see chart), and doing it profitably.Why? Simply because of Facebook’s sheer scale.
Facebook display ads “convert” (lead to clicks and transactions) like most display ads, i.e. at horrible rates. Therefore, they are very cheap.
It is hard to find data on average CPMs, because individual CPMs depend on many factors, including how much you target your ad, who you target it to, etc., but the consensus seems to be that CPMs are between $3 and $5—in other words, low.
That seems like a bad business.
And it would be, if there weren’t 845 million people visiting the site every month, 483 million of whom visit every day. A large number of these people visit several times a day. A large number of these people spend a lot of time on Facebook, looking at photos, playing games, and so forth. This generates billions of page views, and on each of these pages, there are typically more than one ad (see example screenshot below). Even at a fraction of a penny per ad, that is still a huge business.
Ok, but can it grow? Can it really grow?
We think it can.
- Facebook’s user numbers will keep growing. Facebook has a network effect, which means it will draw in more of the population in the places where it is dominant. Despite how big it already is, Facebook still has regions left to conquer where it’s not yet dominant; besides China, where it is banned, it’s hard to think that it won’t become dominant in many of these regions (Russia, Brazil, India, South-East Asia) as it has everywhere else.
- CPMs will keep growing. CPMs grew 8 per cent in Q4 of 2011 sequentially, according to a TBG Digital study—an impressive number. CPMs will keep growing because of simple supply and demand factors: Even as pageviews grow along with usage (i.e. supply), all available evidence points to advertiser demand growing even faster, raising prices. For all its size and importance, Facebook is still a relative minnow in the $100+ billion global online advertising market.
In other words, in the next few years Facebook will find itself in the enviable position of selling ever more of its product at increasing prices. What’s more, this will be accomplished only by the product’s “momentum”: increased usage and increased advertiser demand that goes with it. Display ads are a well-understood commodity, not hard to comprehend or sell, and Facebook can pump it out by the billions. At some point this momentum will wane, of course, but there’s no indication we’re close to that.
Because display ads are a (profitable for Facebook) commodity it means Facebook can keep riding its growth, but it also means that it’s also highly unlikely to deliver the kind of amazing revenue and profit growth that Facebook needs. For that, it is betting on its more experimental forms of social ads.
But in the meantime, it’s an amazing strategic advantage to have: Facebook has a multibillion dollar, high-growth, high-profits cash cow that it can basically run on auto-pilot, giving it all the operational and financial leeway to experiment with more speculative—and potentially even more lucrative—products.
These more speculative products are social ads.
It’s not an overstatement to say that Facebook is betting its future growth on social ads. As we’ve noted, while display ads are an excellent business which is likely to keep growing very nicely, Facebook’s growth has been decelerating of late (see chart).And Facebook needs accelerating growth to justify a sky-high valuation. This is where social ads come in.
What are social ads?
They come in basically two flavours: (Check out our explainer on Facebook ads for a more in-depth look.)
- The first is Sponsored Stories, which turn organic user actions into ads. If a user likes an ad or product on Facebook, a brand can pay to promote that action as an ad to that user’s friends, thereby promoting themselves along with a friend’s endorsement.
- The second, recently announced and called “Premium On Facebook”, lets brands pay to spread content originating on their brand pages throughout Facebook. This is interesting because only a fraction of users who have opted in to receive a brand’s content will see any given piece of content, because it’s mixed in with all of the other updates they receive in their news feed. Brands can pay to make sure almost all of their “fans” see specific updates. And this is all the more interesting that those users are presumably “Glengarry leads” because they have already opted in to receive that brand’s content.
The questions to ask to know whether social ads will give Facebook the growth it needs is: Are they catching on? And: Will they catch on?
Are they catching on?
From our various conversations with industry insiders involved in Facebook advertising, we would say the answer is “Yes, but not on fire.” Most advertisers we’ve spoken to find these products interesting or useful, but they’re not wild about them. Some of them are. But not most of them.
And Facebook wants most of these people to go wild in order to get the revenue growth it’s betting on. Wild in the way advertisers were when Google search ads first came on the scene.
Ok. So: Will they catch on?
It’s speculative because Facebook only recently launched its latest social ad product, Premium On Facebook, but we do believe Facebook social ad products CAN be amazing growth engines.
For that to happen, social ads need to provide at least one (preferably two, but at least one) of the following things:
1. A clear link between ads and transactions.
It’s what makes search advertising so successful, and what makes social network advertising (from a ROI perspective) so dismal. Search ads lead to transactions in an efficient and measurable way. Right now, social ads do not.
It might not be that way forever, however. One of the most tantalising findings of our discussions with insiders in the Facebook ecosystem is that Facebook ads might lead to transactions in a way that’s not measured but may be measurable. Here’s how we put it in a note about a discussion with James Borow, CEO of GraphEffect, a startup that helps brands manage advertising on Facebook:
“A sponsored story may influence someone to share a post and then that share leads to the sale. We can now attribute that to the original ad [,” Borow said.] Because that second-order effect isn’t usually tracked, Facebook ads seem to have a much lower ROI than they do. […] “I often refer to it as the death of the click. What now is relevant is the connection, or the share, and that is why Facebook is going to be a force for [direct response] advertisers in the coming years.” If this effect works and can be measured well for advertisers, this could completely change the picture for Facebook. Google’s bottom of the funnel business is the most amazing online business model because it delivers measurable, reliable ROI for direct response advertisers[.]
If Facebook can figure out a way to measure and scale this idea, it could threaten to cannibalise Google’s business.
2. Engagement on demand. But an even bigger story is the promise of engagement on demand. This is what Facebook is aiming for. It’s what advertisers are craving. And it’s what no social service has thus far been able to provide in a completely satisfying way.
What does “engagement on demand” mean?
The promise of social media marketing is that it can help brands engage with consumers in a much more personal and effective way. The problem with accomplishing that promise is that the kind of engagement that works now is also very high-touch: It requires frequently creating custom creative, hiring “community managers” to interact with people on Facebook and Twitter, and so on. For social media advertising to become a gigantic business the way search advertising has, it needs to be able to provide engagement in a scalable way—to go from high-touch engagement to engagement on demand.
Here’s why this matters: Social networks often hype up their potential as advertising platforms by pointing to some clever campaign that a brand did that helped lift some metric or generate sales. And that’s great. But the reason why search works for advertisers is because you don’t have to be clever. You choose your keywords, write your creative, and buy, and you will get as many clicks as you buy, and many of those clicks will lead to sales because many of the people who clicked were people who were looking to buy. There are no ad industry awards for search ads.
It’s the same thing with TV, which is the king of “top of the funnel” advertising that Facebook seeks to replace. An amazing, award-winning TV ad is a great thing for a brand to do. But TV advertising is an enormous business because, as countless soft drinks/beer/car/lingerie/CPG brands have discovered, buying tons of air for mediocre ads also works. It increases brand recall, which over the long run increases sales. You don’t have to be clever. It’s better to be clever. But you don’t have to be. By definition, a medium that you can only make work if you’re really clever about it will only attract a minority of advertisers, because clever people are a minority. It’s never going to scale. Social media works great for a minority of brands that have invested in becoming clever about the medium, and that’s great, but it won’t be a gigantic business the way search is for “bottom of the funnel”, and the way TV is for “top of the funnel”, until it’s scalable the way these media are.
If a social media ad product accomplishes this—if it finds a way to provide engagement on demand, as opposed to high-touch engagement, it might make social media replace TV as the king of “top of the funnel” advertising the way search has become king of “bottom of the funnel” advertising. That’s what Facebook wants to do with social ads. And if it pulls it off, the business opportunity is as big as, if not bigger than, Google’s.
- If social ads don’t deliver a clear link to transactions or engagement on demand, Facebook’s business opportunity will be limited to commodity display advertising, and the best way to think about it will be as a kind of super-Yahoo.
- If social ads deliver a clear link to transactions, Facebook’s business opportunity won’t just include display advertising but search advertising and other kinds of direct-response/”bottom of the funnel” advertising. It will also pose a much more direct threat to Google’s business.
- If social ads deliver engagement on demand, they have a very good shot at gobbling up not just the online display market, but also a share of the offline market, particularly TV, by becoming advertisers’ preferred “top of the funnel” advertising medium. (Premium On Facebook ads can be video ads.)
In other words, Facebook’s advertising opportunity could be not just enormous, but much bigger than most people even dare to dream. Or, if it fails at “cracking the code” of social advertising, it could be much smaller than its current valuation suggests.
So, which is it?
We think there is a good likelihood that Facebook will figure out a way to deliver engagement-on-demand with social ads.
We think the new Premium On Facebook formats, or some variation thereof, can do this. Why?
Because the way Premium On Facebook works is to show brand content to users who have already opted in to receive that content. In other words, it promises to take users that are already, if mildly, engaged, and jack up their engagement.
It’s a very clever model. Facebook is essentially saying to brands: “We’ll let you talk to about 15 per cent of your fans for free, but if you want to talk to 100 per cent of them, or if you want to talk specifically to a targeted subset of them, you’re going to have to pay up.” Everybody wins in that scenario (sorry brands, you’re not going to get everything for free).
It’s scalable. It’s on demand. And conceivably, trackable if it leads to a transaction.
Now, this is just speculation at this point. Premium On Facebook has only recently been announced and we don’t yet know for sure how well it works and how much advertisers like it. But we definitely think it has a lot of potential. And we think that, if not Premium On Facebook, then something like it will “crack the code” and become the “search ad of ‘top of the funnel’ advertising.”
This suggests that Facebook is poised, over the next few years, to grab a much bigger slice of the display advertising market than it has today.
Another good aspect of Premium On Facebook is that it’s allowing Facebook to start monetizing mobile in a very clever way.
Photo: BI Intelligence
Facebook has 425 million monthly active mobile users. It’s the number-one app on most mobile platforms.And up until very recently, Facebook was not monetizing this audience. Not one bit. That has changed, however. And the way Facebook is doing it is very clever.
Facebook will not be selling “mobile ads.” Instead, mobile ads are part of the new Premium On Facebook format.
As you’ll recall, the way Premium On Facebook works is that it takes content originating from brand pages and spreads it elsewhere on Facebook so that brand fans can see it. One of the places where Premium On Facebook ads will be shown is users’ news feeds on mobile.
Why is this so clever?
Because mobile ads are very cheap. CPMs are very low. And justifiably so: The ads are tiny, and for most kinds of advertising, GPS and other mobile features don’t really add value.
By making mobile a part of its broader advertising offering, Facebook can provide a better experience to its users (ads in the news feed in a native format instead of ugly banners in the app) and monetise at a much higher rate than with standard mobile advertising. And it’s defensible to advertisers as well: If the point of the ad is to show something in a user’s news feed, then that would, at least arguably, have similar value if you do that on mobile or on a desktop.
The bottom line is that this is a huge audience that Facebook will only now start to monetise, and it is going about it intelligently.
Facebook’s big revenue source besides ads is Credits: its virtual currency. It’s been growing very fast as a percentage of revenue (see chart).
Is it going to keep growing? And if so, how fast?
As Henry Blodget wrote, while credits revenue exploded from $100 million to $500 million in 2011, it’s unlikely that this growth rate will continue, as it comes from the fact that Facebook started charging a 30 per cent fee on transactions on its platform. The growth rate came from this tax, which Facebook can’t reproduce or raise for fear of killing its platform.
Does that mean that credits will stop growing?
Photo: Business Insider Intelligence
We don’t think so. Credits revenue mostly comes from virtual goods bought by players of social games on Facebook and, as we explained in our report on the future of social gaming, we think the sector will grow rapidly over the next few years (see chart).Right now, about a third of the online population regularly plays social games. We think this user base will expand to two-thirds of the social network-using population over the next five years. This user growth will be driven by the creation of games that appeal to demographics who do not currently use social games, such as younger adults, teenagers and hardcore gamers.
So over the next few years, the credits business should grow very nicely. It just won’t grow as fast as it’s been growing for the past year or so.
One aspect of Credits is the often-mooted idea of Facebook starting a payment system for outside Facebook, competing with PayPal. Once Facebook already has enough credit cards on file, it can build a payment system that would be highly competitive. We think it’s highly unlikely that Facebook will build a PayPal competitor in the short, medium or possibly long term.
Why? Because the payments business is brutal and has incredibly high barriers to entry. It’s often argued that what makes payments hard is that you need a critical mass of users, and that’s true. But the real secret of PayPal is that its competitive advantage lies not in that network effect but in fraud detection. PayPal has some of the most advanced fraud detection algorithms in the world, and it is a reason why it works—why it’s not swallowed whole by fraud payments and litigation—and that is why very few competitors have been able to break into the market. Amazon is the only worthy competitor because it already has years of data on commerce transactions and of online security experience which it can use to bolster its Payment system—and even then, it hasn’t grabbed much market share. Facebook has no such advantages. Furthermore, payments is a scale business that is only profitable at high volume and it is a regulatory minefield.
It’s just a very bad business for Facebook to enter into. We assume that with PayPal co-founder Peter Thiel on his board, Mark Zuckerberg is well aware of all of this.
The idea of Facebook starting an ad network is tantalising, but it’s also the most speculative. Facebook executives have repeatedly denied that Facebook is working on an ad network (even though they’ve carefully avoided explicitly denying that they might do such a thing in the future).
But many people, including Facebook shareholders we’ve spoken to, believe this could be a huge business for Facebook and is in their longer-term plans.
Here’s why we believe Facebook won’t be doing an ad network soon:
- It’s a hard, highly competitive commodity business. Facebook controls advertising on Facebook.com. Meanwhile, there are hundreds of ad networks competing for every publisher’s space, and offering every advertiser all the imaginable possible refinements of targeting, measurement, re-targeting, audience slicing, and so on.
- Facebook already has its work cut out fulfilling demand on its own platform. Facebook is still a very small company. Google has more job openings than Facebook has employees. It has a very limited supply of engineers and sales people. Of course, it is hiring rapidly. But that will remain a significant constraint on Facebook’s ability to enter new businesses for a while. Conversely, Facebook already has a rip-roaring Facebook.com display ad business and is currently investing in a very important and promising social ad product.
Given these constraints, it makes little sense for Facebook to enter the ad network business soon.
We would put the likelihood of a Facebook ad network in 2012 at 0 and in 2013 at less than 50 per cent.
All that being said, an ad network does remain a promising business. Here’s why:
- Facebook already has a unique asset: its enormous dataset on its users.
- Facebook already has the technology. Facebook has built a scalable ad server, it has built ad formats that are now well-known within the industry, and so on. There would be some technology to build, but a lot of the technology is already there.
- Facebook already has the relationships. It has the relationships with advertisers, obviously. But it also has relationships with millions of sites through its Like Button and Facebook Connect products.
An ad network is an especially tempting proposition given Facebook’s Premium On Facebook product. The way the product works, you’ll recall, is that it shows users content that they’ve opted into but that they might not have necessarily seen organically, by pushing it across Facebook.com.Facebook also has its “Instant personalisation” service, which shows a user’s activity feed on third-party websites.
Since the idea of Instant personalisation is to show a user their feed on a third-party service, and the idea of Premium On Facebook is to show a user ads inside their feed, it’s not hard to see how an ad network would tie into this.
It’s also worth noting that ad networks are an inherently lower-margin business than advertising on owned and operated properties, since ad networks share revenue with publishers.
With all that being said, at a more macro level, Facebook is going to have to start an ad network at some point. Over the long run, even if Facebook keeps amassing users and growing, other services like Twitter, Pinterest, Instagram, Path and more that haven’t been invented, are going to draw eyeballs away from Facebook.com. Facebook.com is a closed ecosystem, and closed ecosystems tend to be overtaken by open ecosystems, like the web and mobile platforms. Mark Zuckerberg knows this well, which is why he has turned Facebook into a platform and opened up APIs for third party sites. Over the long term, an ad network is the best way for Facebook to monetise its enormous data and membership assets without relying on its closed website.
So yes, Facebook is going to start an ad network at some point. But it won’t be soon. And it won’t be as wildly profitable as its current businesses.
THE BOTTOM LINE
- Facebook’s display ads business is an excellent “cash cow” business, and it’s going to keep growing very nicely. But it won’t be growing fast enough for Facebook to justify its current valuation. For that, it will need to find a Google-scale business. Display ads on Facebook are a very good business, but not Google-scale.
- Facebook’s social ad business has enormous potential, and, if it fulfils that potential, it could be Google-scale. And we think that’s relatively likely to happen at some point. But it is by no means assured, as Facebook’s efforts in this area are still very early.
- Facebook’s Credits business is a very good business. It will keep growing as the social gaming market grows, but it won’t grow as fast as it did last year, when Facebook instituted its 30 per cent tax on virtual goods. Facebook will be smarter than to try to kill PayPal, though.
- Facebook is probably going to start an ad network at some point. But it won’t be soon. And it won’t be as profitable as its current businesses.
Questions? Feedback? What did we get wrong? [email protected]
This is Part 1 of a report on Facebook’s business opportunity. In Part 1 we analyse Facebook’s various business engines and try to figure out whether and how they can grow. In Part 2, to be published next week, we will draw on this analysis to provide our revenue and earnings estimates for Facebook over the next few years.
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