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Why, on the face of it, Facebook is struggling

Is the death of Facebook somewhat exaggerated? Or, as US journalist Michael Wolff suggested, is Facebook one of the great business fallacies of our time? The truth lies more in column A, but there is no doubt that Facebook is struggling to adapt to the perils of a mature, public company — largely a result of it failing to generate substantial secondary revenue streams outside of banner advertising.

Like Google and Yahoo, Facebook is a media company (as opposed to Amazon, for example, which is part media company, part retailer). Like Yahoo, Facebook has remained hostage to banner advertisements for almost all of its revenue — as Wolff correctly observes, “Facebook currently derived 82% of its revenue from advertising. Most of that is the desultory, ticky-tacky display advertising that litters the right side of people’s Facebook profile.”

This is certainly a valid point. Facebook’s display advertising is vastly overpriced. (My company briefly used Facebook for advertising in 2010 only to discover within weeks that the return-on-investment was substantially worse than Google and virtually all other digital advertising). The only reason that businesses would advertise on Facebook is because they are too stupid to properly calculate the costs of their investment, or they’ve been convinced by marketing “experts” that they need a social media presence. (Of course, there are plenty of worse places to advertise than Facebook — but unfortunately for Facebook, it is not necessarily competing with TV or newspapers, which make it far harder to determine ROI).

Facebook would argue that most media advertising is branding related — and Google is the exception to the rule in providing advertisements relevant to what a user is looking for. But the problem for Facebook is in many cases, it is competing for digital marketing spend with Google. And partly because of Facebook itself and partly because of display aggregators, a flood of cheap display inventory is significantly deflating prices. Despite Facebook’s panache, if its advertisements can’t deliver a superior return on investment, its ability to charge premium prices for advertising will evaporate.

But focusing on Facebook’s current reliance on display advertising for revenue, and concluding, that Facebook “will fall with everyone else” is to forget the fact that Facebook has created without peer, the greatest network effect since the telephone. Barring an unprecedented technological meltdown, Facebook’s position as the world’s social network will be (probably for decades) virtually impossible to displace. Think more Microsoft rather than IBM. Microsoft’s position as the virtual monopoly provider of operating systems and office suites is because of its network effect. When everyone else uses a particular product, if you don’t, it is difficult to work with that other person. Similarly, one cannot simply create a social network, as the strength of the network comes from its size. It shouldn’t be forgotten that the average US Facebook user spends more than six hours each month on the site — compared with 98 minutes for Tumblr (the second most engaged site) or only six minutes for Google+.

Facebook’s financial problems are because it hasn’t been able to properly monetise that network. Historical revenues (which started rising after former Google executive Sheryl Sandberg was appointed in 2008) were largely derived from that overpriced display advertising (and a smaller part from partners such as Zynga who are also struggling). Instead, Facebook should have been focusing on how it can generate profits from transactional and search services provided to its captive audience. Facebook has unparalleled reach, especially through its news feed, to be able to create transactional services. That is has failed to capitalise on that is an indictment on the group’s management, but let’s not forget, before Adwords, Google didn’t make much money either. (Facebook’s attempts to monetise news feed posts have failed, and have caused users to lose faith in the business).

Facebook’s other great hope is the possibility that is can challenge Google in search — to do so, it would need to come up with more relevant results than Google based on the data provided by Facebook’s own audience. This is, of course, easier said than done. And also questionable whether a peer-based search function would provide more relevant results that Google’s credibility-based algorithms. If Facebook can challenge or even take some market share of Google’s search supremacy, it will vindicate the lofty valuations that remain.

There is little doubt that Facebook has stumbled in recent times. The conversion to “timeline” has been almost universally criticised, while its mobile site is clunky and generates a fraction of the revenue of its website. Meanwhile, the company announced last week that it had lost $US157 million for the three months ending June 30, with revenue from the US barely increasing compared with the corresponding period in 2011. (Facebook did manage to generate $US586 million in cash last quarter, but its profit result was reduced by more than $US1 billion in staff options).

It should be noted that Facebook spent more than $US700 million on R&D in the June quarter (up from $US99 million in the June quarter of 2011), although the benefit of that higher spending has certainly not been seen through higher sales, which remain captive to display advertising.

Arguably Facebook’s major foible was of its own making — the decision to go public. The move means that Facebook is now captive to non-managing owners as well as commentators — a problem it never faced as a private company. The late Steve Jobs once told a US interviewer that he “admire[d] [Facebook founder, Mark] Zuckerberg … for not selling out, for wanting to make a company”. The problem — Zuckerberg did sell out. Instead of being lauded for creating a business that grew from nothing, to $US4 billion in sales in less than a decade, Zuckerberg is criticised as investors have seen the company share price fall by more than 45% (wiping $US37 billion) from its inflated IPO price.

Despite the criticism, Facebook is still a viable business and won’t be collapsing like pets.com or the tech disasters of the late 1990s. It may become a Yahoo, with its history of (profitable) underachievement, rather than a runaway success like Google or Microsoft — unless it learns how to make money from its unparalleled audience.

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