The following note is part of my June 25th initial report titled "Facebook: Compelling Growth, But Fairly Valued."
Facebook (FB) lists many risks in its S-1 filing, but three key risks that are worth noting are:
- User growth and retention
- Competitive online advertising market
- Unproven mobile monetization
User Growth and Retention
Facebook's financial performance will depend on its ability to grow and retain users. As the company continues to grow, its active user growth will slow, making user retention a top priority. Over the past two years, Facebook's monthly active user (MAU) growth has declined sharply across all four geographic regions.
Daily active user (DAU) growth also declined across all regions.
Understanding user preference will be critical to maintaining user engagement. Earlier social networking sites, such as MySpace and Friendster, enjoyed tremendous success in their early years. However, these sites failed to develop features that attracted and retained users, which eventually led to their diminishing popularity. Facebook could suffer similar fate if user engagement declines.
Competitive Online Advertising Landscape
Despite providing a large platform that connect users around the world and allow them to share information, communicate and play games, Facebook is still an online advertising company. Advertisers could switch to competing websites if user engagement declines, which could leads to revenue deceleration and margin pressure.
The online advertising market is highly competitive and sensitive to economic conditions. In an economic downturn, advertisers are likely to cut back on spending even if active user base remain consistent. Since Facebook generates less than a quarter of its revenue from users, an economic downturn could have a severe impact on the company's top and bottom line.
In addition, advertisers could avoid the cost of advertising on Facebook by using free online products that leverage Facebook's viral effect to broadcast their messages to the relevant followers. For example, artists, public figures, businesses and brands can engage their fans and followers using Facebook's free product, Facebook Page. Whenever a Facebook user likes a page, he is automatically subscribed to the news feed from that page. Broadcasting messages to Page followers could be just as effective as using Facebook's paid ads because advertisers can be certain that their messages are broadcast to the relevant audience. As of March 2012, Facebook users follow over 42 million Facebook Pages created by artists and companies such as Eminem (>58 million Likes), and Coca Cola (KO), (>42 million Likes).
Advertisers could also use free products, such as YouTube, to broadcast their messages while leveraging Facebook's viral effect. I note that in 2009 T-Mobile successfully raised its brand awareness by broadcasting the famous "Flash Mob" videos on YouTube, which generated over 94 million views.
Unproven Mobile Monetization
Consumers are becoming more mobile due to rising adoption of smartphones. According to comScore, the number of smartphone subscribers in the US almost tripled over the past two years and penetrate 46% of all mobile subscribers as of April 2012.
Over the same period, users are increasingly accessing social networks via mobile devices because they can be informed of their network's activities wherever they are.
Facebook's mobile usage is growing faster than PC usage and such a trend is likely to continue. Historically, Facebook has not shown any ads on its mobile platform. In March 2012, the company introduced Sponsored Stories in the user's newsfeed, but it is not currently generating any meaningful revenue. Facebook's financial performance will be negatively affected if it fails to attract advertisers to its mobile platform.
Because of these key risks Facebook faces, I maintain my Equal Weight rating and $29.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
