Facebook's Challenge Isn't Adding Members, It's Monetizing Them

Jul.27.12 | About: Facebook (FB)

At the moment, every 6th person in the world that is old enough to read and write is a Facebook (NASDAQ:FB) member. The company has tremendous amount of valuable information regarding nearly a billion individuals across the world. This is huge; however, since the company can't seem to monetize this great potential, it will not find favor in the eyes of investors.

The number of the website's monthly active users (i.e., users that sign on to their Facebook account at least once a month) is up to 955 million with 543 million mobile users. The company sees a lot of potential in the mobile users; however it has yet to figure out a way to make money off this. As phone the mobile device screens are much smaller than computer screens, it is difficult to effectively put advertisements screens of these devices.

The company's revenue in the quarter was $1.18 billion. This is up 32% from the same quarter a year ago. Here is the problem though: basically, the company's revenue per monthly active member was $1.23 for the quarter. Since the same quarter last year, the number of monthly active Facebook users is up by 29%. The growth in the number of monthly active Facebook users accounted for the most of the revenue growth and the company was not able to increase its revenue per member by a significant amount.

After excluding the one-time charges, the company earned a net income of $240 million. Basically, Facebook's earning per monthly active member was only 25 cents. Unless the company can actually start monetizing its members by significantly increasing its earnings per member, the company's member growth rate will have very little meaning. The company's quarterly advertisement revenue was nearly $1 per active user. Facebook will have to at least triple this number to make its investors happy.

The company will have to find the right balance between keeping its investors happy and keeping its users satisfied. Too much advertisement will scare the users away; too little advertisement will scare the investors away. The company will start introducing more advertisement in the news feeds of the users. The increase of the advertisement will be done in small doses and the company will be testing the waters by measuring the reaction of the users at each step of dose increase. In time, the company's management hopes to find the optimal amount of advertisement where both investors and users are fairly satisfied. Donna Hoffman of the University of California Riverside criticized this approach by saying: "They are one of the most reactionary tech companies I have ever seen. They're not proactive, barely responsive and not in tune with the zeitgeist or needs of their own consumers."

The fact that Facebook didn't issue guidance for the rest of the year will not be welcomed by the investors. At the moment, there is too much uncertainty surrounding the company to make it a safe bet. The investors are not convinced that Facebook will find an efficient way to make money out of its potential. Many people don't even believe the company's CEO Mark Zuckerberg actually cares about returning value to shareholders, even though he is the biggest shareholder of the company.

Currently Facebook's share price is below $25, which is an all-time low for the company. The company's current share price is down 35% since its highly anticipated and over-hyped IPO. The analysts expect the company to earn 37 cents this year, 41 cents in 2013, 62 cents in 2014 and $1 in 2015. This looks like a great rate of growth; however, even this growth rate, if it materializes, will give the company a forward P/E ratio of 25 by the end of 2015.

After this point, the website's user growth will come from developing nations as most people in the developed world have already had exposure to Facebook, and they already made a decision of whether they want to join or not. Normally, companies welcome growth in the developing world but Facebook might not be that grateful. After all, advertisement revenue per user will be much lower in a developing market than in a developed market. The future members of Facebook will not bring as much revenue as the established members as most of the established members are from markets where advertisement costs more. Before things get better, they will get worse for Facebook as its revenue per user will decrease before the company finds a way to increase this metric.

In conclusion, I continue to be skeptical on Facebook. However, I wouldn't short it either, because it is very difficult to predict how the market will act in the short term.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.