The Facebook Bait And Switch

| About: Facebook (FB)
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A few weeks ago, Facebook (NASDAQ:FB) changed its privacy settings that will allow the company to gather user data from its own and external services such as Instagram but it had bigger implications when the company announced that it is working on an external ad network. The move will be welcomed by its investors as Facebook could potentially double its earnings within a short span of time. It will also be welcomed by users who won't have silly ads inserted into their streams.

The company also announced ending its silly policy of needing 30% of users to vote for a specific change. =30% of Facebook users means 300 million people, 2.5 times more than those who voted for the U.S. President. While people's Facebook feeds are likely more important to them than whom the president is, it is still no way to run a multi-billion dollar company. Since the IPO the focus has been on how will Facebook actually monetize its user base to justify its $56 billion market cap amid falling CPC rates. The story of their click-through rates being abysmal is well known, the question has been what Facebook would do to alter their revenue path.

According to recent estimates, the CPC rates have fallen by as much as 40% in the U.S. and 27% in Canada in Q3. On the other hand, CTR have increased from less than 0.06% to approximately 0.09% from Q3-2011 to Q3-2012 which should give more confidence to Facebook's advertisers. Nonetheless, it's falling CPC rates that should worry investors. The company turned to "sponsored stories" but that has caused uproar among some consumer watchdogs, particularly in Norway where the country's consumer protection agency is looking to have these "unsolicited advertisements" banned throughout Europe or at least in Norway.

Through this new external ad program, Facebook could not only generate more profits but change its failed business model of getting paid from Facebook ads. This is a natural progression of monetizing its huge user base and has already been successfully implemented by Google (NASDAQ:GOOG) through Adsense.

Facebook now has at least two other untapped income streams, paid search and China. Mark Zuckerberg had discussed about getting into search at TechCrunch Disrupt held in early September. Meanwhile he has been trying to get Facebook into China's 513 million internet users who are more active on social networking sites than their American peers - Americans spend 37 minutes daily on social networking sites as opposed Chinese who spend 46 minutes daily. But so far, Facebook remains banned in China where Renren (NYSE:RENN) dominates with more than 147 million users, mostly college students.

Although GlobalWebIndex claims that 15% of Chinese internet users are on Facebook via bypassing the government's firewall, several analysts, including the Chinese blogger and internet freedom activist Michael Anti, believe that China's Facebook numbers are highly exaggerated. Moreover, given the strong role played by Facebook in the latest Arab Spring uprisings, it is unlikely that the newly-elected and reportedly conservative Chinese leadership will change their policy concerning Facebook. If anything the recent blocking of all of Google's services in China during the party Congress make this point even clearer. Moreover, China's choking off of Google's search engine is taking its toll on other business there as well. The latest data from Analysis International shows a near 50% drop in market share for Google Maps, The open platform of Android is not serving Google at all in China, if anything it's enriching its competition like Baidu (NASDAQ:BIDU).

And this is ultimately Facebook's future in China as well. Even if they are granted access to China's market Facebook will have to compete fiercely with domestic social networking firms, such as RenRen, Sina Weibo (NSINA) and Tencent, all of whom have Chinese roots and have evolved over the years to cater the domestic market. Every day they become more entrenched in the hearts and minds of their users while Facebook is not. Given that reality, it would be highly optimistic to assume that Facebook could significantly increase its profits simply by showing up in China.




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So, back to the original point. Facebook's external ad network decision is the right move. They face a lot of hurdles to build something that can compete at a platform level with Google, but the market is ready for something else to challenge in this space. The immediate impact of this will be available on Instagram which Facebook acquired earlier this year in a $1 billion. Watch for partnership announcements to determine the path of success for this venture. Facebook's comparative advantage is that they have a database of user information that is verifiably yours and it is where they should leverage all of their business decisions going forward in how they apply that data. Facebook's ad network will succeed or fail based on this and the proof will be in who they sign up for the service.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.