Facebook: Graph Search Is About Targeting And Revenue

| About: Facebook (FB)
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Facebook (NASDAQ:FB) simply isn't leveraging its current user base nearly as well as other popular sites. In fact, as you'll see later in the article Facebook's revenue per user is more comparable to Yahoo (YHOO) than to Google (NASDAQ:GOOG).

Facebook has two simple goals they need to achieve in order to continue to recover the loss after the IPO. Customer retention and monetization.

In the 2012 Facebook Q3 Earnings conference call, Mark Zuckerberg listed three "pillars" or strategies for the company.

  • Mobile Focus
  • Socialization of 3rd Party Apps
  • Monetization Platform (ads, in-app revenue, etc)

Everyone, including myself, seems to be on the mobile bandwagon. Facebook is doing an admirable job of providing the features and apps to leverage this market. Normally this would be a growth strategy but in Facebook's case, this is more of a customer retention/engagement strategy.

When it comes to socialization of 3rd party apps, Facebook has made excellent progress here as well. Their various APIs and Social Plugins along with new beta features such as their Mobile App Install Ads show they are headed down the right path here as well.

The area they need to work on most is the monetization. It is my belief that Facebook is really missing the boat in one major area: targeting.

Customer Retention vs Growth

Facebook is still growing worldwide both as countries have increased access to the Internet and new population growth as well as the remaining unconnected populations give in and finally get online. The beauty of social networking in general is that you will become a Facebook user not because of marketing dollars, but because they are the only one in their social circle who is not online.

"Hey, did you see those pictures from Christmas dinner that Mom posted to Facebook?"

"Our trip to Vegas was awesome! We're broke but the view of the Grand Canyon from the helicopter was fantastic! Check out the video we posted on Facebook."

The problem with this is that Facebook is reaching saturation in primary markets like the United States. For a lot of companies this would mean revenue growth would have to come from alternative strategies but this assumes that the company is already monetizing its existing subscribers effectively and Facebook is not.

The targeting of their advertising is currently very poor. In Facebook's Q2 conference call, Sheryl Sandberg opened by informing investors that 84% of their revenue was derived from advertising. In their Q3 earnings call, that number grew to 87% of Facebook's total revenue. While there are certainly a large number of other opportunities to monetize Facebook, if they can increase their efficiency as it pertains to targeted advertising they can grow their existing revenue substantially.

Why Can't Facebook Provide Better Ad Targeting?

While this is something that Facebook should be able to deliver better than any other company, they have failed to deliver on this promise so far. When they figure out targeting, they will finally start moving along the road towards unlocking the revenue generation power hidden in their user base.

Facebook has an enormous amount of personal data for each user. They know who you are, where you are, what you like, who you know and they even have the dubious honor of knowing about a large number of relationship breakups before the other party in the relationship. Compare this to Google, where the majority of the user information is derived from click-stream data.

In spite of the limited data, Google has optimized their platform to insure highly targeted advertising with much less data than Facebook.

If you look at the data in the following table, you can see how Facebook compares to Google, Amazon (NASDAQ:AMZN) and Yahoo.

Engagement and Average Revenue Per User Minute

Let's talk about engagement for a minute. My wife and I go to a store. She browses the products, selects one or more and after some period of time, makes her purchases. Meanwhile, I follow with my smartphone checking email, twitter, stock prices and news. In this scenario, my wife is fully engaged where I'm completely unengaged. While it's a flawed example, it illustrates the point pretty well and for the record, this is a hypothetical scenario.

For online, one of the metrics I'll use to compare the sites is average revenue per user or ARPU and one that I haven't seen used before but I personally like as a metric of engagement, average revenue per user minute or ARPUM.

The idea is to measure engagement by the amount of revenue you are receiving from the user for each minute they spend on your site.

Site Users* Time** MnthRev*** ARPU ARPUM
GOOG 174,914 1:54:15 $3,962 $22.65 $0.20
FB 153,412 6:40:32 $474 $3.09 $0.01
YHOO 140,147 2:20:45 $414 $2.95 $0.02
AMZN 79,915 0:34:54 $4,771 $59.70 $1.71

Data Source: Nielsen Top US Sites, September 2012, and Google Finance
* users in thousands
** time in hh:mm:ss format
*** average monthly revenue based on trailing quarterly revenue for last 4 quarters

This data shows some very interesting aspects of the user experience on each site. Note that Facebook has by far the largest time spent per user of the four sites. The interesting part is that while engagement will vary across these sites, Facebook should have the highest level of engagement as well but as we'll see, they are clearly not monetizing their users.

Yahoo is a bit all over the place but depending on the site, they have different levels of engagement. My wife still loves her "My Yahoo" home page and uses that to get her daily dose of news and information every morning with coffee. However, if you look at the revenue per user, Yahoo could improve their targeting quite a bit.

Amazon, has the lowest time spent per user on the site but by far the largest engagement as measured by revenue per user minute. I realize that Amazon has a dramatically different business model than the other sites but it makes a useful comparison of an online site leveraging their user base.

For the most part, Google users search for something, select a site from the results and they are off to someplace else on the Internet. However, Google has maximized the revenue per user they receive in such a way that you simply have to be impressed. Their Adwords advertising system provides for targeted high quality ads that to my knowledge hasn't been reproduced in other similar systems.

Now let's talk about Facebook. They are second in the group in terms of number of unique monthly visitors. User time on the site is three times more than any other site. They likely know more about each user than the other three sites combined. But they make less per user out of the group and only come close to Yahoo. User revenue per minute is the really embarrassing part. Facebook is barely able to extract a penny per minute from their user base.

Even if you look at ARPU for the United States only, they are leaving a large amount of revenue on the table.

How Does Graph Search Fit In?

Google treats each part of the company as a silo. Search quality focuses on pure search quality. They don't consider whether a change will have a positive or negative impact on revenue. Facebook is doing the same thing with graph search. Its all about the quality of the user's experience. Zuckerberg even pointed out in the announcement on Monday (1/15/2013) that Facebook is a big database and you should be able to query a database.

This is a feature that they've needed. But it's more important than that. To implement this sort of search, they need to capture the relationships between the various user characteristics and provide indexes to make the data searchable.

By doing this, the are also creating the framework for much more robust targeting. As we demonstrated above, Facebook's user base is very nearly ad-blind. Graph search will help provide a more valuable better-targeted ad experience and help with the issue of ad-blindness.

Graph Search Enables Ad Targeting

Facebook spent a lot of time talking about how you could use Graph Search. What music do my friends like? What restaurants are popular among people like me in a particular location? How can I find more friends? You can now leverage the information that Facebook has always had to ask and questions you always wanted.

These same attributes will allow Facebook to improve ad targeting significantly. Not only can you ask questions, but when placing ads, Facebook can look at its ad inventory and determine based on your graph which ads are most interesting to you.

If they do it right, they cannot only target based on static interests but temporal interests as well. What are your most recent interests? Did you just go to a concert? Which band was playing? What type of music do they play? What social group likes that band and so on.

Google approaches the problem from two directions. First, in a keyword-centric manner, by analyzing the search phrases and the clicks to determine which sites users attract interest for a given search phrase. Second, in a user-centric approach, by using click-stream data to develop a user profile.

When presenting ads, a decision is made to use the user profile or the keyword profile to present the ads. In general, Adsense looks for an intersection of the two when presenting ads on a website but the keyword profile is the primary driver during searches.

The website content is an indicator of interest and the keyword search is an indicator of intent.

With Facebook, the usage model is more similar to a website but the interest indicator is limited. It is similar to browsing the news in that you are not completely sure what the user is looking for (intent) or what might catch the user's interest while browsing their timeline.

This is the toughest scenario to leverage for ads but graph search is a major step towards doing just that.

Facebook Awkwardness

As a company, Facebook is one of the most awkward I've seen when it comes to communicating with investors. But the truth is it's a company of nerds. I can say that because (full disclosure here), I'm a nerd myself. Facebook presents extremely technical features and doesn't seem to understand why the market doesn't "get" it.

The point is that Facebook is a company full of very smart people. They do "get" technology and demonstrate that daily. And they are making simple mistakes that other more seasoned companies don't make but they will learn from these mistakes as well.

I heard an interesting comment on a financial news channel referring to Zuckerberg finally coming across like a real CEO on one of the recent conference calls. See? He's learning.

Graph search is a major step towards creating the monetization engine especially in terms of more accurate targeting but even for features yet to come and I think it will have a massive impact on the bottom line over the next year.

How Can I Trade Facebook?

You didn't do yourself any favors if you got in after the IPO but now that the company is getting its sea-legs, I think that Facebook has the platform, the user base and the technical talent to increase ARPU and ARPUM and graph search as solid evidence of this fact.

After the IPO, the market took its time trying to get a sense of Facebook and Mark will likely make decisions that seem poorly thought out and demonstrate lack of understanding of its users. In my opinion, they do understand these issues and if they forget, their user base will quickly correct this fact. When these gaffes happen, it will create buying opportunities that you should leverage.

Facebook is a simple trade. Buy the pullbacks and take your profits. I do recommend taking profits prior to announcements or earnings since the company is still working on the communication thing.

What If I Bought During the IPO?

Unless you have a tax justification for selling or something extrinsic to the stock itself, don't sell. If you are comfortable with options, this is a perfect time to buy calls to augment your profits.

If the IPO left a sour taste and you just want to get out of the stock, you can implement a stock repair strategy. As an example, the stock is currently around $29, you might buy a $30 March call on a pull-back to get the best price and on the rebound, sell two $34 calls with the same expiration as your original call. One of these will be secured with the original call you purchased with the other secured by your original stock purchase.

If Facebook hits $34 by March you will recover your losses completely if you time the purchases right. At worst, you should be able to recover the majority of your losses.

How Can I Invest in Facebook?

Facebook is a perfect growth stock for long-term investing. If you are investing for your retirement account or simply prefer the buy-and-hold style of investing, buy Facebook on a pullback and don't look back.

Market hype and company awkwardness make this a bit of a roller-coaster with plenty of volatility. Facebook is a not a company that's easy to trade unless you can figure out how to anticipate their mistakes (privacy anyone?) but go long on Facebook now and I'm expecting to see Facebook back at the IPO price or higher by the end of 2013.

Disclosure: I am long FB. 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.

Additional disclosure: As with any options purchase, timing is important. Do not attempt the option strategies described in this article unless you are an experienced options trader.