Facebook (NASDAQ:FB) has launched its roadshow where it will promote its stock to large institutional investors, who will buy up large chunks of the stock. Individual investors will not have the ability at the very beginning of trading on May 18 to buy FB shares, but can start buying later on in the day.
With 900mm monthly active users (MAUs) worldwide, and 188mm MAU's in the U.S. and Canada, or just about half of the total population between the two countries, FB has made truly changed the world wide landscape. However, despite this popularity I would like to raise two issues regarding the company, and whether it will have the ability to sustain long-term growth. FB last year made $1b in net income, has a market cap of $100b, and therefore a P/E of 100 (TTM). Its main competition - Google (NASDAQ:GOOG) - has a P/E of 18, which essentially says that FB has 5 times better growth prospects than Google.
In this article I will raise two issues, which I think call into question FB's lofty valuations. These issues center on the nature of online advertising/marketing, and will compare the way FB and Google approach online marketing, and who has a more successful model.
Two Types of Advertising
Broadly speaking, advertising gets broken up into two pieces: Advertising which leads to a sale, and advertising that creates brand awareness/identity. FB tries to traffic in both of these areas, by providing targeted advertising based on what they know about you - age, location, marital status, etc. And by allowing brands to interact with customers, thereby creating a brand image and awareness.
Ads Which Lead To A Sale
No less a figure than Sir Martin Sorrell CEO of ad giant WPP (WPPGY) raised issues with the first type of advertising. He said FB works for brand building, but companies that use traditional advertising "are invading a social space. You have to be extremely careful." Google, on the other hand, does not invade personal space - yet.
I will now use the example given by FB on page 89 of its most recently amended S-1, as a way to compare FB advertising strategy versus Google's. FB ran an ad campaign for a local florist in Minnesota. The florist targeted ads toward females who marked their status as "engaged," and who lived in Minnesota. FB proactively showed anyone who logged on with those characteristics the relevant ad. Google could accomplish the same goal, a florist from Minnesota can target ads to anyone searching for "floral wedding arrangements" in Minnesota. The basic distinction between these two approaches lies in whether the advertiser actively seeks you out, or whether you decide to engage with the advertiser on your own terms, making the advertiser into a passive player.
I would argue, like Sir Martin, that users will remain more comfortable with the Google model as opposed to the FB model. I personally find it a bit creepy when advertisers know too much about you, and I think I am not alone. Google has moved more toward the FB model with integrating Google+ into search results. However, they had a strong ad business before Google+ and can choose to emphasize or de-emphasize that element of it as they wish. FB, on the other hand, only has the social element to use for ads. I think the jury is still out on deciding whether or not users will feel comfortable with this form of advertising.
Brand awareness is a wholly different type of ad than the one described above. Think of it like a super bowl ad - in the commercial the company does not tell you how much the item costs, its advantages over competitors, or any special features, it merely tries to elicit an emotion that will connect you with the brand/item. In order for a brand to successfully elicit an emotion it must have an engaged audience willing to listen to the brander's message. This explains why advertisers will pay so much to advertise on the Super Bowl, American Idol Finale, and other major media events. The audience has a high level of engagement with the displayed content, and as such will continue that engagement during the commercials as well.
FB faces the problem that they cannot recreate such high levels of excitement and engagement that brands need when they want to spend big advertising dollars. Additionally, and importantly, the brands cannot control the conversation when it comes to engaging with users, and can lose control over the conversation as what recently happened to McDonald's on Twitter. Google has effectively separated these two types of advertising - using Google search for the "ads which lead to a sale" type, and YouTube for the "brand awareness" type. In the past, because YouTube did not have any professional content, users did not engage with the media in a meaningful way. Therefore, Google could not attract many big name advertisers to its Internet property. However, recently they have hired some big name celebrities to start producing original content for the site, which shows you they understand they must increase their audience engagement in more traditional ways, which make companies feel more comfortable buying time on their site.
To summarize, FB has taken a new approach to advertising and marketing that diverges with industry standards - both in the "ads which lead to a sale" area, where they having taken a proactive, and some may say, intrusive, approach to customer relations. And in the "brand awareness" area, where they don't have the same level of engagement, and control with their customers. In short, if the advertising business undergoes a truly seismic shift in strategies, FB could find themselves the beneficiaries of a new wave of ad dollars. But if things stay the status quo, the valuation could seem quite expensive.
According to IDC, worldwide advertising hit $588b last year, with online (both mobile and PC) advertising accounting for around $70b of the pie. FB had about 5% of the market ($3.7B in revenue), and Google had about 50% ($37b) of the market. This pie will grow - in the same IDC report, they projected that by 2015 online advertising would double to just under $140b, which will surely benefit both Google and FB. Investors need to ask themselves if they think FB will get 5 times more of this pie than Google. In short, I think based on the above we should answer, "no." Not only has Google embraced the more traditional forms of advertising, simply migrating them to the digital world, which FB has rejected opting for a more aggressive, game-changing approach. But Google also has a more diversified product line within advertising - Search and YouTube - allowing it to tap into the distinct ad dollars discussed above.
Additionally, Google has other businesses, which could meaningfully add to the bottom line. I discussed Google's opportunities in the handset and OS/productivity software market, which as I discussed in those articles could both become new $1 billion business, and further diversify Google away from its bread-and-butter search business.
Bottom line, FB will have higher revenue in the years to come, but if I had to own FB or Google I would choose Google. Google has equal prospects for growth, a more diversified product portfolio, and sells for one fifth the price.
Disclosure: I am long GOOG.