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Word of the Year or Hype of the Year?

Word of the Year or Hype of the Year?

10.1.2013 9:53

The American Dialect Society named the Word of the Year at its annual conference in Boston this weekend. The word is “Hashtag”. For the uninitiated, that is the sign you use at the end of every Tweet, or message, on the social network Twitter. Last year’s world of the year was “Tweet”. Funny that. For me, hashtag is, if anything, associated with conference calls. For most people anywhere in the world it has very little meaning.

Tweets and Twitter altogether are a phenomenon which many people have a hard time understanding. But brace yourselves, we will be hearing a lot more about Twitter this year. Why? It may be because the services this company is offering will really hit it big in the world. It may also be because it is widely expected that Twitter will attempt to go public in 2013. Remember all the publicity about Facebook in the year or so prior to its initial public offering?
I have to admit to a certain fascination with the story of Facebook. It is a mixture of awe and bewilderment. I am sure many other people feel similarly about it, although perhaps without focusing so much on the gory details. Just the other day, someone asked me why exactly do media describe Facebook IPO as a failure these days. At the risk of stepping into someone else’s territory (Ondra Palat is the one who usually writes about tech companies here), these are the facts and myths about Facebook.

Facebook’s long-awaited IPO in May 2012 was one of the biggest in technology, and the biggest in internet history. Media at the time, fueled by Facebook’s enormous PR machine, called it a "cultural touchstone”. How did this company become so hyped up? First we were treated to the growth-in-users message. Facebook has 500 million users globally. Then 750 million users. Facebook has passed the billion user mark now. According to Internet World Stats, by mid-2012, there were 2.4bn internet users in the world. That means Facebook is used by almost a half of all internet users on the planet. Isn’t it unbelievable what a global appeal this company has, how essential it is becoming in the lives of people from New York to Bangalore? Well, let’s stay in Bangalore for a little bit. Facebook doesn’t wish to report the geographical split of its users but it is widely suspected that the number of users in the developed countries where investors could reasonably expect most revenues has been stagnating or even declining for some time.

Industry insiders also point out that a lot of the accounts entered into Facebook in recent years seem to be outright fake, manufactured in thousands for a few pennies in India, China or other countries with cheap labour. Why? These fake accounts or their use is sold to people who need to increase the “likes” on their own Facebook accounts. In order to start a business profile on Facebook, you need to gain a certain number of “likes”. Also, popularity breeds popularity. Likes and traffic on websites makes celebrities more popular (or do you believe that Justin Bieber was “discovered” because of his superior talent?) and helps popularize products. Manufacturing “likes” is a great business. Social marketers have successfully been employed for a while by companies, political campaigns and celebrities to play this game. After strenuously denying that for years, in August 2012 Facebook admitted for the first time to the existence of fake accounts, and announced 83m of its user profiles were fake. Industry insiders believe that the actual number is between 30-50% of all its profiles.

The main problem of Facebook is however the long-term sustainability of its business model. While Facebook user numbers do grow, with the caveats mentioned, it is not clear whether the company, or any other social network, can generate sustainable long term cash flows. Facebook services are offered for free. The profits from trading in “likes” goes, sadly for the investors, to others. The Facebook revenues are mostly (86% in 3Q 2012) limited to advertising revenues. The rest are mostly revenues from commissions on sales of products generated through its site. Facebook has admitted that it is not an innovative company so ad revenues are likely to remain the main revenue growth driver.
But there is a problem there, too. While manufacturers and retailers globally are shifting an increasing part of their advertising budgets online (according to Bain/IAB study, ad spend on internet is 17% of total ad spend, or 2.8x less than that on TV), it is now also known that the impact of advertising online is falling well below expectations. Click-through advertising in particular has been in a huge decline for some time. Banner ads currently achieve on average 0.2% click-through-rate and suffer from a serious “banner-blindness”. In addition, studies have found that, unlike with Google, people simply don’t use social networks to purchase things. The psychology is different, people come to Facebook in the mood to socialize and not with intention to shop. Facebook performance metrics document this. According to Webtrends and Booz & Co, its click-through-rate worldwide is only 0.05% and 72% of respondents say they are not willing to purchase anything through its site ever. In another recent study by Forrester, only 7% of retailers say that Facebook has been an effective customer acquisition source. Facebook market share of online advertising in 2012 was thus only 3.1% compared with Google’s 44.1%.

This is further compounded by the growing use of smart phones which are particularly unsuitable for online advertising due to their small screen size. Boston Consulting Group has developed a measure of internet intensity, called BCG e-Intensity index, which is very useful in, among others, measuring the potential advertising revenues by country. They have found that outside the OECD, especially in the BRIC countries, consumers are leapfrogging the computer as the internet access device, and using mobile handsets instead. In China, e.g., mobile penetration in 2011 was 57%, nearly 3x the PC penetration. Facebook has admitted that it struggles with its mobile strategy.

On the backdrop of moderately growing revenues, Facebook costs are growing at an alarming rate. I am talking about the infrastructure costs. These are the costs of running servers to store the Facebook database and exponentially growing back-up data, and the extremely sophisticated servers to manage the storage and to deliver the data when required. While Facebook revenues grow some 30% p.a., the capex grows by 215% (both based on 3Q 2012 financials) plus the portion of servers financed through capital leases. Of course, due to its huge and growing server costs, not only do Facebook revenues have to be sustainable, they have to grow faster to keep up with the costs. This may be difficult.

This is all my opinion and I sincerely believe that the market is still viewing the company more positively than that. The reason the IPO has been called failed goes rather back to the IPO process itself. Facebook announced its intention to IPO in February and went public in May 2012, after one of the longest and most intense PR campaigns in history of public markets. It floated at US$38 per share, at the top of target range, mainly on back of strong demand from retail investors. Many of these expressed such a keen interest in Facebook because they felt they had missed out on the massive gains Google saw in the wake of its going public. The IPO price valued Facebook like "an ultra-growth company," with a P/E ratio of 85, despite a decline in both earnings and revenues in the fiscal quarter immediately preceding the IPO. The market frenzy was also fuelled by the ever increasing and well-publicized buy-in price of the pre-IPO investors and by the price of Facebook shares on the illiquid private market, SecondMarket. Much of Wall Street expressed concerns over the high valuation, saying that the company would have to undergo "almost ridiculous financial growth” for the valuation to make sense. Immediately in the wake of the IPO, its exchange, Nasdaq, suffered a computer malfunction, leading to tens of millions of dollars in trades being wrongly placed. Its underwriter, Morgan Stanley, and some of Facebook executives were then accused of selectively revealing adjusted earnings estimates only to preferred clients and industry insiders, respectively. Facebook, Morgan Stanley, and Nasdaq are now facing litigation in more than 40 separate law suits over the matters. Many of the early investors have cashed out in the IPO, including Mark Zuckerberg and co-founder Dustin Moskovitz and the first big investor Peter Thiel who sold 80% of his shares. Facebook employees sold many of their shares immediately following the end of the mandatory lock-up. This all prompted questions on whether the insiders hold a genuine believe in the long-term viability of the company. The stock went on to less than half its IPO value within three months from the IPO before recovering to the current price of US$29.80.

The IPO had an immediate and wide reaching impact on the global stock markets, dampening the prospects and trading price of many technology companies as well as putting a lid on the global market new issuance in general for several months. The unbelievable thing is that it hasn’t caused a fully blown tech bubble burst yet.
You may ask, why am I writing about it now, Facebook went public half a year ago. Well, most of this goes for Twitter, too. Twitter is a social network, too. While it doesn’t have such spiraling server costs, the revenues are a real problem. Just try to advertise effectively within a 128 character Twitter stream on your mobile. But you can be all but sure that we will be hearing a lot of highly positive news about Twitter in the next months, right up until its IPO. Mark my words, so much for the word of the year...

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