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Questions hover over Facebook

by Olaf de Senerpont Domis | Published May 17, 2012 at 11:27 AM

The buildup to Facebook Inc.'s $13 billion initial public offering has been like a dragster smoking its tires as it prepares to explode off the starting line at the flash of the green light.

The price range on Tuesday was raised to $34 to $38 per share, up from a previous estimate of $28 to $35. On Wednesday, Menlo Park, Calif.-based Facebook boosted the size of the IPO by as much as $3 billion, or about 25%, as several early investors increased the number of shares they planned to sell in the offering. Many of Facebook's 3,539 employees are set to become millionaires or even billionaires from the offering; even California politicians debating the state budget are salivating as they ponder the estimated $2.1 billion in state tax revenue the IPO would generate for the state's coffers.

The company's shares are expected to price Thursday evening, more than likely above the estimated price range, and begin trading Friday. At the top end of the predicted range, Facebook's valuation would be about $104 billion. But amid the euphoria, there have been signals that the amount of risk facing the company and its public investors might be anything but a runaway success, especially after the first year or two of Facebook's existence in the public limelight.

One unsettling sign emerged this week, when reports surfaced that General Motors Co., the third-largest advertiser in the United States, had decided to stop using Facebook as a platform for its ads. GM's business is worth about $10 million annually, a drop in the bucket compared to Facebook's $3.1 billion in advertising revenue in 2011. But some observers worried that the automaker's move opens the door for the departure of other big Facebook advertisers, many of whom might view their ad spending on social networks as an experiment.

"It isn't time to push the panic button yet, but if two or thee major advertisers start to pull back, then that's a problem," said IPO analyst Tom Taulli. "GM might be a crazy outlier at this point, but revenue growth has been decelerating at Facebook. The machine is slowing down."

Indeed, Facebook in April announced that its first-quarter revenue declined 6% from the previous three-month period, to $1.06 billion, marking the company's first quarter-to-quarter slowdown in at least two years.

Like Google Inc., Facebook derives the vast majority of its revenue from advertising. It represented 85% of total revenue for the company last year. The balance came from payment revenues, mostly from the sale of virtual goods to players of social networking games on Facebook.

The question arises of whether Facebook waited too long to go public? Has it already peaked in popularity and, perhaps, growth? They are hard questions to answer, but very few consumer Internet companies have proven to possess real lasting power far beyond the eight years that Facebook has been in existence. Struggling Yahoo! Inc. is a good example.

Many among the general public seem to agree. In a poll released by CNBC and the Associated Press this week, half of the respondents said they thought of Facebook as a passing fad. Half of those surveyed also described the company's valuation as too high, while only a third viewed it as appropriate.

There isn't much doubt the company will continue to grow, at least in the relative short-term, especially as it mines new avenues of expansion for its advertising. Facebook, for example, lacks a strong platform for serving ads on mobile devices, one of the richest growth markets.

"Growth in use of Facebook through our mobile products, where our ability to monetize is unproven, as a substitute for use on personal computers may negatively affect our revenue and financial results," the company said in its IPO prospectus. Cracking the mobile ad market would open a major avenue of growth for the company, which took a small step in that direction in March by introducing sponsored stories in the news feeds of mobile users.

But it will take a lot more than that to match Google, the company that many view as the closest comparison to Facebook because of its high-valuation IPO eight years ago and its ad-based business model.

By comparison, Google, whose shares debuted at $85 apiece in August 2004 and traded recently at $627 each, was growing at 109% year-over-year when it went public. Granted, Google was growing from a significantly smaller revenue base -- it generated roughly $939 million in the year before it went public -- but its growth was significantly higher than the 40% growth estimated for Facebook this year in a recent report by Susquehanna Financial Group LLLP.

Putting aside the fact that Facebook CEO Mark Zuckerberg wore a hoodie at a recent road show stop in suit-and-tie New York, there is a perception that the 28-year-old founder cares more about the Facebook user experience than the financial performance of his company. It's an admirable goal, but not necessarily one that will sit well with any investor interested in long-term gains.

The $1 billion agreement to buy mobile photo sharing software startup Instagram Inc. is an example of this attitude, said Susquehanna's Herman Leung.

Facebook in April agreed to buy the tiny app developer, which does not generate revenue or ostensibly even have a business model to do so, largely because of its quick user base growth.

"Part of the risk to the Facebook story is that the company will put user experience first, and financial performance could be pushed as a secondary priority, causing significant near- and medium-term financial volatility," Leung said, adding that the Instagram acquisition "makes little financial sense in the near-term."

Taulli predicted that Facebook shares will price above the predicted range Thursday evening and have a strong first day of trading Friday. But after that, the company will face many challenges in continuing to produce a strong performance.

"Zuckerburg doesn't seem to care too much about money or fighting for dollars, and the company hasn't necessarily figured out its business model yet," Taulli said. "That's a dangerous combination for Wall Street."

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Tags: Facebook Inc. | Mark Zuckerberg

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Olaf de Senerpont Domis

Bureau chief, West Coast; Editor, venture capital

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