Can Facebook Break Its Dangerous Addiction to Advertising?

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Advertising is an easy-to-understand and relatively easy-to-execute revenue source, but it may also be the least defensible, most risky of business models. Conversely, offering products and services that people trust and pay for is a difficult business model, but when it clicks, it brings stable, long-term success. Facebook is addicted to advertising but is signaling a coming shift toward services. I wonder if it is (or soon will be) too late for the social network to pivot from treating users as eyeballs to treating them as consumers of trusted, high-value services. If Facebook fails to make this pivot with enough speed or conviction, the future of social business may belong to someone other than Facebook.

I have always bristled a bit when people gripe on Facebook that users are the "product" and not the "customer." That attitude has always struck me as hopelessly naive about the way the world works. After all, this isn't exactly a new phenomenon. Do these people really think their local newspaper could afford to gather news, print it and deliver it to their doorstep for a quarter a day? Traditionally, newspapers made well over half of their revenue from advertising and not subscriptions, which meant--guess what?--you were the product, not the customer. (Same with network TV, Gmail or any other service that is paid for by advertisers rather than your cash.)

Although Facebook's advertising model may make some uncomfortable about what is being sold and to whom, one thing is clear: Advertising has been "bery, bery good" to Facebook (to paraphrase SNL's Chico Escuela). Facebook has been a remarkable success, growing from a dorm room to a $66 billion organization in just eight years, but the company's reliance on advertising could very soon become its Achilles's Heel.

Currently, around 85% of Facebook's revenue comes from its own advertising, and the vast majority of the remaining 15% is derived from others' advertising income. Most of that is from game-maker Zynga, which is struggling with its own advertising-centric business model; daily activity has dropped 20% in two months and in the past three months, its stock has fallen almost 60%.

Zynga's troubles could portend the future for Facebook. While much of the current buzz about Facebook's business model is around its struggles with advertising on mobile, the company's greatest challenge is not that it hasn't yet succeeded in turning people's cell phones into ad-delivery devices but that it only makes money out of delivering ads. I've long seen a rosy future for Facebook, but without more diversification away from advertising, Facebook may stumble, both on NASDAQ and in users' lives.

The Lure and Problems of Advertising Models

The concept behind advertising-centric business models is simple Come up with a great idea that attracts time and attention, give it away for free or low cost, sell space so advertisers can reach eyeballs, and profit. It is neat and offers a simplicity anyone (especially investors) can understand: "900 million users? Americans devote 100,000 years each month on the platform? Facebook ad revenue up 37% year over year? Buy. Buy!"

Sounds good, except advertising models are notoriously difficult to make work. Oftentimes, ad revenue just simply won't cover the cost of delivering the free services and content. That's why the content in your free local newspaper sucks while the high-quality New York Times needs to supplement advertising revenue with subscription income. It's also why things that were once free--like access to all the content on NYTimes.com--are slowly and partially slipping behind paywalls. (A year into the New York Times' new partial subscription model, it is being called a success, with no drop in ad revenue and 390,000 paying subscribers.)

For a sign of how difficult ad models are to attain and sustain, just look at the top 10 websites in 2001. Seven were primarily based on the model of giving users what they want for free and selling ad space to brands: MSN, Yahoo, Neopets, AOL, Go, Excite and Geocities. Eleven years later, all are now struggling or practically dead. Only Yahoo remains in the top 10 sites, and its issues are well known with layoffs, leadership woes and negative revenue growth for the past three years. Of the rest, Go and AOL aren't even in the top 50 sites any longer, and Neopets, Excite and Geocities aren't in the top 4,000.

Web 1.0 companies struggled, but what about old-line organizations that have succeeded with ad-based models for decades? They're not looking too healthy nowadays, either. The stock prices of the New York Times and Gannett have dropped 80% since 2002 as a result of a decade-long collapse in newspaper ad revenue. And if you think online ad revenue is replacing newspapers' lost print ad revenue, guess again; newspaper's online ad revenues grew from $808 million in Q1 2011 to $816 million in the first quarter of this year--an increase of just one percentage point.

Advertising has generally been a more stable revenue model for network television, but the networks now fear that ad-skipping technology such as that offered by the Dish Network could further undermine an ad model that has been under attack from cable and timeshifting. You don't need to look at online-only companies to see that the advertising model is fraught with dangers.

Of course, the young social media industry already has its own cautionary tale: MySpace was the undisputed leader of social not that long ago. It worked mightily to stay innovative in the advertising space, offering a self-service ad platform, search ads in cooperation with Google, and ad targeting based on users' interests. But in the end, a horrible user experience spelled the demise of MySpace, a problem created at least in part by the overabundance of advertising.

Source: Forrester, http://bit.ly/AgeOfCustomer 

In the age of the customer, it is very hard to win with a business model based on giving consumers something they don't like and don't trust. Don't get me wrong--advertising will always have a place in sales and marketing strategy (and Facebook's business model), but we cannot bury our heads in the sand and ignore the evolving state of the consumer/ad relationship: Fewer than one in four tablet users have clicked an ad on the device; trust in paid TV, magazine and newspaper ads has dropped more than 20% in just two years; only 33% of consumers have any level of trust in mobile ads; 71% of US consumers are watching more time-shifted TV from a year ago, and 96% of them skip ads on their DVR; and ad-blocking software are two of the top 10 most downloaded Chrome extensions and the most popular Firefox add-on. The consumer is more in control than ever before, and that means advertising is difficult and hostile soil in which to plant and grow a stable, growing business plan.

The Lost Opportunity of the Facebook 'Like'

But Facebook advertising is different, some would argue, because it can be based on what people really like and not merely on demographics and psychographics. Facebook had the chance to lead with a new form of consumer-centric advertising based on the true affinity people have for brands, people and activities, but that is not how Facebook's platform has actually evolved. Facebook allowed (and perhaps encouraged) brands to squander to value of the "like."

Thousands of sweepstakes, giveaways and game freebies have created a situation where users' "likes" are a random collection of meaningless data points and not an indication of true brand affinity; for instance, I "liked" Gerber to vote for a friend's child in a photo contest, but I'm childless and have no relationship whatsoever with the brand. Nor has Facebook advertising helped to make the "like" a more meaningful signal for marketers. Take the ad at right; I'm invited to "like" something because I fly the US flag, but what am I liking--the flag? Walmart? A campaign page? Patriotism? US of A? Facebook's confusing and increasingly vapid "like" is a tremendous opportunity lost for Facebook, advertisers and users.

If Facebook cannot create a compelling difference between the value of its advertising compared to other ad alternatives, then all it can deliver to advertisers are the same eyeballs as every other undifferentiated site and ad network on the Internet. The history of online ad values is well established, with CPCs (cost per clicks) pushed ever downward as page views and ad inventory soar.

Facebook is well saturated in the US, so future growth won't come from adding large numbers of new users. Faced with this challenge, Facebook is seeding more ads into its user experience; Inside Facebook recently found that users may now be exposed to as many as ten ads per page. Populating more ads per page can increase ad revenue, but it comes at risk that Facebook could Myspace itself.

Google: The Exception to the Rule

Of course, there is one company that has succeeded wildly with an advertising model: Google. It rests firmly in the top 20 most valuable US companies, and it makes the vast majority of its money from advertising. According to the company's last quarterly filing, 96% of Google's revenue comes from advertising, and despite efforts to diversify, including owning the most popular smartphone platform in the US, that percentage only moved from 97% to 96% in the last year. Last quarter, Google earned $111 million of revenue from advertising per day.

Google succeeded by fundamentally changing advertising, and advertisers beat a path to Google's door. The company didn't merely offer up content or functionality that people wanted (as did the seven dot-com media companies noted above) but instead became the de facto gateway to the Web for Internet users across the globe. It is worthy to note that one of the ways Google succeeding in differentiating itself wasn't just through its advertising but the lack of it--while other search engines and portals polluted their home pages with dozens of banner and text ads, Google's clean, white home page waited for consumers to indicate their interests before serving up relevant ads.

Perhaps Facebook can follow in the footsteps of Google and succeed in changing advertising itself, but it's difficult to see how with the "like" being so useless.  Does your advertising in Facebook appear to be any more relevant than advertising on other sites? I keep getting a stream of ads for conservative candidates and organizations, despite all of my left-leaning posts (not to mention the fact I keep whacking those right-wing ads and reporting they are "against my views.") 

Facebook has other ways to follow Google's lead and wring more value out of advertising without increasing page views or the number of ads per page. It could extend its advertising off of its platform (a la Google AdSense). Or Facebook could become a search engine, serving ads that match people's immediate and stated needs, just like on Google. With reports Facebook is readying its own competitive search engine, the social network could soon be competitive in the Search Engine Marketing space.

Facebook can also increase its margin from advertising by validating its ads are worth higher rates. The company has several interesting case studies posted online, but advertisers aren't convinced, yet. When asked about driving purchase intent in a recent Citigroup/Ad Age survey, 19% of advertisers said they "don't know" if Facebook is useful, 13% said it's "not useful" and 55% said Facebook is "somewhat useful." And while 72% of advertisers said they expected their social-media advertising budget to increase, only 57% said they thought their Facebook advertising budget would increase.

Of course, even Google isn't bulletproof--its stock has underperformed NASDAQ in the past year and has been essentially flat for the past five years. Among the risk factors cited in the company's recent 10-Q filing are that revenue growth and operating margins could fall due to "increasing competition." And it is interesting to note that in the 57-page filing, social media and social networking are mentioned just a single time--not as strategy or opportunity, but as a competitive threat.
 

New Products and The Value of Consumer Trust

Facebook presently has an unsustainable P-E ratio of 98--Google's is 17 and Apple's is 15--which means Facebook must rapidly increase income or face more and substantial decreases in share price. It may sound encouraging that in the first quarter of 2012, Facebook ad rates rose, but assuming minimal growth in Facebook page views, these rates would have to increase 500% to bring Facebook's income inline with its stock price. That won't happen unless Facebook can change the face of advertising and become the next Google; otherwise, it must quickly demonstrate to the market that it has other solid and reliable business models for rapid growth. 

To increase revenue in the short run, Facebook could run even more ads on every page of the site. Or it could begin to offer new forms of interruption advertising, such as page-takeover ads and video pre-rolls. The company is also testing a new revenue source in New Zealand and Russia, where people can pay to have their posts reach more of their own friends. And Reach Generator promises brands that pay will get their posts seen, pushing aside the organic content from brands that don't. That little Italian restaurant you "liked" because you love it? Sorry, you will see less of its posts because big advertisers are paying to get more posts in your newsfeed.

Did reading that past paragraph make you a little queasy? Does this not sound like the authentic, transparent future social media promised? Therein lies the true problem of Facebook's advertising model--it drives business and customer decisions that tend to upset users and weaken trust in the Facebook platform.

Facebook users have griped about many of the changes the social network has made to increase ad views and ad value on its platform, such as the recent replacement of people's email addresses with Facebook.com addresses and Facebook's notorious and now defunct Beacon tracking program. While these incidents haven't caused the decrease in usage that some have predicted, they have come at a cost to Facebook: Few people trust Facebook. An AP-CNBC poll found that 59% of consumers have little to no trust in Facebook keeping their information private; customer satisfaction in Facebook is among the lowest of any site tested by the ACSI; female bloggers surveyed by BlogHer indicated more trust in blogs, Pinterest and Twitter than in Facebook; and ThreatMetrix found that a majority of consumers do not believe Facebook storefronts are committed to protecting them from fraud.

(UPDATE: The day after I published this, the ACSI annual customer satisfaction results were released. Facebook's satisfaction tumbled eight points in one year--the fourth-lowest score among all 230 companies surveyed in the index and the lowest among "e-business" companies. Among the top complaints were ads, and 61 percent of users say they pay no attention to Facebook advertising. All of which, of course, simply reinforces the point that Facebook, despite its usage, has a reputation problem.)

(UPDATE 2: A day after that, All Facebook published an article on the failure of two high-profile Facebook storefronts. Heinz wanted to use Facebook to sell customized bottles of new balsamic vinegar ketchup but later found Paypal a more welcome platform. Said an agency rep, "Hosting the e-commerce page within Facebook actually put people off as it’s not a trusted platform for making a purchase. It created a lot of nervousness." Again, more issues of reputation and trust for Facebook.)

(Update 3: I'm going to have to stop adding to this post, but a couple days after the last update came word of a study from Placecast. Asked how comfortable people were with their privacy and use of data, 81% were comfortable with grocery stores using purchase data to identify coupon offers and 66% were okay with Amazon using purchase data to make personalized recommendations. At the bottom of the heap? You guessed it: Facebook using your posts to target advertising, barely edging out cell providers using location to send local offers.)

It can sometimes seem that Facebook is immune to trust concerns; after all, Facebook's site accounts for one in five US page views and is deeply integrated into the web experience, with 22 percent of the pages on the Internet linking to Facebook and 8 percent using Facebook's Open Graph. With numbers like those, why should Facebook worry about trust? Because diversification of its business model requires that consumers trust the company.

For instance, Facebook could usher in a new era of social shopping online, offering social experiences such as real-time cobrowsing, group buying and collaborative decision making. The idea of Facebook playing a role in ecommerce is not new; the company sparked rumors about an ecommerce play when it launched Facebook Credits and Facebook gift cards started appearing in bricks and mortar stores. Facebook Credits have gone to little use except to buy virtual goods in social games and now Facebook is phasing out Credits, but that doesn't mean they have given up on commerce; there is evidence of Facebook building new social commerce features, such as a Facebook "Want" button (which doesn't strike me as a terribly appealing feature, but it is a step forward into social commerce.)

Changing the face of commerce is how Web 1.0 companies like eBay and Amazon created enormous wealth, but there is one giant difference between them and Facebook: Trust. Amazon is the second most trusted company in the US, and eBay is in the top 80 according to the Temkin Trust Ratings. Integrating itself into consumers' purchase behaviors without the same high level of consumer trust could be an insurmountable challenge for Facebook.

Other potential business models Facebook might explore demand even greater trust. When Gartner predicted Facebook could begin to offer banking and insurance services, I scoffed because of the low trust the social network engenders; however, recent reports indicate Facebook is now testing banking services in Australia. With new business models like peer-to-peer lending growing at a rate of almost 200% annually, it's easy to see the appeal of social banking to Facebook, but will people really trust their savings and financial transactions with Facebook?

There is considerable conflict between what Facebook needs to do to diversify its business model and what it loses with each enhancement of its advertising model. I don't believe it can have it both ways--if it wishes rapid growth of advertising income to support its stock price, that will further reduce Facebook's chances for success with other business models that require trust. Conversely, to succeed in diversifying, Facebook must make a strong shift away from advertising and start building consumer trust, but this will come at a short-term cost to shareholder value.

If Facebook is going to stumble in the future and leave an opening for another service to become the hub of people's socializing--not just social communications but new forms of social business--it won't because some other site offers better features. (Sorry, Google+.) Instead, this will occur because Facebook failed to break its addiction to advertising quickly enough, resulting in more user-exploiting, trust-destroying platform changes.