Thursday, December 26, 2013

2014 in Review: Facebook's Very Bad Year

Anyone can create a list of predictions for the coming year, but I wanted to do something different. After seeing the return of Brian to Family Guy courtesy of Stewie's time machine (apparently Seth MacFarlane never learned the number one rule of Hollywood,"Don't kill the dog"), I decided upon my approach. I traveled forward in time to December 2014, stole this blog post off my PC and can share--one year in advance--the year that was (or will be) for social media, particularly Facebook.

(Disclosure: Although it may ruin the illusion, now is a good time to point out that time travel is not real, I am not offering financial or investment advice and the predictions and opinions expressed below are my own. This is a work of speculative, albeit informed, fiction.)


2014 in Review: Facebook's Very Bad Year

The past year has certainly been quite the wild ride, hasn't it?

A surprising number of social services had a bad year. Vine withered as consumers adopted more flexible sharing platforms. The answer to "Is Quora still around?" is "Yes, but only in Asia." Tumblr tumbled as users fled the appearance of advertising on the network (and as Yahoo improved its ability to spot and delete porn). Snapchat has lost $3,500 of value every second since turning down Google's $4 billion offer in late 2013--its current valuation stands below $2 billion, a steal at just 1,000 times this years' revenue, wouldn't you say? Twitter, despite steady increases in users, time and tweets, saw its stock fall as the typical post-IPO hangover set in. Meanwhile Google+ is still doing as well as any Google social strategy to date, which is to say quite modestly.

While some tech companies had a bad year, for others, 2014 was fatal. Groupon is hanging tough (although it gave up much of its 2013 stock surge as its string of flat quarters and after-tax losses continued) but LivingSocial is no longer among the living. I will not mourn the loss of LivingSocial, but I feel a bit sad to see Barnes and Noble's Nook throw in the towel. The retailer deserves credit for trying to innovate, but they just could not compete against iPads, Androids and Kindles. With the book closed on Barnes and Noble's digital strategy, the retailer now seems poised to follow Borders to the great bookstore in the sky.

Facebook's year has perhaps not been as bad as LivingSocial's or Nook's, but 2014 has been quite painful for the folks in Menlo Park. Facebook started the year on a high, with its stock selling more than 50% above its IPO price, but the company is ending 2014 in a very dark place. After briefly exceeding a price of $70 per share, Facebook's stock is now back to its mid-2013 level.

The social network still welcomes around 1.5 billion active users on a monthly basis, so it isn't exactly on the ropes, but questions dog Facebook on three fronts: Declining active users in developed markets, a deceleration in the growth of advertising revenue and a lack of diversification in its business model. While many could not see it at the start of 2014, the seeds for Facebook's rough year were planted and already blooming at the start of the year.

Users, Loyalty and Trust

Facebook's long march toward worldwide saturation has ended. The company, which as recently as two years ago could reliably post more than 6% quarterly increases in monthly active users (MAUs), was barely able to grow its worldwide MAUs in the last two quarters of 2014. Even more concerning, for the first time ever, Facebook saw a decline in MAUs in North America.

None of this should have been a surprise, since Facebook acknowledged in October 2013 that the company was seeing "a decline in DAU (Daily Active Users) among younger teens in the United States." As has happened time and again since the dawn of the digital era, teens' communication habits influenced those of older demographics, and thus use of new mobile and sharing apps grew in every age category. WhatsApp, Kik, TinyChat and Pheed all increased active users by 150% to 300% in the US in 2014, and it seems 2015 will be the year for one of these mobile sharing apps to emerge from the pack.

While investors may have shrugged off Facebook's late 2013 warning about teen usage, it was clear the company was deeply concerned; this is why Facebook was willing to extend a $3 billion offer for SnapChat. Although SnapChat does not publicize its user numbers, several tech writers (such as those at Buzzfeed, GlobalWebIndex and TechCrunch) estimated the service had just 10 to 25 million active users at the time of the offer. If accurate, that means Facebook was willing to pay at least four times more per user than it did for Instagram in 2012--quite a premium for a service that had no revenue and was plagued with questions about bullying, sexting and predatory behavior.

While Facebook was willing to spend lavishly to retain teen users, in other ways, it was remarkably complacent about user issues back in 2013. The company showed no sign of urgency, even though studies demonstrated Facebook was less trusted than any other company to protect consumers' data and the social network earned rock-bottom scores for customer satisfaction. While teens started flocking to other services where they could better control who could see their pics and posts, Facebook did little to improve posting control or its news feed; in fact, a significant news feed improvement announced in March 2013 was quietly abandoned before year end. Distrust, dissatisfaction and diminishing active users are a dangerous combination, and many now believe Facebook will face the long-anticipated "tipping point" in 2015.

Advertising Growth Slows

With Facebook's user base stagnating and limited opportunity to serve new ads to consumers before they rebel, Facebook's advertising revenue began to get squeezed in 2014. Revenue continued to grow at a healthy pace in early 2014, but by midyear top-line growth was slowing. Why? Many marketers were not happy with the results delivered by their ad spend on Facebook and email continued to deliver considerably better results than Facebook ads.

Of course, mobile advertising is still a bright spot for Facebook, but just as had occurred on the desktop in 2012 and 2013, the pace at which Facebook mobile advertising was rising began to slow in 2014. The number of ads that can be served to consumers on their mobile devices and the price advertisers are willing to pay both show signs of approaching peak levels.

Faced with advertising saturation, the only solution to keep ad revenue growing was for Facebook to offer new advertising products for which marketers were willing to pay larger sums. This meant, for example, the launch of auto-run video advertising in consumers' news feeds. The reaction to these ads was not, to say the least, very positive. Consumers, already unhappy with advertising on the social network, objected to the distraction of the moving ads, the impact on PC and phone performance and the additional unwanted data throughput that sucked up too much of their monthly data plans.

Almost immediately, people began posting on Facebook links to new ad-blocking browser addons and instructions for how to prevent Facebook's Flash ads from running. (Ironic that the same power Facebook gives users to share is now being used to reduce Facebook's advertising results, huh?) Auto-running video ads were just one step too far for many users, leading to more complaints and more abandonment.

As we enter 2015, Facebook may have the sort of revenue growth that other sites would kill for, but the rate of growth is slowing. This is bad news for investors who earlier in the year had been willing to pay a price-earnings ratio of more than 140, substantially greater than Apple's P-E of 14 or Google's 32. With slowing growth, the market reassessed the P-E premium at which the stock was trading, and Facebook shares took a tumble.

Lack of Diversification in Facebook's Business Model

The final issue that has investors vexed and undermines confidence in Facebook is the company's lack of revenue diversification. In 2011, more than 16% of Facebook revenues came from payments and other fees, but this percentage steadily declined as social gaming revenue lagged behind ad revenue growth, Facebook yanked its virtual credits program and the social network failed to sell physical gifts as part of its Gifts program. At the end of 2013, the company had never been more beholden to ad revenue, with slightly more than 10% of revenue coming from non-advertising sources, and in 2014 the situation worsened--the percentage of revenue from advertising now exceeds 91%.

Diversification is a vital factor that drives investor confidence and stock price, particularly for firms that rely on advertising. While advertising can furnish easy income for companies such as Facebook that amass many users, it also comes with profound risks. Just ask Excite, AltaVista, Geocities or Myspace how advertising worked for them. Or, check out print media, which is still struggling to deal with a decade-long collapse in newspaper ad revenue.

Investors buy stocks when they can see room for substantial and sustainable growth of the bottom line, but advertising revenue cannot grow indefinitely as users and page views stagnate. Facebook desperately needs to demonstrate non-advertising sources for growth in 2015 and beyond in order to again earn a higher P-E premium from investors.

In 2014, the sharing economy continued to grow, with firms like Airbnb, RelayRides, LendingClub and Prosper posting solid growth despite considerable challenges with the legal and regulatory environment and with slow consumer adoption. Meanwhile Facebook, the firm most responsible for bringing Web 2.0 services to the masses, has continued to sit on the sidelines of the sharing economy. While startups innovate with new and lucrative ways for the peer-to-peer (P2P) economy to grow, Facebook is mired with a stalling Web 1.0-style business model.

Perhaps this will soon change, as Facebook is rumored to be considering sharing economy acquisitions in 2015. (I'd humbly suggest TaskRabbit, a P2P marketplace for services, would make an excellent addition to Facebook's existing and sizable P2P social network.) Acquiring sharing economy firms that produce revenue by giving consumers services they welcome would be a long overdue move for Facebook, which for too long has relied on old-fashioned interruption advertising.

Facebook is also rumored to be considering an ad-free paid model, an action that would surely anger advertisers but could bring immediate diversification to the social network's income. Many folks are speculating about the price at which Facebook might offer its paid service, but if the rumors are true, Facebook can count on me to sign up for the $39.95 annual offering! (If, by the end of 2015, Facebook can encourage just 10% of its base to pay that annual sum, the company would diversify and boost revenue by around 40% this coming year!)

It's been a bad year for Facebook, with users beginning to abandon, advertising reaching saturation and no diversification to appease the restless market, but I certainly wouldn't count out Facebook in 2015. Zuckerberg and Sandberg deserve the lumps they have taken in the media this year for failing to address Facebook's problems before they developed, but the two leaders still have a chance to turn things around. With better usability, less onerous advertising and new programs that bring sharing economy products and services to its 1.5 billion users, Facebook could look like a reinvigorated company by the end of 2015.

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