Bull Vs. Bear - Facebook's New Revenue Strategies Carry Real Risks

By Stephen D. Simpson, CFA | September 28, 2012 AAA

Question: Will Facebook's new plan for ads help push up its stock price?
Bear's Response
Apart from the debate over whether Apple's (Nasdaq:AAPL) new iPhone is a great leap forward or the first warning of stalling innovation, perhaps the most popular topic in finance writing right now is "What's wrong with Facebook (Nasdaq:FB)?" and "Can it fix the problem?" It seems pretty clear that the more starry-eyed investors have had to revise their expectations down, but Facebook's management has been more assertive lately now that they have oncoming revenue growth strategies that will make a significant impact.

While I would not count Facebook out just yet, investors should appreciate that its new investment strategies carry some meaningful risks.

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Mobile Is Tricky
As Facebook sees more and more users engage with mobile devices, it also faces some increasing challenges. For instance, ad impression growth was softer in Q2 (up 18% from 35% in the first quarter) and mobile has never been as profitable for Facebook as its traditional business.

Facebook is moving aggressively to address these deficiencies, but it seems that
Google (Nasdaq:GOOG) is a step ahead when it comes to mobile advertising. With more and more Facebook users accessing the site through smartphones and tablets, this is a mission-critical issue for Facebook management. It also doesn't help matters that Amazon (Nasdaq:AMZN) has pointed to an alternative where the hardware makers can influence or control the ad environment on mobile devices (though it has yet to be seen if customers will tolerate/accept this).

SEE: Earning Forecasts: A Primer

Will More Aggressive Ads Push Away Users?

One of the most challenging balancing acts for Facebook management is preserving the user experience while maximizing the earnings potential. Remember, Facebook users are the product, but they don't generally think of themselves that way. So while new mobile ads, new ad formats and sponsored stories are all great, hitting users with too many ads (or ads that are too intrusive) is going to lead to user attrition.

Does Facebook Deliver Value for the Advertiser?
If Facebook has to worry about degrading the user experience with intrusive or excessive advertising, the company also has to worry about ad fatigue that leads users to simply ignore those ads. So it's all well and good to find new ways to charge companies for the ability to present their goods or services to users, but there has to be value for everybody.

To name one example, Facebook has recently decided to charge for promotional offers. While Facebook offers had been free, they will now carry a charge based in part on the size of the company's Facebook page (the number of customers it can address with those offers).

At a minimum, I would expect that this will force the companies in question to be more careful about tracking the returns on those offers - with free offers there was no risk, but now companies will have to evaluate the return on using the Facebook platform, as opposed to rival services like Groupon (Nasdaq:GRPN) and LivingSocial.

SEE: A Primer On Investing In The Tech Industry

Challenging a Big Dog
Facebook also seems to be preparing to take on Google more directly than it has before. Amidst talk of more focus on paid search, Facebook is also launching an ad exchange that will go up against Google's DoubleClick Ad Exchange. This isn't likely to be an easy task; Google has built itself into the leading online ad player and it's not as though there is a long list of companies that have succeeded by challenging Google head-on in those areas where Google is already strong. The risk, then, is that Facebook invests resources here (and boosts investor expectations) in a fruitless battle.

The Bottom Line
Although I do believe the negative drumbeat on Facebook is likely getting overplayed, that doesn't mean that it's all smooth sailing for the company. If maintaining the user experience (and user loyalty) and maximizing the Internet's ad revenue potential were easy, companies like AOL (NYSE:AOL), Yahoo! (Nasdaq:YHOO) and Microsoft (Nasdaq:MSFT) wouldn't get singled out as cautionary tales.

I do believe that challenging Google is not going to be easy for Facebook, and I likewise believe that adding more ads and revenue opportunities risks the user experience at Facebook. Although I'm not calling for the doom of Facebook, I would suggest investors consider the risks that go with some of these new strategies.

At the time of writing, Stephen D. Simpson did not own shares in any of the companies mentioned in this article.

Don't forget to read the Bull Side of this debate and weigh in with your opinion below.

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