Why Facebook’s Business Model Needs to Change

Facebook's a great company with terrific brand recognition and a product that people love to use, but the market’s expectations of what the company can deliver financially far outstrip the reality.

“Facts do not cease to exist because they are ignored.”

– Aldous Leonard Huxley

Facebook has a problem. It is a great company with terrific brand recognition and a product that people love to use – but the market’s expectations of what the company can deliver financially far outstrip the reality.

At the time of the writing this article, Facebook has a market capitalization of approximately $58 billion and the company has a non-GAAP trailing twelve month net income of $1.344 billion. These numbers indicate that the market expects Facebook to have spectacular growth prospects, but unfortunately all the key metrics to measure this growth are pointing in the wrong direction.

Let’s consider the company’s Q1 2013 results.

While revenues have grown at a respectable rate, improving from $1.058 billion in Q1 2012 to $1.458 billion in Q1 2013, growth in the high value North American and European markets is flat and may even be declining in some niches. The company’s management loves to point to excellent growth in the mobile segment, but this segment has proven notoriously tough to monetize and the dominant platform providers in the space, Google and Apple, have ambitions that do not coincide well with Facebook’s plans.

On the operational front, Facebook has been spending an increasingly higher proportion of its revenues to sustain the growth. The company’s net margins have declined from 46% in Q1 2012 to 39% in Q1 2013, leading to virtually no earnings growth during this time period.

Over the same timeframe, Facebook’s average revenue per user (ARPU) increased from $1.21 to $1.35. A healthy increase, but nowhere near the level necessary to support Facebook’s gargantuan valuation. The bulls will argue that the company has not yet tapped out all the possible advertising options, which is true. The Facebook platform does provide creative avenues for advertising and other forms of monetization that will increase the ARPU over time. However, the real question is not if the ARPU can grow, but if the ARPU can grow by an amount required to justify the current valuation.

Competitors set to invade Facebook’s turf

For the last several years Facebook has been the unquestioned leader in the social networking space with very little competition. But that is starting to change as competitors find some clever niches that invade Facebook’s turf. Path, Snapchat, and Google+ are all potent competitors that are stealing users and eyeballs from Facebook. For the first time in the company’s history, Facebook is facing headwinds on the Daily Active User (DAU) count as well as the time users spend on the platform.

Revenue and subscriber growth is slowing down in the core markets, and is probably the surest indication that Facebook may not have much of a growth path in terms of both absolute number of customers or ARPU. We fully expect to see a downturn in total time users spend on the platform in the core North American market no later than 2014.

The problem with public markets

Had Facebook been a private company none of this would have mattered. But, Facebook is a public company with market expectations. And, the equity market expects Facebook to continue growing revenues and profitability at a rate that justifies the valuation. And therein lies the problem. As new competition takes hold, it will be impossible for Facebook to meaningfully increase its share of users – especially in the core markets where it gets its major share of revenues. And, for the company to keep delivering per expectations, any loss of growth in users should be made up by increasing ARPU.

With advertising as the primary source of revenue, there is no easy way for Facebook to increase the ARPU to a level sufficient to compensate for the decline of customer growth in the core markets. It does not help that in the all important mobile sector, Google and Apple are likely to put further pressure on Facebook’s ARPU aspirations. This calls for a fundamental rethinking of the current Facebook business model.

Why a Freemium Model makes sense for Facebook

What if Facebook starts charging subscribers monthly or introduces annual fees? What about Facebook’s homepage, which proclaims that the social network is “free and always will be”? Having paid subscribers and offering a free service does not have to be exclusive, and that brings us to the freemium model. Freemium is a business model by which a company delivers its basic product or service to its customers for free but charges a premium for more advanced features or functionality.

What does it mean for Facebook to be offering a freemium model? Once a freemium model is implemented, a vast majority of Facebook’s customers may continue being subscribers at the free “basic” level. To incentivize customers to become paying subscribers, Facebook could provide additional tools and services that give them better control of their feeds; a better user experience (e.g. faster uploads and downloads), or the ability to tailor the types of advertising they receive. Paying customers can help dramatically improve Facebook’s ARPU in a very short period of time. Assuming even a modest $20 per year subscription rate and a 10% take rate in the first year, the ARPU would go up by $2 within the first year. Something that can be achieved with relatively little effort!

There are also some other indirect benefits related to the subscription model. Contrary to popular belief, premium does not have to mean “no advertising.” It is entirely possible that many advertisers will find that they are better off targeting premium customers than free customers. And, these advertisers may be willing to pay more to access this market. That could effectively increase Facebook’s ARPUs even further.

If a premium account could provide a better user experience, more targeted advertising, and an element of peer pressure, it could (in a perverse way) incentivize some of the free users to upgrade to premium subscriptions, contributing further to Facebook’s ARPU growth.

Given that Facebook now operates as a public company, we see the adoption of the freemium model as a virtual certainty and more of a question of “when” than “if”. Exploiting a high return freemium option, especially when the company’s growth and valuation are under scrutiny, is an easy decision that we expect Facebook’s management will make.

Chak Reddy

Chak Reddy is a Mergers and Acquisitions Advisor with Elite Mergers & Acquisitions. Elite specializes in selling businesses with revenues between $1 million and $100 million. Chak is a business M&A and Marketing expert in the technology and energy industries, and is the chief deal maker at Elite. He can be reached at 916-220-3052 or by email at creddy@elitemanda.com.