One of the interesting things about an initial public offering (IPO) is the requirement to limit the amount of public information that is released prior to and shortly after the IPO date. The goal is to make sure that no one gets an unfair information advantage, but it can make life difficult for a company that may have a legitimate reason to talk. Facebook’s (FB) hands were tied by this rule as criticism of its business model and corporate performance mounted leading up to its IPO.
It would be hard to call the Facebook IPO a success for investors, though the company made plenty of money on the issuance. One of the biggest negatives, which appeared just days before the offering, was that advertising on Facebook apparently does not work as well as other options. There were legitimate stats to back that claim up, including a public decision by General Motors (GM) to shift away from the platform.
Unfettered by the IPO mandated “hush period,” Facebook has released its own internal tracking of selected advertising campaigns and a sponsored study by comScore. Both showed that Facebook advertising was effective. This isn’t surprising, since the company wouldn’t have bothered to release information that wasn’t supportive of its cause. That said, the results can legitimately be questioned since the Facebook research may, or may not, have cherry picked advertising campaigns—hard to tell either way. And, the comScore effort tracked advertising to Facebook users who were fans of a particular brand—it isn’t hard to believe that a group of people who admit to liking a store spend more at that store than people who don’t claim to like the store (the design of such a study would be wildly important to the validity of its findings). Moreover, neither of the studies fully addresses the issue of advertising to mobile users of Facebook, which is an increasingly important concern.
The free-supported-by-advertising model is still not proven for Facebook. Google (GOOG) has proven its ability to use this model, but others, like Yahoo! (YHOO) and AOL (AOL), are still struggling to make a long-term go of the model. Facebook looks like it is still fine tuning its approach to the model.
Indeed, the most successful internet companies are clearly those that actually sell things, like Amazon.com (AMZN), or provide a selling service, like Priceline.com (PCLN). Looking at what has happened to the newspaper industry’s advertising revenue is illustrative. One of the cornerstones of the newspaper industry was small advertisers, from local businesses to the long list of classified ads paid for by individuals. That was an unloved backbone of support. eBay (EBAY) destroyed the latter and working with mom and pop local businesses requires a material sales effort—something that Groupon (GRPN) has found out the hard way. National and regional advertisers, meanwhile, found options beyond the papers that worked well enough to reduce the use of the medium—an issue that has hurt any number of ad supported internet sites, as well. And, perhaps the most damning development for the newspapers, readership of broad sheets materially declined.
While all of the issues above show that Facebook has material obstacles to overcome, the last is probably the one that should be most concerning to investors. Facebook isn’t the only social network, it is just the most widely used and best known. If that changes, akin to people stopping the purchase of newspapers, what happens to Facebook’s business model? At this point, Facebook is built on the so-called network effect, in which more people congregating at one place makes the value of the people and their connections stronger. If the tide ever turns, the network effect will begin to work in reverse—not a good thing for Facebook or its financial results.
No matter what anyone would like to believe, the internet is still in its infancy. Things have moved quickly, but that doesn’t mean that today’s success stories will be tomorrow’s winners. By way of example, the auto industry was once much larger than it is now. Successive industry shakeouts have left us with the dozen or so global players we have today. To its credit, Facebook is continuing to innovate, but that doesn’t mean it will succeed.
Investors who bought in on the IPO have already learned how risky investing in internet darlings can be. Anyone looking at Facebook shares and thinking that they are in the bargain bin should strongly consider what is at stake. For example, Lockheed Martin (LMT) is currently trading at what appears to be bargain prices, though for good reason. Lockheed is facing the likelihood of government budget cuts that may have an outsized impact on its top and bottom lines. That said, Lockheed’s entire business model isn’t in question—selling specialized products and services to the U.S. military isn’t going to get replaced by the next cool app. Plenty of additional examples like this one can be made with little effort—investors might find better opportunities, at least on a risk/reward basis, than at a company like Facebook whose entire business model could conceivably fall apart like a house of cards.
A quick list of companies worth examining include household name Johnson & Johnson (JNJ – Free Value Line Research Report for Johnson & Johnson), and lesser known companies such as Sysco (SYY), Paychex (PAYX), and Nucor Corporation (NUE). All are material companies with solid business models that are, most likely, temporarily out of favor. Investing in any of these names won’t allow for much bragging at cocktail parties, but then very few IPO buyers are bragging about having bought Facebook.
At the time of this article’s writing, the author did not have positions in any of the companies mentioned.
