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Why a Facebook IPO Could Flop


Since Facebook is increasingly reliant upon emerging markets for growth in the user count, that revenue-per-user number is going to drop over time.

"It's good to be in something from the ground floor. I came too late for that, I know. But lately I'm getting the feeling that I came in at the end. The best is over."
-- Tony Soprano

The prospect of a Facebook IPO is one of the hottest topics within a tech-stock universe that looks more and more staid by the day. (See Five Things You Need to Know: Why Is Tech So Hated?)

Outside the exclusive private equity and venture-capital markets where huge bucks are being made in social media, there just hasn't been much opportunity to get in the bonanza.

The exceptions, of course, are LinkedIn (LNKD), which recently came public, and Groupon which recently delivered its IPO filing to the SEC.

But as my opening sentence implied, Facebook is the Big Daddy for which everyone's waiting.

On Monday, CNBC reported that Facebook was planning on coming public in early 2012 at a valuation of $100 billion.

This shouldn't be a shock. Private-market valuations recently pegged Facebook as worth $85 billion. $100 billion isn't much of a jump when you consider that Microsoft's (MSFT) $240 million investment in Facebook back in 2007 valued the company at just $15 billion.

Early-stage Facebook investor Peter Thiel said back in 2010 said that Facebook wouldn't come public until 2012, and the fact that a timetable exists at all says something.

Plus, Facebook's January press release announcing a $1.5 billion capital injection from investors including Goldman Sachs (GS) contained this tidbit:

"Even before the investment from Goldman Sachs, Facebook had expected to pass 500 shareholders at some point in 2011, and therefore expects to start filing public financial reports no later than April 30, 2012."

So it certainly looks like the stars are aligning for a Facebook IPO.

However, in the midst of the excitement, I began to wonder:

Could a Facebook IPO Could Actually Flop?

Yesterday, reported that Facebook was seeing declining users in key markets like the US, UK, and Canada. The findings were based upon figures from Facebook's advertising engine, which gives marketers information on potential reach within individual

In response, Facebook told the following:

From time to time, we see stories about Facebook losing users in some regions. Some of these reports use data extracted from our advertising tool, which provides broad estimates on the reach of Facebook ads and isn't designed to be a source for tracking the overall growth of Facebook. We are very pleased with our growth.

Obviously, Facebook would want to deflect negative reports, but they do have a point. Anyone who knows any kind of Web-analytics program knows that they're far from perfect. Any number that is +5% could easily be -5%, and vice versa.

So Can Having 500 Million Users Actually Be a Bad Thing?

According to Facebook's fact sheet, the company has over 500 million active members, which it defines as "users who have returned to the site in the last 30 days."

And Alexa, Quantcast, and Compete all rank Facebook as the second most-visited site on the Web.

Facebook is big -- very big -- and that means we need to start wondering just how much bigger it can get.

Now, I did some playing around with Facebook's advertising application myself to confirm numbers I'd been reading across the Web, and some things were obvious.

Relative to population, Facebook penetration is very high in developed countries like the US, UK, Canada, Spain, Italy, and France. This lends credence to the idea of slowing, or even potentially declining user counts in some of these markets. At some point, you just start running out of bodies.

On the other side, Facebook penetration is fairly low in many emerging markets including Africa, as well as a few highly populated countries like China and Russia, which have their own popular social networks.

The US Census Bureau says that there are about 6.9 billion people on planet Earth.

So as of now, about 7% of the human race are active Facebook users. That sounds like a low penetration rate (which normally implies a high level of potential growth), but think about these numbers:

1. World Bank researchers concluded that 95% of the developing world's population lives on less than $10 a day.

2. According to the Food and Agriculture Organization of the United Nations, 925 million people are undernourished.

3. The CIA says that 785 million people can't read or write.

Now it's entirely possible that Facebook could eventually grow to 2 or 3 billion users, capturing a big chunk of the 5 billion-plus people using mobile phones, PCs, and other devices.

The problem comes in that future growth in the user base will be coming from less-affluent areas of the world, which means less revenue-per-user.

The latest rumors have Facebook bringing in $2 billion in operating income on $4 billion in revenue this year. Assuming these numbers are true, Facebook is bringing in about $8 for every active user.

The exact numbers don't matter. My concern is that since Facebook is increasingly reliant upon emerging markets for growth in the user count, that revenue-per-user number is going to drop over time. What may be $10 per user in the United States could easily be $1 in Bangladesh.

So while the user count could theoretically grow six-fold from here, the revenue base may not grow with it.

That means potential multiple shrinkage as investors will be forced to focus on a terminal-growth number for the user base.

Remember the valuation numbers that are being tossed around for Facebook these days. $85 billion. $100 billion. Hell, even $50 billion assumes a ton of growth over the long run.

Now big bucks have been made by the smart, rich, and well-connected people that got in early.

But sooner or later, there just aren't going to be many more people signing up for Facebook. And who wants to be buying the stock at that point?

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No positions in stocks mentioned.
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