Facebook Releases Negative Report Before IPO

Could Facebook’s cash machine be slowing down? That’s one possible conclusion observers can draw from the paperwork the company recently filed with the Securities and Exchange Commission. While it’s not likely to slow down investors, it’s not the best news to get so close to the social media giant’s IPO.

According to a quick item from David Angotti for Search Engine Land, Facebook reported that its net income fell 12 percent in the first quarter of 2012. Looking at the previous quarter’s total revenues, the latest quarter saw total revenues fall six percent, to $1.06 billion. That may not be cause for serious concern, however – especially when you consider that the previous quarter included the holiday shopping season, and Facebook makes its money from ads. Indeed, the company itself noted that the downturn was due to “seasonal trends.” Compare Facebook’s revenues to the year-ago quarter, and you see growth of 45 percent.

While those numbers should hearten investors, digging a little deeper reveals some cause for concern. As Angotti noted, “acquisition and operating expenses are rapidly rising.” Some of that can be attributed to the explosive growth in Facebook’s membership. The L.A. Times reported that Facebook is up to 901 million monthly active users as of the end of March. That represents more than 50 million new users in just three months.

Correct me if I’m wrong, but that many new users means Facebook needs to keep building on its infrastructure to make it scale properly: new machines, new software, and more skilled employees, in both technical and non-technical areas, to keep everything running smoothly. In fact, operating expenses have risen enough to make accountants put out whatever may be left of their hair after this tax season. Looking at the year-over-year figures, operating costs went from $343 million for the first quarter of 2011 to $677 million last quarter. That’s nearly double the expenses in just one short year!

But these aren’t the only new expenses facing the social media site. Last year, Facebook’s total acquisition costs came in at $68 million. Just this quarter, the company agreed to purchase Instagram, a relatively new but wildly popular photo sharing app, for $1 billion ($300 million in cash plus 23 million shares of stock). Facebook also spent $550 million acquiring rights to a patent portfolio from Microsoft. Observers expect the company to use these patents to help defend itself from a Yahoo lawsuit.

The messy legal situation could complicate matters. As the Wall Street Journal explains, Yahoo accused Facebook last month of violating 10 Yahoo patents covering online advertising and communications. The patents Facebook bought from Microsoft, according to WSJ’s unnamed source, “relate to fundamental Internet technologies, including email, instant messaging, Web browsing, Web search, online advertising, mobile technology and e-commerce.” In addition to the patents purchased from Microsoft (which the software giant originally got from AOL), Facebook has also recently bought 750 patents from IBM, and gone on the attack by countersuing Yahoo.

Observers seem to be all over the map as to whether these figures will put a serious damper on Facebook’s IPO. Even the same person may end up telling you two different things. For example, take Lou Kerner, founder of the Social Internet Fund, which invests in social media companies (but not Facebook, or at least not at the moment).

For the Wall Street Journal, Kerner started by sounding a warning note. “We are seeing slow growth [at Facebook], which is never a positive thing,” he said. But he also noted that “Few investors are buying Facebook for first-quarter results. Facebook is trying to dominate a massive new sector — social media — and is willing to forgo short-term revenue growth and profitability.”
 
Facebook may offer a lot of good surprises in the future. As part of the Microsoft deal, for instance, Facebook agreed to take over the shell of Netscape, along with some patents that originated at that pioneering Internet browser company. That may not be that surprising to those who know that Marc Andreessen, co-founder of Netscape, is also a Facebook director.

Not everyone is convinced that Facebook has its act together for the future, especially if they plan to continue getting their revenue from advertising. One of Angotti’s readers commented on his article to note that Facebook’s “FastTrack” program is “a total joke.” While he admitted that their ad program can be effective, in his opinion it did not compare at all favorably to AdWords or AdCenter. “Seeing as that is how they generate the bulk of their revenue I think they should focus on improving their ad infrastructure, I see it as a huge weakness and it’s far too important to ignore. I have no illusion about Facebook going anywhere, but before I’d personally invest in a company I’d like to see their system to generate revenue significantly improved,” he concluded.

Another commenter, Bryan Gene Thompson, disagreed. “Facebook has the potential to become the leading ad platform, even surpassing Google,”  he observed. “A site where millions of people share their likes, interests, and opinions should be any advertisers dream. The trouble lies in finding that perfect balance of making people still believe that their not being sold something, and it is an actual social network.” He cited MySpace’s mistake of flooding their site with ads and selling landing pages, and noted that Facebook so far has remained popular because it continues to keep things simple. (I have to wonder where he’s been every time Facebook has made a change to the system that has angered its users – which seems to happen at least once per quarter).

So if you’re in a position to invest in Facebook, should you? Well, the company will almost certainly enjoy the largest IPO in Internet history. Angotti noted that the social network is expected to raise as much as $10 billion, and could come away from the IPO with a valuation in excess of $100 billion. Compare those numbers to Facebook’s expected revenue this year of $6.1 billion.

Better yet, if you have a historical bent, compare it to Google’s IPO, back in August of 2004. It raised $1.67 billion and gave Google a market capitalization of more than $23 billion. Google’s performance since its IPO has seen its stock rise 580 percent. Does Facebook have the potential to do the same, or even better? That’s the question investors need to answer, because with an IPO, that’s what you’re really buying.

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