Facebook: Change or Die

Facebook's (Nasdaq: FB  ) market capitalization has fallen from $100 billion to its current value of a little less than $50 billion. Can it even justify this value? With slowing user growth, questions about its advertising efficiency, even more questions about mobile monetization, and revenue ties to the waning Zynga (Nasdaq: ZNGA  ) , many think it's still overvalued. Here's what Facebook should do that could return 45% to investors, renew its reputation, and untie it from an advertising death spiral.

Users do not automatically turn into money
For technology start-ups, users signify value. Take Instagram, a mobile photo-sharing application, which Facebook bought for $1 billion. While Instagram made no money, it claimed roughly 40 million users at the time. This is because users give the promise of future revenue. However, sometimes this revenue stays in the future, and it is never realized. To make sure Facebook realizes all its potential, it needs to break with its advertising-based business model and begin charging users.

Facebook already has the network effect, and it's time to reap that value with a monthly fee.

Advertising blues
Facebook's ad model has been jilted, slighted, criticized, and insulted. And that's just been in the past few days. Even for Google (Nasdaq: GOOG  ) , the cost per click, or how much it can charge an advertiser each time a user clicks on an advertisement, fell 16% over the past year. However, Facebook's ads are notoriously less effective than Google's: According to WordStream, a search-engine marketer, Google display ads are clicked on 10 times more than Facebook ads. Most recently, a small startup is making news for ditching Facebook ads after concluding that 80% of its clicks came from bots instead of actual humans. Facebook is investigating the issue.

It seems that social media, even with its superior data, is suffering from the same maladies of the old-media industry. And while it took old media hundreds of years to transition from advertising to subscriptions, social media is on its way to transition in a decade.

Depending on advertising threatens Facebook beyond just relying on healthy business cycles and good ad performance (both of which already seem precarious). Facebook also comes under fire for its privacy practices, and looking for more ways to sell its users' data will only intensify that issue. Facebook can avoid all these issues by ditching the ad model and moving to subscriptions.

Subscription-based sanity
Facebook earned $1.32 in revenue per user in the first quarter of this year, while Google earned $9.52 and LinkedIn (NYSE: LNKD  ) earned $1.84. Even Yahoo! (Nasdaq: YHOO  ) beat Facebook with $1.74 in revenue per user. Worse, in the most recent quarter, Facebook's revenue per user dropped to $1.24. How can Facebook make more money and nix advertising and all the ills that it brings? Simply charge a low monthly subscription fee of $1 per month.

"Heretic!" you might scream. Facebook is, was, and always will be free! Well, just maybe it's worth paying for its services.

By charging its users, it wouldn't have to defend its questionable ad efficiency, scrounge for ads, or sell out its users' privacy. Users would get a secure service where they could share videos, photos, and games and message their friends. There is actual value in those things that would make Facebook worth a fee. And for businesses, Facebook represents an easy, boilerplate webpage. Why find other Web hosting if you just need to communicate your business hours, address, and sales?

How much could Facebook make? Let's say the monthly active users lack the interest to pay for Facebook, and we'll judge potential revenues based on daily active users. For June, there were 550 million daily active users. At $1 per month, Facebook would make $6.6 billion in revenue each year. Add in a small fraction of the 37 million pages that businesses and brands use, and Facebook could bring in $7 billion in revenue per year. With about $1 billion in expenses, double what it had in 2011, Facebook could book a profit of $6 billion per year. And at a conservative price-to-earnings ratio of 10, the company would be worth almost $32 per share, 45% higher than it currently is worth.

Unfortunately ...
As Mark Zuckerberg stated in the IPO filing, "we don't build services to make money." And Facebook's website does proclaim that the service will always be free. However, Facebook could integrate upgraded premium services to users. Like LinkedIn, which charges users a premium to have higher visibility to potential employers, Facebook could offer better photo sharing or an ad-free interface for a fee.

In the end, it's clear Facebook needs an answer to better convert users to revenue. There is no doubt plenty of opportunity to improve that metric. What remains unclear, however, is how Facebook plans to go about achieving that growth. Learn more about the company's key opportunities and threats in our brand-new premium research report, which is all Facebook, all the time. Learn more.

Fool contributor Dan Newman holds no position in any of the above companies and might actually considering joining Facebook if it charged. Follow him on Twitter, @TMFHelloNewman.

The Motley Fool owns shares of Linkedin, Facebook, and Google.
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  • Report this Comment On July 31, 2012, at 9:30 PM, GeneRickyShaw wrote:

    I would actually pay $1 a month for FB on two conditions; one, no ads, but two, NO CHANGING FB WITHOUT MY APPROVAL. FB keeps changing its layout, what items appear, etc, and I as the user have absolutely no say in the matter. If I'm paying for the service, I want control over my FB screen.

    Otherwise, forget it. I've started to stop using FB because of their arbitrary changes.

  • Report this Comment On July 31, 2012, at 10:12 PM, TMFNewCow wrote:

    For what it's worth, ARPU in Q2 increased to $1.28, up from $1.21 in Q1. FB calculates ARPU by dividing revenue by *average* MAUs in the period, not ending MAUs in the period.

    -- Evan

  • Report this Comment On July 31, 2012, at 10:27 PM, TMFHelloNewman wrote:

    @Evan,

    Thanks for the correction. I got that figure from a source outside of Facebook's earnings slides (available here for others: http://investor.fb.com/results.cfm).

    It seems ARPU itself hasn't changed much since late 2010 - ranging from $1.14 to $1.38.

  • Report this Comment On July 31, 2012, at 10:28 PM, TMFHelloNewman wrote:
  • Report this Comment On July 31, 2012, at 10:45 PM, TMFBane wrote:

    "Facebook's (Nasdaq: FB ) market capitalization has fallen from $100 billion to its current value of a little less than $50 billion."

    Just wanted to note that I think the market cap you are using is incorrect. Yahoo Finance and Google Finance have the share count wrong, and are using 2.1 billion shares. Henry Blodget actually checked with the Facebook, and was able to determine that the correct sharecount is 2.74 billion. That results in a market cap of slightly under $60 billion. Blodget writes about it here:

    http://www.businessinsider.com/facebook-shares-outstanding-2...

    Anyway, I just wanted to mention that.

  • Report this Comment On July 31, 2012, at 11:10 PM, TMFHelloNewman wrote:

    @John

    That's interesting, as well as extremely confusing. I used the share count from their latest earnings, which they list at 1.879 billion (which is the same number at Yahoo!). But that's even different than the one that Blodget quotes from Yahoo.

  • Report this Comment On August 02, 2012, at 9:45 AM, TMFBane wrote:

    Hi Dan,

    Blodget has another post today, which clarifies the confusion. It explains how the share count is determined. Very useful stuff!

    http://www.businessinsider.com/facebook-shares-outstanding-2...

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