The social networking site has ascended to Silicon Valley stardom. As it heads toward a possible share sale, it will next need to win over Wall Street
Google has become one of the most sought-after tech stocks this decade, but it wasn't always considered a sure bet. In the runup to Google's (GOOG) 2004 initial share sale, some investors fretted that, at $85, the Web search company was overvalued. These days, fund managers are running a slide rule over a new Silicon Valley darling that may be headed for an IPO: Facebook. Some potential shareholders have yet to be convinced Facebook is a stock they want to own. While Facebook tops the social networking heap with 350 million users, it competes in a social media realm notorious for swiftly changing consumer tastes. Time was, MySpace was the go-to social network, and before that, it was Friendster. Both have since lost allure. "There's no sustainable model that looks great for social networking," says Michael Pytosh, tech analyst for ING Investment Management, which oversees $600 billion. On Nov. 25, five-year-old Facebook revived speculation it's on track for an IPO when it said it created a dual-class stock structure. The move grants more voting power to existing shareholders than new ones and it's a step typically taken by companies planning to sell shares to the public. "The move was without a doubt done in preparation for an IPO," says Paul Bard, a research analyst at Greenwich (Conn.)-based Renaissance Capital, which researches newly public companies. Another recent step seen as a precursor to an IPO was the announcement in June that Facebook had hired David Ebersman, a 15-year veteran of Genentech (DNA), to be its chief financial officer. Facebook spokesman Larry Yu says the company has no plans to go public. The Profit Question
When and if that changes—and analysts speculate a share sale could come as soon as 2010—the profit question will figure prominently for many would-be Facebook investors. In September, the company announced it was cash-flow positive, meaning the cash it generates from advertising and other revenue sources now exceeds the cost of servers and other capital expenditures. That followed a public comment by Facebook board member Marc Andreessen that the company was on track to generate $500 million in revenue in 2009. The revelations quelled concerns that Facebook lacks a business model. But some fund managers still question the plan for wringing profit in coming years, particularly amid fluctuations in costs for the computers needed to keep the social network running. "We don't know quite what their profit picture is," says Ryan Jacob, chairman and chief investing officer of Los Angeles-based Jacob Internet Fund, which oversees about $36 million. Facebook's reliance on advertising for much of its revenue also gives some investors pause. Google relies on Internet advertising for its sales, but it uses sophisticated mathematical models to place ads based on products or services that people using Web search may actually be trying to find. Many people don't typically go to Facebook to shop or research products. "People mainly go to social networking sites to network, not to buy," says ING's Pytosh.
Getting users to pay for certain features or tiers of access to the site could help to demonstrate a more stable revenue base, he says. Introducing such fees before going public would give potential investors a better idea of the company's prospects. "It would be better if you had a few months or quarters' worth of information" on a fee-based model, he says. Durable Success?
It may also be difficult to make long-term bets on a service that could be easily abandoned by its users for a competing site, such as Twitter. "The biggest risk is that Facebook doesn't end up being an enduring franchise," says Jacob. After all, it was Facebook's arrival in social networking that ultimately led to the decline in use of News Corp. (NWS)-owned MySpace. Already, some pundits regard microblogging site Twitter as a Facebook rival. To be sure, some fund managers are warming to Facebook. The social network has the potential to reap returns on par with those of Google and Cisco Systems (CSCO), Ken Allen, manager of T. Rowe Price Group's (TROW) Science & Technology Fund, said at a Nov. 24 news conference in New York. "Facebook has gone so far beyond what people expected even a year ago," said Allen, whose fund manages $2.56 billion. "They've created amazing value for their customers." Allen's remarks were reported by Bloomberg News. Facebook may try to woo more investors with a charm offensive. "As [companies] start to prepare for an IPO, usually you'll see their advertising changes and they start to market the company" rather than the product, says Peter Iannone, a certified public accountant at Los Angeles-based accounting firm CBIZ MHM (CBZ). Iannone, who advises companies planning to go public, expects Facebook to begin reaching out to investors with ads in business and trade publications. Management could be in for an overhaul, too. "I think you'll see more senior people in there before they go public," says Jacob Internet Fund's Jacob. Of particular interest is the relationship between Facebook's 25-year-old CEO Mark Zuckerberg and the firm's more seasoned Chief Operating Officer Sheryl Sandberg, a former executive at Google, and how their roles may change if Facebook goes public. If Google's past is any indicator, the prospect of a Facebook IPO all alone will bring a boost of attention. "Google's IPO was very helpful to getting them momentum," says Tom Taulli, an independent IPO analyst. "It was a media circus." But when the commotion died down, Google's shares surged, closing on Dec. 2 at 587.51. And even timid investors who bought Google at the start and have held it to now have enjoyed an almost sevenfold return.