Facebook's 84% Problem

Facebook posted it first quarterly earnings statement post-IPO yesterday and one number pops out: 84%. That is the percentage of revenue the company made from advertising, representing $992 million of the total $1.18 billion it brought in during Q2. To maintain stable growth, Facebook must diversify its revenue stream and become less reliant on advertising - a goal that has plagued competitors like Google for years.

Reliance on Ad Sales

Facebook's traditional approach to advertising has been to target banner ads based on user interests. For instance, if a user “Likes” Star Wars, that user is likely to receive advertisements related in one way or another to science fiction. In theory, targeted ads are more valuable than the broadcast ads that dominated pre-Internet media. This has been the cornerstone of Facebook’s revenue and it is what launched the company toward its IPO. 

However, relying so heavily on ads puts all the company's eggs in one basket. A dip in ad revenue due to shifts in the economy or technology could put the company in jeopardy. Consequently, Facebook’s goal going forward is two-fold: Increase revenue from advertising while decreasing the percentage from that source.

Zuckerberg outlined three product areas the company will focus on for the rest of the year: Social ads, mobile, and platform. 

The Social Advertising Advantage

Where targeted ads take advantage of an individual users' data, social ads bring their relationships into play. “The basic idea here is that the best type of advertising is a message from a friend," CEO Mark Zuckerberg said during yesterday's earnings conference call. "Facebook wants to build the best tools to create ads that are social.” 

We have seen instances this year where your friend “Likes” a product and it shows up in on your Facebook page. Your friend likes Coca Cola? Well, now your Facebook page is an advertisement for Coke. 

Meanwhile, the company has been hard at work on new social advertising formats. In the second quarter, Facebook introduced “Sponsored Stories" that put posts by advertisers straight into users’ Newsfeeds. Sponsored Stories generated $1 million a day in revenue, Zuckerberg said.

(Facebook COO Sheryl Sandberg added that local advertising is another important aspect of Facebook’s advertising program, citing one million businesses already on Facebook. It is a natural extension of the company’s platform and one that many startups in Boston and San Francisco have started to tackle outside of Facebook’s purview.) 

“We believe that we are very well-positioned to compete for advertising dollars throughout the entire marketing funnel,” Sandberg said, referring to the sequence of phases customers pass through as they progress from becoming aware of a product to purchasing it.

Mobile Baby Steps

In the first half of 2012, Facebook took baby steps to set itself up for mobile success, in advertising and other ways as well. It bought Instagram for $1 billion (an acquisition that has not yet been formally approved). It is working to increase the quality of its iOS and Android apps and build its presence on the mobile Web. It also released its own mobile Camera app and released new updates to its Messenger.

The Sponsored Stories social ad program will be the cornerstone of Facebook’s efforts to generate mobile revenue, Sandberg said. Indeed, about half of Q2's $1-million-a-day revenue from Sponsored Stories came through mobile devices - a good start. Yet Facebook has bigger things in mind. The first goal is to build robust applications that people actually use.

Camera and Messenger are perfect vehicles in this regard. They are built on content and communications, where ads based on Facebook’s social graph and interest graphs can run without compromising the user experience. By creating satellite applications that perform key functions on the Facebook platform, the company can increase the volume of mobile ads without causing a ruckus by interrupting the user experience in the primary Facebook app. 

"We don't want to just have the most widely used app, though,” Zuckerberg said. "We also want to have the best app and build experiences into every device and every app that people use. We are investing very heavily in building our mobile app, especially through iOS, Android and the mobile Web. We have made some good progress in our last quarter as we released our Camera app, shipped new releases of Messenger, shipped two releases of our Android app, agreed to acquire Instagram, and worked with Apple to be integrated into its upcoming release of iOS. Going forward, you should expect to see a frequency of improvements to each of these mobile experiences.”

The Platform Strategy Lives

Facebook is actively translating its longstanding platform strategy into the mobile space. Facebook wants to be not only the most-used app; it wants to permeate every other app, Zuckerberg said. That follows the Web strategy Facebook launched in 2007, when it released its first platform API. The idea is for Facebook to be the default login for every app. By giving tools to developers to make their apps social, Facebook can draw in more information about users of those apps and advertise more effectively based on that information. 

Beyond Advertising: Payments

So where are the additional revenue opportunities? The bulk of Facebook’s non-advertising revenue comes from its Credits payment program. Facebook made $192 million in Q2 from Credits and other fees. The problem in growing this revenue source that Facebook's primary engine for payments, games, does not translate well to mobile. Social gaming company Zynga announced poor quarterly earnings on Wednesday, and since the two companies have a symbiotic relationship, Facebook’s stock took a hit. Now both companies have to figure out how to take the Credits program mobile. 

But Credits is not just about games. Other types of content will be important to Facebook on mobile as well. Zuckerberg cited music as the next area that is likely to become social. The prime example is Spotify’s tight integration with Facebook. 

One way or another, Facebook must integrate Credits tightly into its platform. This is where the competition has a leg up. An iOS app in Apple's App Store may let users log in using their Facebook account, but Apple will never allow payments that it doesn't control to be made through an iPhone or iPad app. The same goes for Android, more or less. Facebook’s ubiquity as an authorization system in apps is its biggest mobile strength, but it is also its biggest weakness. It makes Facebook part of the other mobile operating systems. But when it comes to users’ money, Facebook is on the outside, forcing it to work with third parties such as advertisers to get revenue from those users.

Zuckerberg said he wants Facebook to be as tightly integrated into devices and apps as possible, but he also said he had no intention to make a Facebook phone. That is good news for investors, because getting into the hardware game would drastically cut into Facebook’s margins.

Facebook’ new App Center is the best avenue for making money outside of iOS and Android. The App Center offers both apps that run on Facebook and apps that integrate Facebook but run on iOS or Android. This poses another interesting problem. Facebook would love to raise the percentage of revenue from sources other than advertising, but it also would love to increase the number of apps running on Facebook rather than iOS or Android. The more apps that live within Facebook, the more the company can take advantage of Credits, which could be a significant revenue driver. That will remain problematic without a Facebook operating system.

Thus, Facebook faces a Catch-22. To be everywhere, Facebook has to play nice with other companies, including rivals like Google. But by playing nice, it is shut out of revenue opportunities such as payments. So it is forced to focus on selling ads, and the percentage of revenue that comes from that source not likely to go down. Being the social backbone to the Web has advantages, but it also pigeonholes Facebook into a certain type of monetization scheme.