Risk Management

Facebook Faces Financial Risks

The finance department’s challenge will be to keep a lid on costs without stifling the company's growth.
Vincent RyanFebruary 2, 2012

If you’re David Ebersman, the CFO of Facebook, the social-networking darling, you’re expecting a huge payday this spring when the company hits the public markets. But you’re also facing a mountain of financial challenges. The “risk factors” section of Facebook’s S-1 filing addresses a host of these, and suggests the company has plenty of hurdles to surmount to build a sustainable business.

One of the biggest risks for Facebook is its revenue stream. The composition of it is similar to an old-line publishing company. Third-party advertising on Facebook accounted for 85% of the company’s $3.7 billion in sales last year. That’s down from 98% in 2010, but still substantial. In contrast, LinkedIn generated 29% of revenue from advertising, 20% from premium subscriptions, and 51% from job postings in its most recently reported quarter.

Putting most of its eggs in the ad basket subjects Facebook’s financials to the vagaries of the advertising market: macroeconomic conditions, changes in pricing, falling user engagement, and users opting out of viewing ads could all hinder growth. But Facebook also faces a challenge from users increasingly using its mobile app instead of the desktop version of Facebook. The mobile version generated 425 million monthly active users (MAUs) in December 2011, says the filing. Indeed, Facebook thinks mobile MAU growth will outpace desktop-user growth. But Facebook does not currently generate any “meaningful revenue” from the mobile platform and says the success of its monetization strategies for mobile are “unproven.”

Customer concentration is another danger for Facebook. Social gaming company Zynga represents 12% of the company’s overall revenue, or $445 million last year. But its influence on Facebook’s growth extends beyond that. Zynga’s apps, says the S-1, “generate a significant number of pages on which [Facebook] displays ads from other advertisers.” The Zynga relationship is also generating “substantially all of [the] revenue” derived from Facebook’s payments platform. (Developers on that platform pay Facebook a fee to use its payments infrastructure for selling gamers virtual goods.)

Investor expectations of future revenue and income growth from Facebook is another risk. Once Facebook lists, the stock could be set up for a fall if investors expect Facebook’s net income to continue its heady performance. Net income hit $1 billion in 2011, up two-thirds from 2010, as revenue jumped 88%. That’s after increasing almost fivefold from 2009 to 2010. But total costs and expenses more than doubled last year. Like any fast-growing start-up, Facebook needs to scale up to keep pace with user growth. The finance department’s challenge will be to keep a lid on costs without stifling that growth.

Facebook expects rates of user and revenue growth to decline over time. They will “inevitably slow as we achieve higher market penetration rates, as our revenue increases to higher levels, and as we experience increased competition,” says the company in its filing.

The contributors to Facebook’s bulging costs in 2011 included $606 million in property and equipment purchased, which was easily double 2010’s number. That line item includes costs of servers, network equipment, and building data centers. Next year Facebook expects to spend another $500 million on data center–related costs.

Marketing and sales expenses also jumped in 2011, to $243 million, or 132%. Facebook attributed the rise to a 46% increase in marketing and sales support personnel, as well as customer-service staffing. In 2012 marketing and sales expenses will again increase “significantly” says Facebook’s filing. The cost hikes will consist of share-based compensation expenses from restricted stock units (RSUs) that were issued prior to 2011.

Those RSUs could amount to a hefty tax bill for Facebook six months after the IPO. That’s when the initial settlement of RSUs occurs. RSUs are grants saying employees will get a certain amount of stock (or cash equivalent) at a later date — such as, for instance, when the company launches its IPO. (Facebook switched to RSUs in 2007.) The tax obligation for this compensation will be in the billions, according to the Facebook filing, and will depend on the price of Facebook shares on the settlement date.

A saving grace for Facebook: it’s well capitalized. Cash and cash equivalents plus marketable securities totaled $3.9 billion at the end of 2011. The company generated $1.5 million from operations and $998 million from the sale of common stock last year.

Facebook also has substantial debt capacity. It has an unsecured, five-year $2.5 billion revolver from five banks. The revolver is cheap — Facebook pays LIBOR plus 1.0% on any drawn amounts. Facebook also secured a $250 million five-year term loan in March 2010. The company drew down the full amount a month later, but repaid it in full less than a year later.

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