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Four Things Not to 'Like' About the Facebook IPO

Facebook has a solid business right now, but keep these weaknesses in mind before getting too excited.

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More ink has been spilled on the Facebook IPO in the few days since its initial SEC filing than many companies will see in their entire lifetimes. Not that anyone is terribly surprised at the buzz around this offering. Tech firms in general have been red hot over the last few years, and Facebook is a product that many investors and journalists alike interact with on a daily basis. Add in a founding story intriguing enough to launch a blockbuster movie and you have the ingredients for wall-to-wall coverage.
 
Further, much of the commentary so far has been quite positive. And not without reason. Facebook's S-1 revealed that the firm is fantastically profitable at the moment and is churning out cash flow without needing to bring on a lot of staff or to make big investments in technology. Compare this with Groupon's (GRPN) filing that showed lower margins than expected and used non-GAAP measures (which the SEC forced the company to correct), and Facebook looks even better. 

But even with everything going for it, Facebook faces some real challenges that investors need to consider before jumping into the social networking giant. Here are four key issues that jumped out at me this week.

Display Advertising
Facebook is a display advertising business. Mark Zuckerberg may write about his goal of bringing everyone together and making government more responsive to its citizens, but for investors, Facebook's purpose is to drive traffic to look at ads on the site. Advertising is essentially the only thing that makes any money for Facebook. This isn't exactly a new business model. For 15 years now,  Yahoo (YHOO) has been trying to drive users to its universe of sites to show them ads.

So in order for Facebook to grow its top line, it needs to either realize higher ad-sales rates or increase the reach of its site. Both are tricky propositions. The secular trend is surely positive--more and more ad dollars are flowing online--and there is no treason to think Facebook won't get its fair share. But ad rates remain highly economically sensitive, and there is plenty of competition for those ad dollars.

Growing the site will also get hard, as the company butts up against the law of large numbers. Facebook already has 845 million monthly active users, and although there is room to add more, the rocket-fueled growth days are over. Further, much of the growth that the company is seeing is in markets that may not be terribly profitable. The biggest growth in users is coming from emerging markets, where the online ad market is not as deep or lucrative as in the United States. These new users might increase pageviews, but in the near term, they aren't going to contribute much to the bottom line.

Another important area of growth has been in mobile. But as of now, Facebook doesn't serve ads through its mobile platforms. This will, of course, change over time, but the mobile ad market is still in its infancy. No one has really figured out how to get users to click ads on their phones, and as unlimited data plans go the way of the dodo, no one wants to pay their cell carriers extra for the honor of looking at advertisements. This may very well be a solvable problem, but it is another headwind to advertising growth as more users move their Facebook time to mobile.

How Much Can You Sell Your Users?
People with Facebook pages are not just the firm's users; they are also the product being sold to advertisers. The firm's core pitch to the advertisers that are filling up its coffers is that it knows an incredible amount of information about individual users, and that Facebook can serve up targeted ads that are likely to make an impact on buying habits.

Facebook strives to get this information from more than just your profile. It wants users to sign in with their Facebook login to leave a review on TripAdvisor or to listen to some music on Spotify. As you move around the web, Facebook can then keep learning more about you and your habits and help craft an advertising message for you. And it goes without saying these targeted ads are worth a lot more than untargeted banner ads.

However, this is all predicated on users feeling like they are still getting value from Facebook in return for handing over personal information. And the pendulum seems to be swinging toward users demanding higher degrees of privacy online. Look at the current discussions over  Google's (GOOG) new privacy policy or the uproar over the SOPA/ProtectIP acts. These issues hardly would have broken into the mainstream just a few years ago, but they are now front-page news. Facebook itself even had to pull back from its Beacon platform, which sent information from third-party sites back to Facebook, over privacy concerns.

The firm is trying to alleviate user concerns with better privacy controls and by agreeing to 20 years of privacy audits from the Federal Trade Commission. But this tension between Facebook wanting to maximize its ad revenues and users becoming increasingly weary of being tracked will keep popping up.

Google
Google appears to be the largest competitive threat to Facebook. The two firms are similar in many respects. They may get their user data in different ways (search versus social networking), but they both are trying to use that data to serve up targeted ads.

And now Google is making a big push into social networking, too. Google+ has become ubiquitous across Google's products, and the site is now surfacing Google+ posts in search results. Google is clearly planning on sinking a fair amount of resources to keep this project going and continue to build a strong platform for advertisers. But even if Google+ doesn't take off on its own, Google can still be a threat. It just needs to continue convincing advertisers that it has the best platform to deliver targeted ads to qualified users. That battle is the one that matters for investors.

And don't forget that Google has a big advantage in mobile. The worldwide success of the Android platform gives the search giant even more opportunities to collect data, reach users, and offer even more options for advertisers. This could become an enviable advantage as the mobile ad market matures.

Corporate Governance
Corporate governance is not the sexiest part of most offerings, but it really does matter. It might not be apparent anytime soon, but handing over total voting control of Facebook to Mark Zuckerberg, even though he only has a 28% economic interest, is not shareholder-friendly.
 
Facebook is Zuckerberg's baby, and he is unlikely to seriously consider any takeover offers years down the line, even if they would be the best thing for common shareholders. Look at what happened at Yahoo. Founder Jerry Yang's insistence on remaining a stand-alone company meant that the firm spurned a lucrative  Microsoft (MSFT) deal that would have created tremendous value for Yahoo shareholders. And Yang only owns a very small slice of the firm!

Zuckerberg's complete and total control of Facebook means that shareholders will essentially have no say over anything that goes on. Investors might not care right now while Facebook is on a hot streak, but if that streak were to turn around, there will be no recourse. This should give long-term investors pause.

Facebook is almost undoubtedly a solid company. But in order to achieve some of the stratospheric valuations being bandied about now, it must find ways to address some of these core weaknesses.

What do you think of Facebook's IPO? What do you see as the biggest threats to its business?

Bearemy Glaser does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.