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Facebook Faces Big Problems, Phone Software or Not

Facebook (NASDAQ:FB) unveiled its fancy new phone software at an event today. You can get the specs here, if you’re interested.

But I’m not going to talk about the Facebook scheme, which in a nutshell is an alternative Google (NASDAQ:GOOG) Android OS to integrate social networking into everything your phone does. To me, it’s academic whether this represents a value add or a big threat to Apple (NASDAQ:AAPL) iPhone sales, because there’s a bigger problem.

Namely, that Facebook users have nowhere to go but down.

My reasoning for this is three-fold: brand tarnish, critical mass on its reach and a deflationary advertising market.

Looking for Reasons to Quit Facebook, Not Reasons to Join

The first reason is admittedly a squishy one — that while there is a core of loyal and very active users, there is a host of less enthusiastic folks who are simply looking for a way out. I frequently hear the lament that people have to be on Facebook because everyone else is.

That’s not a ringing endorsement. And also a big concern that all they need is an alternative and they are headed for the exit.

I interact with Facebook through my wife’s account because, frankly, I have no interest in getting one myself. My concerns are similar to those that many people cite: privacy issues, annoying ads, too much information from friends and relatives that I’d prefer to be only casually acquainted with … you know the drill.

I know many people who feel the same way. But don’t take my anecdotes for it — consider a 2012 report that roughly 1 in 3 Facebook users are pretty much over the social network.

If you’re an investor, this kind of customer sentiment cannot be overlooked or treated as just noise.

True, some companies get by despite negative perceptions and trapped customers — namely monopolistic enterprises like cable provider Comcast (NASDAQ:CMCSA), which has seen its stock double in the past five years. But unlike a capital-intensive business like laying Internet cables and servicing homes with cable TV, a social network is hardly impossible to replicate.

Who Is Left to Join and How Can Use Become More Frequent?

The need for Facebook to keep its reluctant customers is pressing, considering its current tally of more than 1 billion monthly active users. How much replacement potential is there?

Facebook stock went public when the company was already mature, a $1 billion operation that was entrenched and paying back its initial investors — not exploring big growth like a dot-com start up. Always remember this.

Online Ads: A Race to the Bottom

Furthermore, even if Facebook can eke out incremental growth, it is suffering from the same pressure that most digital media companies are: deflating rates in online ads.

That’s because it’s a simple supply-and-demand issue. New websites come online all the time and possibilities for inventory have exploded, so advertisers can be more selective and pay lower rates for the outlets they choose.

It’s not just display ads. The Wall Street Journal quotes BrightRoll, a video-ad firm, as saying, “Prices for ads on top-tier sites last year were down by 10% to 15% from 2011.”

Throw in the mobile mess with questions about the effectiveness of ads where they are smaller or less likely to induce a click, and you can understand the pressure everyone is facing. Particularly Facebook, where 85% of its revenue comes from third-party advertising.

Facebook has tried to convince advertisers that it is worth a higher rate, with a song and dance about how it doesn’t matter if anyone clicks — it’s all about simply being seen. The whole “spend it and they will come” mentality always is a hard sell, but particularly for many companies looking to stay lean in these uncertain economic times.

Verdict: ‘Un-Like’ Facebook

Of course, the froth in tech lately proves that there’s something to be said for being early to a turnaround story. Yahoo! (NASDAQ:YHOO) is up almost 50% in six months despite the fact that its fundamentals have simply stabilized. It remains to be seen if there will ever be growth again for YHOO stock … but hey, investors have made some good money on this trade.

I don’t pretend to know the short-term future of Facebook stock. It’s a volatile issue that has been very good to those who bought it at $17 and very bad to those who bought it at $38.

But I do know that even if the recent Facebook phone software catches on, there might be serious issues with finding any growth in the online ad game — which, as of right now, remains the biggest driver of revenue and profits.

If you’re speculating on a swing trade in FB stock, feel free. But if you’re wondering whether Facebook is worth holding for the long-term, there are too many risks here to make the stock worth owning.

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Jeff Reeves is the editor of InvestorPlace.com and the author of “The Frugal Investor’s Guide to Finding Great Stocks.” Write him at editor@investorplace.com or follow him on Twitter via @JeffReevesIP. As of this writing, he did not own a position in any of the stocks named here.

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