CNBC Stock Blog

Yahoo's Next Problem: Facebook IPO

Antoine Gara|Deals Reporter

As Yahoo looks for the best deal among a host of potential suitors, its problems may only just be beginning.

Facebook's initial public offering in 2012, and the resulting corporate war chest, will post a formidable challenge to Yahoo's main revenue driver: display ads.

"Yahoo's challenge to defend its display business as Facebook emerges is similar to Yahoo's challenge when Google emerged, in that Yahoo appears stuck on a legacy platform and unable to adapt," says Clayton Moran, an analyst with brokerage firm Benchmark Capital.

With new capital from an IPO, Facebook may aggressively bolster its strong display capabilities, which rely on social media engagement.

In contrast, Yahoo and its highly visited websites are a leading producer and aggregator of news content that isn't reliant on so-called mindshare such as "tweets," "likes," and other social postings.

For Yahoo, such a competitive boost may pose a similar threat as Google's IPO in 2004.

Already, Facebook is presenting a giant challenge to Yahoo. In September, the company rolled out features that allow users to share experiences with friend networks, while simultaneously consuming news.

Recently, national papers like The Washington Post have signed up for Facebook's Social Reader, and British paper The Guardian said in November that traffic to its website has increased by one million visitors since it opened a news app to engage Facebook users.

It's a news push that is sure to expand.

With social information sharing challenging Yahoo's algorithm-based news distribution to capture display ads, Moran says, "It appears that Yahoo's display share will erode as Facebook's expands, similar to Yahoo sustained search losses to Google."

In 2011, Facebook surpassed Yahoo as the third most visited web domain in the world according to ComScore data, signaling that the company is facing new threats in the race to replace waning search revenue with display sales.

It wasn't always the case. In 2007, Yahoo was the second most visited website in the world, only to be passed by Google in 2007, and Facebook this year. Since October 2009, Facebook's monthly unique visitors have increased 83 percent, while web traffic to Yahoo has only grown 15 percent.

"Where we are sitting today, the damage has been done," says Martin Pyykkonen, an internet analyst with Wedge Partners.

Still, an IPO would present a further opportunity for Facebook to steal share in the same way that a highly anticipated 2004 IPO only bolstered Google's search ascendance.

When Google went public, it had a moderate market share lead in web searches, commanding 43 percent of the market compared with Yahoo's 31 percent market share.

Since its $2.7 billion IPO, Google has grown to command roughly 80 percent of the search market after it put new capital to work by growing products, investing in research and hiring employees.

As Facebook IPO plans come closer to a reality, "it's only natural for all of the internet competitors to be fearful of Facebook," says Herman Leung, an analyst at Susquehanna Financial Group.

That's because while the sweepstakes for search have been won by Google, there's still plenty to play for in display ad revenue, the fastest growing web traffic and ad revenue market.

In 2011, global display ad revenue grew 15.6 percent to $25.3 billion, while search increased 13% to $35.3 billion.

Meanwhile, display web traffic growth rates of 25 percent nearly doubled the pace of search growth rates, according to 2010 annual data released by ComScore. Within display, ad revenue has been bolstered by social media upstarts like Facebook, Twitter, and LinkedIn.

Social media ad revenues have grown at a compounded annual rate of 85 percent, according to data compiled by Bloomberg Industries. However, Facebook's socially engaged users are starting to tread on Yahoo's algorithm-driven display business — the only significant piece of the company that is growing.

"When you look at all of the traffic and engagement data, it's already happening," says Leung of Susquehanna.

In 2011, Facebook took the top spot in U.S. display ad market share from Yahoo, according to eMarketer data. The threat of Facebook's social-based platform challenges Yahoo's business model, and even that of search and display giant Google.

Instead of algorithms searching for content to pass on to web viewers, Facebook is pinning its hopes on the power of networks.

With networks of friends sharing their media consumption  — and the ad revenue that comes with it — Facebook is betting on connecting discrete consumers with media, instead of vice versa.

If the strategy were to be successful, the rewards could be immense and even potentially enough to rationalize the company's rumored $100 billion IPO valuation and the $50 billion valuation that Goldman Sachs donned the company earlier in the year.

The McKinsey Global Institute estimated in a study that each day, Facebook users make 30 billion monthly content posts and more than 2 billion daily viewable engagements.

As the world's largest social network with 800 million users as of September, Facebook is primed to reap the biggest reward if the "likes" and "comments" within its social network can be further converted into display ad revenue.

When Google filed for an IPO in 2004, offering shares for $85 to raise just under $3 billion, many thought the price was high and valued the company at an exorbitant $12 billion. At the time, Google had just under $1 billion in annual search revenue. It has since grown search sales nearly thirty-fold to $28 billion.

Meanwhile, those overvalued shares have risen over 450 percent, pushing the company's market cap to nearly $200 billion.

With equity capital from investors, Google was able to double its employees to nearly 6,000 within a year, while it also increased quarterly research and development expense by roughly fourfold to $177 million.

That increased investment is surely part of the foundation for the company's present dominance.

To access the exciting growth of the display market, which may be at a turning point as social media companies increasingly figure out ways to their monetize customer traffic, potential Facebook IPO investors will have to make an equally bold gamble.

November reports by The Wall Street Journal signal that Facebook may try to raise $10 billion in a public offering this spring that values the company at $100 billion. To warrant such figures, investors need to expect that Facebook will indeed be to display revenue what Google was for search.

"Facebook display revenue is already comparable (possibly higher) than Yahoo's $2 billion. But Facebook's valuation is more than 3 times Yahoo's, indicating investors' expectation that Facebook will grow rapidly while Yahoo languishes," says Moran of Benchmark.

For tech company executives and private equity investors clamoring to bid on Yahoo in the ongoing saga of its strategic review, which may result in a sale, Facebook should be viewed as a real threat.

As stock investors decide whether to dip into Yahoo shares as deal rumors swirl, they would also be wise to consider the impact of a potential Facebook IPO in light of what happened after the Google offering.

For Yahoo investors, the history lesson should be a sobering reminder.

Though Google shares surged after its IPO, Yahoo shares have fallen over 45 percent in that period.

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