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A photo illustration shows the applications Facebook and Instagram on the screen of an iPhone in Zagreb April 9, 2012. (ANTONIO BRONIC/ANTONIO BRONIC/REUTERS)
A photo illustration shows the applications Facebook and Instagram on the screen of an iPhone in Zagreb April 9, 2012. (ANTONIO BRONIC/ANTONIO BRONIC/REUTERS)

Fabrice Taylor

Facebook's hidden costs Add to ...

Fabrice Taylor, CFA, publishes the President’s Club investment letter. His letter and The Globe and Mail have a distribution agreement. You can get a free copy here.



He might not realize it but the best analyst on Facebook is Mark Zuckerberg. He really gets it. He understands the nature of the business. He knows the risks. By his recent actions he’s told investors how big they are. And he’s already sold enough stock to be set for life. Would you really want to buy shares from this young man?

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Most of the fuss over how much Facebook is worth revolves around how fast the company will be able to grow its revenues. But revenues aren’t the only issue. It’s the costs of running the business that are terrifying. And Mr. Zuckerberg, Facebook’s co-founder and CEO, knows this better than anyone.

In April, Mr. Zuckerberg paid a little more than $1-billion (U.S.) in cash and shares to buy a startup firm called Instagram, maker of a photo app. The company had 12 employees and no revenues but had nonetheless attracted 50 million users in short order.

Since that deal was announced – it was accepted but hasn’t closed – Facebook has developed its own similar app, which will compete with Instagram.

Given that Facebook could easily produce its own version of Instagram, and did, it’s obvious that Mr. Zuckerberg wasn’t attracted by the technology. So what made him want to spend $1-billion on a company with practically no assets?

Simple: Facebook is by and large a photo-sharing site. Most people log on to see pictures or comment on them, like the “friends” who write things like “nice legs, shame about your face” on my wall.

In my view, Mr. Zuckerberg was worried by the threat posed by the meteoric rise of Instagram’s number of users. That’s what media companies live and die by – the number of eyeballs they can sell to advertisers. The more eyeballs Instagram attracted with pictures, the fewer Facebook could attract (or the more it could lose).

Think about what this means, especially if you own Facebook shares. By his actions, Mr. Zuckerberg is admitting that there are few barriers to entry in the social networking business. It’s not clear what it cost to get Instagram up and running but it was a tiny fraction of $1-billion. Yet that’s the price Facebook had to pay to acquire it only a couple of years after the idea behind the company was conceived.

Facebook wasn’t acquiring Instagram as an investment. (If it were, it wouldn’t have developed its own version.) Facebook was eliminating a threat, at a very high cost.

Here’s where strategy and finance collide. Facebook will probably now capitalize the $1-billion cost of its Instagram purchase on its balance sheet. Most of the price will be listed on the balance sheet as goodwill – the excess of the purchase price over the value of the company’s assets. As long as it’s not impaired, goodwill just sits on the books as opposed to, say, a physical asset that gets depreciated as a cost on the income statement every quarter.

But if this isn’t really an investment, it’s a cost of doing business. It’s the cost, in other words, of maintaining a competitive edge, just like marketing a brand name. When Gillette advertises its razor blades to maintain its huge profit margins, it expenses it.

Facebook won’t do that, even though acquisitions like Instagram are a cost of doing business. The company isn’t breaking any laws or accounting regulations, but I think its treatment of acquisitions means its earnings picture appears brighter than it is in reality.

Facebook earned $205-million in the first quarter, which was 12 per cent lower than a year earlier, despite much higher revenues. Facebook’s costs are clearly going up.

But had those costs included the expense of eliminating a threat – of protecting the brand – there would be no profit for the quarter and perhaps the year.

Is this company really profitable? You may argue that acquiring Instagram was a one-time cost.

But it isn’t. On top of all its other struggles – like surviving in the mobile age – Facebook will constantly be under siege by every clever kid who can dream up a photo-sharing app that could draw eyeballs away from Facebook’s pages. Each time it does, it’ll pay a big price and park the assets on the balance sheet. (Eventually it’ll write them off as a “one time cost.”) Smart investors will know better. They’ll know that it’s a routine cost of survival.

So if you want to profit from Facebook, start a cool photo app, attract a few million users and then sell it to Facebook. It sounds hard, I realize, but it’s an easier way to make money than buying stock from Mark Zuckerberg.

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