Simon is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
The king of social media meets the king of online auctions.
It's quite a statement to make, but Facebook(NASDAQ: FB) should seriously entertain the idea of buying a stake in eBay(NASDAQ: EBAY) as a complementary way to monetize its massive social network. There are three reasons that this move would make for an online e-commerce powerhouse:
Fully Utilize the Network Effect
Targeted Advertising at its Finest
Facebook Must Find New Ways to Monetize
Putting that Massive Social Network to Use
Facebook is currently estimated to have 918 million active users (www.checkfacebook.com). Take a moment to digest just what an amazing competitive advantage that is. A user base that is larger than the combined populations of the United States, Brazil, Indonesia, and Pakistan (which are the world's third to sixth most populous countries) is every day sharing its interests, opinions, and likes with one another. Absolutely incredible.
The largest tech companies are already aware of how important this network effect is. They are increasingly trying to find ways to learn more about their users and to find new ways to interact with them.
Take Google's recent acquisitions as an example. Why did Google(NASDAQ: GOOG) acquire Zagat and make the previously exclusive Zagat.com free to the general public? Because they wanted to learn more about where we like to eat, which they can then use to make future recommendations to us at the local level. Through the process, Google is able to improve their recommendations and can charge local restaurants more to advertise online.
Why did Google also offer $6 billion to buy Groupon? (sorry Groupon...since you didn't take the deall, I know this hurts to bring up.) Because Google wants to learn about the things we like to do, so it can similarly direct us to more of our interests in the future. Again, this continues to strengthen its advertising money train.
Targeted Advertising is much more Effective
I mention the Google examples above because Facebook is also starting to learn that it too can utilize its massive social network to appeal to online advertisers. The following is an except directly from their advertising homepage:
People have a better experience when ads are relevant and useful. Advertisers can ask Facebook to show ads to an audience based on demographic factors such as location, age, gender, education, work history and the interests people have chosen to share on Facebook. Facebook does this in an anonymous way so advertisers don’t know the individuals who see their ads.
Though Facebook is careful to protect its users privacy, the information provided is a marketers' gold mine. All of our interests, demographic information, and history is voluntarily sitting within our profiles. This results in showing the right products to the most interested potential buyers. From there, the company can maximize the sales conversion rate -- which is essentially the number of people who end of buying as a percentage of the total people that visit the advertised page in the first place. You'll get much better results selling Steven Seagal movies to users who like kicking and karate than to those who like kittens and koalas.
But Facebook needs to diversify its revenue stream. They don't want to go head-to-head with Google on advertising. Facebook needs to utilize its network to find new ways to monetize its business.
Why eBay is Such a Perfect Fit for Facebook
eBay makes money primarily in two ways:
They charge a minimal fee for posting your auction item.
They take a small cut of transactions that are made using PayPal.
Just like Facebook, eBay relies on the network effect of its 100 million active global users. More users = more buyers = more sellers = more profits. You get the picture.
This is exactly why a deal with eBay would be so perfect for Facebook. Rather than relying on other companies to pay them to advertise, Facebook could incorporate the eBay platform into their already established network and website to unlock an incredibly profitable new revenue stream. An added bonus is that members would see this as a value-added service available to them that comes with no additional cost. After all, it doesn't cost users anything unless they actually sell something on the eBay platform. No monthly user fees, etc.
Obviously there are a few things that Facebook should make sure that it doesn't do if it buys eBay.
Most importantly, it should not require that buyers or sellers be Facebook members to use eBay. Users should still be able to use eBay.com as it exists today, but also supplement it by incorporating it into the Facebook network (and point out the targeting advertisement advantages of using their network). Facebook should continue to make transactions possible through PayPal, so it's a seamless transition for current eBay users and they can continue to take a cut off the top.
Then there's the case about the financials. At $49 a share, eBay's market cap is $61 billion today. Facebook is currently sitting on only $6 billion in cash, with a total market cap themselves of only $41 billion. eBay is 50% larger by market cap than Facebook, so buying them outright today seems unlikely if not downright impossible.
But there are definitely other options that Facebook could pursue. Facebook could issue additional equity (which is selling at 61X earnings) to buy shares of eBay (which is selling at 17X earnings). Though there would be a line of angry people taking numbers just to get the chance to scream about the dilution, it's not a terrible move from a capital allocation perspective.
Also, Facebook is churning out $3 billion a year of operating cash flow. They could bank some of that and raise a sizable amount of debt to buy eBay in a year or two. As long as the income produced by eBay more than covers the interest costs, it could be a viable option.
Lastly, would it really be necessary for Facebook to buy eBay outright? The company could explore options where Facebook pays royalties or a portion of sales to eBay in exchange for allowing it incorporate within its existing network. Kind of like an eBay franchising deal.
The Foolish Bottom Line
The network effect is one of my very favorite types of competitive advantage. Once up and running, it costs very little to maintain and expands word-of-mouth advertising at an exponential pace. Facebook and eBay have both figured out the network effect in spades and have built multi-billion dollar businesses off of it.
If Facebook could have a profile to describe itself, it might consider including eBay in its list of interests.