Playing to Win on the Digital Frontier

By Simon Smith and Erica Velis

Digital is advertising’s new ecosystem, a dicey frontier for most major businesses, a new medium for conversation, and a technological wonder that has connected the world. It’s also among the most misunderstood phenomena in business today. We are only just beginning to discover its potential to enhance business and, so far, investing in digital companies has proven to be a gamble. With a billion users on Facebook and 500 million on Twitter, there is no doubt that social media is flourishing. A huge captive audience, and the promise of transforming “likes” into sales, has piqued the interest of investors and companies who want to build their brands and turn key groups of people into paying customers. However, several companies that appeared to be paving the way to the profitable new digital age have faltered, shaking the confidence of investors and resurrecting the ghost of the dot-com bust of 2000.

Heralded with hype, Facebook, Zynga, and Groupon were all heavily promoted and seemed poised to deliver. Facebook’s IPO on May 18, 2012 was a milestone in Silicon Valley and internet business history. On the morning of the 18th, the media clamor reached fever pitch: The Street predicted the stock could rise to $60, $70, even $80 USD; trading broke stock volume records, and the market saw the stock peak at $45 USD. That left the company with a higher market capitalization ($104 billion USD) than all but a few of the largest US corporations. For the moment a winner, CEO Mark Zuckerberg’s personal stock was valued at $19 billion USD. A few days later, Mark even married his girlfriend of nine years — and let the world know by updating his relationship status. It was a perfect Hollywood ending.

Unfortunately, cracks appeared and the stock kept sliding. The share price dropped over 30% in the first 20 days. Regulators are now investigating the IPO, and more than 40 lawsuits have been fi led. A $100 billion USD company just prior to its debut, Facebook is now a $65 USD billion company, beset with problems, and the stock continues to fall. With the IPO a distant memory and the stock value roughly halved, the Facebook brand has taken a hit and the effects on the market, the sector, and the company itself, are likely to last a while.

Another digital company that has fallen far short of expectations is Zynga. Using Facebook as a platform, Zynga is best known for interactive games like FarmVille and CityVille, and has grown rapidly since it emerged on the social network scene. Games and apps have exploded in popularity in the past few years, an outgrowth of social media and the transition to mobile devices. Cheap to produce but often lucrative, Zynga has successfully capitalized on this trend. However, since the company’s December IPO, its shares have dropped 70%; investors worry about the long-term viability of its business model, its dependence on Facebook, and its ability to keep making money from the people who play its digital games.

And then there’s Groupon. Relying heavily on marketing to acquire new customers, Groupon turns a profit by offering consumers deals on local goods and services, and splitting the discount proceeds with the participating merchant. Though questions later arose about Groupon’s business model, namely the relationship between marketing spend and its growth rate, Groupon CEO Andrew Mason initially assured investors of his business’ enormous profit potential. However, with an inability to compete with larger discounters like Amazon, the company has shifted from hypergrowth to stagnation, which has left its stock at a fraction of its recent worth.

Is this the beginning of the end for social media, FarmVille-esque games, and internet daily deals? Haven’t we all heard and seen it before with once-hot internet companies like Netscape, Napster, LimeWire, MySpace, or Friendster? They all dominated the market at one time, then quickly got trumped. It could be that this is just the nature of the digital era. The price of entry is low, the growth is quick, and the fall to near-oblivion is swift and hard. Or, could it be, at least in the case of Facebook, that we have a true digital megacompany that will survive the growing pains, find its balance, mature as a brand, and become a leader of the digital frontier?

What all three of these companies have in common is no guarantee of long-term growth and a business model that relies on “unproven” sources of revenue. Furthermore, they all went public at too high a value, propped up by late-stage money — part of a recent Silicon Valley trend in which prominent investors jump into young companies just before their IPOs. Unprepared for the scrutiny and expectations of Wall Street, issues with the “fundamentals” of all of these companies came to light as soon as the first earnings reports were released. Challenged by the transition to mobile, as well as the fact that their main sources of revenue are dependent on something that doesn’t feel durable and concrete (“likes” on Facebook), it will be hard for such companies to secure the confidence of investors.

Clash of the titans: Silicon Valley vs. Wall Street

Clearly, Wall Street wants to see results — as in swift growth in revenue. Silicon Valley venture capitalists, however, are focused on the long term. They take the ups and downs of the stock market with a grain of salt and determine the value of an investment based on what it might be worth in a few years, not next quarter. They expect volatility after a company goes public and believe, especially in the case of Facebook, that the downward slide in public valuations, while it may have an effect on private valuations, will ultimately be manageable.

However, with Facebook and Groupon hitting new lows, concerns about these companies in terms of durability and their ability to grow their business are intensifying — not least of all because of the lock-up expiration on many of the shares that were not on the open market during the IPO. Concerns are even greater for Groupon, not only due to skepticism over its business model, but also owing to the fact that there are more stocks out there, which is hurting the stock price and spooking investors.

When it comes to Facebook, many are wondering if its CEO has the chops and maturity to grow the social media giant beyond display ads and master the mobile segment. Lured by the size of Facebook’s user base, which has allowed Facebook Inc. to build a $3 billion-a-year USD advertising business, ad spending has increased. However, because of that, companies are becoming more interested in measuring the results of social media advertisements, which can be hard to quantify. There are also concerns that Facebook’s advertising methods are untested or unproven. For brands, social media is a key part of marketing, a way to build brand awareness. But for investors, the question is: How does all of this translate directly into revenue?

Under similar pressure are Groupon and Zynga. Both companies are losing customers. Zynga, for instance, expected to make just half of what it hoped this year; the company develops games that have little depth, and while people may become obsessed in the short-term, the novelty soon wears off and they move on. Also, more gamers want to play on the go, and Zynga’s mobile games aren’t big hits as of yet. To make matters worse, the brand spends disproportionately on R&D and SG&A (selling, general, and admin), all of which use up much of what profit the company does make, leaving little for shareholders.

One of the difficulties with investing in tech companies is the sheer pace of their development. Because they grow so quickly, the start-ups’ initial burst generates excitement, which makes investors want to cash in. But these businesses can also reach saturation in their markets extremely fast. It’s hard to figure out when the growth might begin to slow down, as it inevitably will. Silicon Valley, with its risk-taking, start-up culture, is more accustomed to the volatility — even expects it — and is, therefore, willing to ride things out. Wall Street, on the other hand, operates under a different paradigm and reacts to the daily ups and downs, which only makes it harder for young companies to regain their luster once Wall Street’s attitude toward them sours.

Wall Street’s minute-by-minute changing of position is out of step with Silicon Valley’s approach to moneymaking. Wall Street wants instant results and Silicon Valley takes a longer-term view. Technological innovation takes time to develop and some attempts fail — that’s part of the process. In Silicon Valley, where some of the brightest have had multiple start-ups and risen from failure — it’s the price of success. On Wall Street, failure is not an option.

In a recent Wall Street Journal article, Dan Rose, Facebook’s Vice President of Partnerships, is said to have put the company’s situation in perspective at a company meeting in early August. In an attempt to assuage employees who were worried about the stock price, he shared a story from his time at Amazon. The company stock had tanked and, as a father with two young children, Rose became especially concerned about his ability to provide for his family. Facing a tough decision with no obvious answer, he asked himself, “Do we have the right people in place and is our mission worthwhile?” He believed the answer was yes; rode the situation out, and is, presumably, better off for it. He asked himself the same question about Facebook and is convinced the answer is yes. In the end, it is our collective confidence in a company that keeps it going — which is why brand management, essentially the management of perception, is so incredibly important.

Is the bubble about to burst?

It’s true, there are parallels between now and the dot-com days. Back then, the stock prices of internet companies soared to dizzying heights and, as a result, those companies moved faster and with insufficient caution. Market confidence in these companies was high, as was the promise of future profits. Many companies were grossly overvalued. Today, things are different — we have the benefit of hindsight.

If the fundamental need to be connected to friends, get daily deals, and play silly games online is still in place, there is hope for Facebook, Groupon, and Zynga, no matter what things look like now. The pressure to please investors will always be there, but whether or not a company survives really depends on how well it pleases the people who use their products or services. When we at Interbrand say brands have the power to change the world, we mean that they have the power to change people’s lives — making life easier, more meaningful, more enjoyable, more convenient and productive. When a brand delivers that, consistently — people love them for it — and everyone, including investors, gets exactly what they hoped for.

If anything, we need a reality check. Not everyone is running away from Facebook’s stock. Investors are not overlooking traditional metrics. Silicon Valley is still rich with investment opportunities. And some people are making a lot of money right now, even as Facebook, Groupon, and some other recent internet IPOs continue to struggle. The internet, today, is no longer a novelty. In fact, the number of people connected to the Web is mind-boggling. So, despite the foreboding comparisons, 2012 is vastly different from the dot-com era. There is no reason to lose faith. We’re simply in transition.