What Facebook's S-1 Filing Reveals About Social Gaming

Many analysts have dissected Facebook's Security and Exchange Commissions S-1 filing. For the most part the goal of this evaluation has been to determine the risk/reward ratio of investing in the Facebook IPO. My interest in looking into the S-1 was to focus on the role of social games in Facebook's business model and how that impacts their future projections. The following are key portions of the S-1  relevant to that subject and my own opinion on how to interpret Facebook's social game commentary.

"When users purchase virtual and digital goods from our Platform developers using our Payments infrastructure, we receive fees that represent a portion of the transaction value. Currently, substantially all of the Payments transactions between our users and Platform developers are for virtual goods used in social games. According to an industry source, the worldwide revenue generated from the sale of virtual goods increased from $2 billion in 2007 to $7 billion in 2010, and is forecasted to increase to $15 billion by 2014. We currently require Payments integration in games on Facebook, and we may seek to extend the use of Payments to other types of apps in the future."

 Facebook's introduction of  its own virtual currency payment system was clearly the result of research conducted on the virtual gaming/currency bonanza  initially developed in China, Korea and Japan. The projections for a 15 billion dollar industry in 2014 is astounding and speaks to the shift away from the importance of physical goods and "traditional (Dollars, Euros, Yuan") currency. Clearly Facebook wants to establish itself as the issuer and manager of a universal currency to attract and retain social gamers and virtual currency transactions around the world. It also wants to draw social gamers and publishers in Asia that have already accepted virtual currency as a viable transaction model. Should Facebook use its IPO money to buy Tencent in China?

" The substantial majority of our revenue is currently generated from third parties advertising on Facebook. In 2009, 2010, and 2011, advertising accounted for 98%, 95%, and 85%, respectively, of our revenue."

Why is advertising revenue dropping as a percentage of total revenue? It is dropping because social games are beginning to generate more and more revenue based on virtual currency and virtual goods transactions.  Essentially, game related revenue is growing faster than advertising revenue. 

"Apps built by developers of social games, particularly Zynga, are currently responsible for substantially all of our revenue derived from Payments"

Social games are the only application(s) currently generating revenue from virtual currency and virtual goods transactions. This is likely to change as "gamification" begins to take hold and other types of Facebook applications begin to integrate virtual goods and currency into their models. The concept of loyalty points traditionally issued by airlines, credit card companies, etc would be a great target market for Facebook. Facebook also needs to leverage its virtual currency outside of the US and especially in Asia if it expects to support aggressive growth projections.

"If Facebook-integrated websites draw users away from our website, it may reduce or slow the growth of our user activity that generates advertising opportunities, which could negatively affect our advertising revenue.

Although we believe that there are significant long-term benefits to Facebook resulting from increased engagement on Facebook-integrated websites, these benefits may not offset the possible loss of advertising revenue, in which case our business could be harmed."

 So what is Facebook talking about here? Recently web sites and game sites have decided they do not want to go through the effort of building Facebook specific applications. Instead, they are redirecting people from Facebook to their web applications by embedding a redirect in Facebook. Facebook realizes this and worries that this will result in Facebook users realizing that there is a world outside of Facebook. Facebook wants to keep you in Facebook. They have already taken steps to shut down the ability to move Facebook users out of Facebook via the fake Facebook application strategy. 

"We currently generate significant revenue as a result of our relationship with Zynga, and, if we are unable to successfully maintain this relationship, our financial results could be harmed." In 2011, Zynga accounted for approximately 12% of our revenue, which amount was comprised of revenue derived from payments processing fees related to Zynga’s sales of virtual goods and from direct advertising purchased by Zynga. Additionally, Zynga’s apps generate a significant number of pages on which we display ads from other advertisers. If the use of Zynga games on our Platform declines, if Zynga launches games on or migrates games to competing platforms, or if we fail to maintain good relations with Zynga, we may lose Zynga as a significant Platform developer and our financial results may be adversely affected. "

Clearly Zynga's influence on Facebook is enormous. It also indicates that social gaming has an impact on advertising revenue as well. Not sure if the 12% takes  into account the advertising revenue that Zynga generates and how much of the total revenue Zynga contributes to Facebook. We will have to dig into Zynga's own S-1 to sort that out. Also, Facebook does not mention the total revenue influence of all social games in Facebook from a virtual currency and advertising perspective. I suspect Wall Street was not wise enough to ask this question. If you are going to invest in Facebook you should find out the answer to this questions. There are several large game publishers in Facebook and I suspect the aggregate has a big influence on Facebook's bottom line. 

So what is the total revenue contribution of social games to Facebook's bottomline? I suspect far greater then the 12%  that they are reporting from Zynga. If you add up the other social game publishers and the advertising revenue they generate for Facebook the story is very different than the one pitched in the S-1.

"Our users can use the Facebook Platform to purchase virtual and digital goods from our Platform developers using our Payments infrastructure. Depending on how our Payments product evolves, we may be subject to a variety of laws and regulations in the United States, Europe, and elsewhere, including those governing money transmission, gift cards and other prepaid access instruments, electronic funds transfers, anti-money laundering, counter-terrorist financing, gambling, banking and lending, and import and export restrictions. In some jurisdictions, the application or interpretation of these laws and regulations is not clear. To increase flexibility in how our use of Payments may evolve and to mitigate regulatory uncertainty, we have applied for certain money transmitter licenses and expect to apply for additional money transmitter licenses in the United States, which will generally require us to demonstrate compliance with many domestic laws in these areas. Our efforts to comply with these laws and regulations could be costly and result in diversion of management time and effort and may still not guarantee compliance. In the event that we are found to be in violation of any such legal or regulatory requirements, we may be subject to monetary fines or other penalties such as a cease and desist order, or we may be required to make product changes, any of which could have an adverse effect on our business and financial results."

There are a number of things we can derive from this statement. Clearly government  regulators are beginning to look more deeply into Facebook's virtual currency payment platform and social game transactions that allow or require players to "buy" virtual currency with traditional currency. There are all kinds of issues that could arise from drawing so much attention and revenue from these transactions. First and foremost is the age of people transacting with virtual currency and especially in games like poker and other gambling style games.  If people under the age of 18 are buying currency to enter gambling games and losing is this legal? If it is should the authorize do something about it? Even if they are not gambling games should these people be allowed to buy unlimited amounts of virtual currency and goods?

With the opening up of US legalized gambling and the history of  legal Internet gambling in Europe Facebook is rumored  to be interested in allowing gambling games in its environment to serve these markets. How will Facebook make money on this and how will they safely implement gambling within Facebook?   Regulators will be watching.

"Twelve percent of our total revenue in 2011, and less than 10% in 2010 and 2009, came from a single customer, Zynga. This revenue consisted of payments processing fees related to Zynga’s sales of virtual goods and from direct advertising purchased by Zynga. In May 2010, we entered into an addendum to our standard terms and conditions with Zynga pursuant to which it agreed to use Facebook Payments as the primary means of payment within Zynga games played on the Facebook Platform. Under this addendum, we retain a fee of up to 30% of the face value of user purchases in Zynga’s games on the Facebook Platform. This addendum expires in May 2015."

Zynga begrudgingly entered into this agreement with Facebook. They even threatened to pull out of Facebook all together.  Zynga did  cut a deal with Google to put games into Google+ to offset their dependence on Facebook. 2015 is certainly  light years away in social networking time. However, if the Zynga/Google partnership can make a dent in Facebook's social gaming dominance Zynga will have more negotiating power to reduce the 30% haircut.

"When users purchase virtual and digital goods from our Platform developers using our Payments infrastructure, we receive fees that represent a portion of the transaction value. Currently, substantially all of the Payments transactions between our users and Platform developers are for virtual goods used in social games, for example virtual tractors in the social game FarmVille. According to an industry source, the worldwide revenue generated from the sale of virtual goods increased from $2 billion in 2007 to $7 billion in 2010, and is forecasted to increase to $15 billion by 2014. Payments integration is currently required in apps on Facebook that are categorized as games, and we may seek to extend the use of Payments to other types of apps in the future. Our future revenue from Payments will depend on many factors, including our success in enabling Platform developers to build experiences that engage users and create user demand for their products, and the fee arrangements we are able to negotiate in the future." 

Facebook is clearly thinking about how it can encourage "force" all e-commerce transactions though its payment system. Not a bad idea really if they can pull it off. Facebook's current dependence on social games to generate all of its virtual currency revenue is certainly dangerous, especially if Zynga threatens to withdraw from Facebook unless the fees are reduced. The more Facebook dominates the E-commerce world requiring all business to have a presence in Facebook the more likely this will occur. 

In conclusion the Facebook S-1 does not reveal much more than most followers of Facebook already know. The dependence on social games for Facebook's long term growth is obvious. Add the advertising revenue generated in social games with their virtual currency and goods sales will expose a much higher dependence on games then the S-1 has revealed. From an investor perspective impeding legislation to regulate virtual currency transactions may have a significant impact on Facebook's revenue if many of the social gamers are under the age of 18. The introduction of gambling in Facebook could be paradoxical adding an additional revenue stream and at the same time resulting in regulation of existing virtual currency transactions. Although Zynga has made a fortune off of Facebook they have also become a prisoner of this relationship. They have to be thinking about how they can diversify outside of Facebook to reduce their own risk and to increase revenue outside of Facebook.  This means that Facebook should, and is going to decrease, its revenue dependence on Zynga by expanding virtual currency beyond games and to attempt to gain market share with Asian game publishers.

Kevin Flood is the CEO of Gameinlane, Inc. Kevin writes extensively about online games and their impact and integration into iGaming and E-commerce environments. Kevin is a frequent speaker at online game events and conferences in Asia, Europe and the US. Kevin and his Gameinlane team are currently working with online gambling, social gaming and e-commerce companies integrating social gaming with online gaming operations and integrate game mechanics into e-commerce applications.