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How To Monetize a Social Network: MySpace and Facebook Should Follow TenCent

Posted on March 9, 2009. Filed under: advertising, casual games, Internet, social networking, Uncategorized, video, Virtual Goods | Tags: advertising, Avatars, casual games, Digital Items, Facebook, MySpace, social network, social networking, Virtual Goods |

“Little Joe never once gave it away
Everybody had to pay and pay”
                  — Lou Reed, Walk on the Wild Side

The consensus seems to be that social networks have a monetization problem.  On this topic, both the leading technology industry blogs and the world’s top news organizations agree.  The problem is not that these sites have no revenue.   I “guesstimate” that MySpace and Facebook have annual revenue run-rates of approximately $650mm and $450mm respectively – highly reputable numbers.  The perceived problem relates directly to revenue per user or page view, as these are two of the most heavily trafficked sites on the Internet.  As a comparison, other companies with similar usage, like Yahoo, are doing $7.2B in annual revenues.  When reporting earnings from Q4 of 2007, Google also opined on the difficulty in monetizing social networking sites.  Sergey Brin noted, “I don’t think we have the killer best way to monetize social networks yet.”

There is ample historical data that proves web sites like these are inherently difficult to monetize.  Most other online communication products have had similar struggles.  Two great examples of this: the many leading players in the Instant Messaging (IM) space (AIM, ICQ, Yahoo Messenger) and the leading free email sites (Hotmail, Yahoo Mail).  These products/sites have always had some of the lowest eCPMs on the Internet.  Many speculate that this is because the user is so heavily engaged in using the product (i.e. communicating) that they are unlikely to be distracted by or engaged in an advertising message.  Another corollary to this point is that other Internet properties offer more direct purchasing intent based on the way they aggregate users.  Example here include TheKnot for brides, TripAdvisor for travelers, and even Google, where the search query highly delineates the direct intent of the user, allowing the advertiser to find users already in the purchasing funnel.  All of these properties have incredibly high eCPMs.

Despite this conundrum, there is a solution.  Luckily for these U.S. based companies, a Chinese company named TenCent has already paved the way by identifying the optimal way to monetize this type of product.  For those that don’t know, TenCent is the owner of the leading IM franchise in China – a product known affectionately as “QQ”.  TenCent was founded in 1998, has 355 million users,  US$1.2B in annual revenues, and a US$11.2B market capitalization.  The stock chart for the past 5 years is included in the adjacent graphic.  The two primary drivers of revenue for TenCent are digital items and casual game packages and upgrades.  Advertising, which doesn’t work well on U.S. products like IM, doesn’t work well in China either.  Advertising revenues for TenCent represent only 12% of total revenues.  Recently, I asked a leading Internet analyst which company in China is best positioned above all others?  He quickly replied “TenCent”.

The spreadsheet below tries to highlight the monetization differences between TenCent, Facebook, and MySpace.  For each we have taken our best guess at monthly unique users, monthly page views, monthly revenues, and advertising as a percentage of revenue.  For TenCent, these numbers are published.  For MySpace and Facebook we used the best information we could find and/or infer.  We then calculated effective CPM (eCPM), revenue/user, and advertising revenue per user.  Lastly, we show these same numbers for TenCent with a cost of living adjustment.  In China the cell-phone ARPU (average revenue per user) is about 1/5th of that here in the U.S., so adjusting these numbers up by 5X gives you a much better number for comparing directly with the U.S. properties. 

The takeaways are quite straightforward.  The amount of advertising revenue on an adjusted basis at TenCent ($2.08) is quite similar to Facebook ($2.44) and MySpace ($5.85) (some may wonder why MySpace ad revenue per user is higher than Facebook – many believe they are more aggressive with ad placement and insertion).  The key difference in this comparison is obviously the revenue TenCent generates with business models that are largely absent on both Facebook and MySpace — digital items and casual game revenue.  For every $2 of adjusted advertising revenue TenCent has per user per year, they generate $17 in other revenue streams.  Benchmark Capital has invested in two private companies in the social/virtual world space – SecondLife and Gaia Online.  In both cases, the company revenues are significant, and in both cases advertising is not the leading business model.

More supportive data comes from the three leading social network players in Japan.  Believe or not, all three companies are already public and trade on different segments of the Tokyo Stock Exchange.  You will see in the same spreadsheet that Mixi, DENA (Mobage-town), and GREE have market capitalizations of US$511MM, US$1.5B, and US$1.1B respectively, and are all very profitable.   DENA and GREE, which interestingly are more popular on mobile than on the PC, have invested heavily in these two magic business models (casual games and digital items) and have revenues per user that dwarf that of Facebook or Myspace (DENA is 10X Facebook on this metric!).  As a result, these companies sport market capitalizations per user of over $100.  Here is the big punch line: Mixi is the actual leader in the market in terms of users, is the clear leader on the PC, is the company that most resembles U.S.-based social networks, and has remained focused on advertising as its core revenue steam.  Not surprisingly, their revenues per user are a fraction of DENA and GREE, as is their market capitalization.  

At a recent public investor conference in San Francisco, Alexander Tamas, an executive associated with the leading free email service in Russia (Mail.ru), noted that his company felt that the U.S. companies have little understanding on how to monetize a product like Mail.ru, and that they were taking their clues from TenCent in China.  Most of the public market investors in the audience, who have witnessed TenCent, DENA, and GREE’s remarkable success, nodded in agreement.  Gaia also presented at this conference and the crowd was standing-room only.  The questions from the audience made it even more apparent that the buy-side investors have a strong appreciation for the digital item business model. 

It is peculiar to have a situation where the NY-centric public market investors are more open minded to a new business model prior to the entrepreneurial executives on the west coast, but that is clearly the case here.  It is not hard to see why investors like this model.  When Pony Ma, the founder of TenCent, first described the digital item model to me five years ago I was blown away.  He was selling virtual clothes and accessories for digital avatars that represented his users online.  Think about it; this is a beautifully high gross margin business with very low marginal costs.  He even told me he thought digital shirts should deteriorate over time like real ones.  Pure genius. 

It is my perception that most U.S. executives have trouble conceiving and believing in the digital item model.  For starters, they simply think it’s strange.  “Why would someone buy clothes for their virtual avatar?  That’s weird.”  What they fail to realize is that U.S. consumers pay for “virtual” things all the time.  In the attached picture you see a pair of expensive Chanel sunglasses that retail for $329.  If you removed the Chanel logo from them, and offered them for $50 cheaper, you could not sell a pair.  Not one.  Why?  People are buying an image that they want to project about themselves.  Without the logo, they fail to make that statement.  The same is true for watches, clothes, cars, sodas, beers, cell phones, and many more items.  People care greatly about how they are perceived, and are willing to part with big bucks to achieve it.  Digital items are merely the same phenomenon online.

Another reason that digital items are a great monetization model for a social network is congruence of fit with the core activity of the site.  We already discussed how for TheKnot, the decision to come to the site is very consistent with identifying exactly “who” the advertiser is trying to reach and at “what time”.  For social networking sites, one of the key “experiences” of users is self-expression.  Think about it: is the Facebook news feed more about the reader or the poster?  Isn’t someone’s MySpace page all about self-expression?  If people are there to represent and express themselves, shouldn’t you build a business model that charges for the ability to better differentiate oneself?  Shouldn’t you also charge for ego-gratification on a sliding scale (the bigger the ego, the more the charge)?

These same executives like to believe that digital items are distinctly an Asian phenomenon – a convenient theory will prove to be a dangerous rationalization over time.  Here are some numbers from a U.S. corporation.  As I mentioned we are investors in LindenLab and their leading vitual world, SecondLife.  In SecondLife, the users are the ones that get to sell digital goods (rather than the company as in TenCent’s case).  Linden makes its money providing the platform services underneath this powerful economy.  At this moment in time, the economy inside of SecondLife – the amount of digital goods and services – sold each year between SecondLife users, is over a US$450mm annual run rate.  Of this, developers are realizing over $100MM in real profits extracted from Linden’s in-world to real-world currency exchange.  And keep in mind that SecondLife has much fewer users than either Facebook or MySpace.

Another interesting data point exists in the Facebook and MySpace application developer programs.  Best I can tell, the startups that are generating the most revenue on top of either platform are either selling digital items/avatars, or providing casual game packages — the exact two business models that are the drivers at TenCent, DENA, and GREE.  This is hardly a coincidence.

Despite these arguments and the fact that others have also been arguing this same point, it would be surprising if either MySpace or Facebook move in this direction.  First, they would need to have executive buy-in, which is not obvious at this point.  Second, they would need to hire people with experience in executing against this model.  Like any other endeavor in life, there are right ways and wrong ways to exploit these models, and there are already many experts in the field of digital items and casual games.  Lastly, they would need to prioritize this direction over other programs.  Currently, MySpace seems extremely focused on music, and Facebook on user-based communications.

The good news is that if they ever get around to deploying these models, they will not have trouble convincing Wall Street it’s a good idea – Wall Street is already there.

(follow me on twitter)

More Information:

Wikipedia on TenCent
TenCent IR About Page
TenCent IR Investor Intro
Stock Information and Company Financials on Mixi
Stock Information and Company Financials on DENA
Stock Information and Company Financials on GREE

In addition to these, most of the large US investment banks are covering TenCent, DENA, and GREE with English based research.  If you have a relationship with one of these banks, you can likely ask for their reports.

 

 

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