Inside Facebook

On Tuesday, Facebook said it had become “free cash flow positive” this past quarter — meaning the company is financing its own growth rather than using investor money. But why is revenue growing? Reporters earlier this year have fueled speculation about many different revenue streams, from brand ads to self-serve ads to virtual goods.

Overall, Facebook revenue is “likely going to be above $550 million this year,” we have recently heard from several sources close the company. Last year, the company brought in a total of between $280 million and $300 million, as we and others heard then. The story now is how Facebook has gone beyond traditional social network banner advertising to grow revenue.

Where Facebook was, not too long ago

In our January interview with Facebook Director of Monetization and performance-advertising head Tim Kendall, he told us that “we have tens of thousands of monthly active advertisers” using the company’s self-serve targeted ad system. He added that “we are very pleased with revenue growth” on that front.

At the end of March, the company said it was seeing 70 percent revenue growth over the previous year. Around the same time, a TechCrunch article mentioned a surge in self-serve ads. 70 percent more than $300 million is $510 million. So at that point, it appeared that the big Facebook advertising experiment was starting to work. The company has been trying to develop new forms of ads that rely on user data and behavior — rather than the traditional impression-based model of most social network ads to date.

In early July, Business Insider and investor-blogger Fred Wilson both said they’d heard revenue was growing even faster, to around $550 million. Both reported revenue being broken down along these lines:

•    $125 million from brand ads
•    $150 million from Facebook’s ad deal with Microsoft
•    $75 million from virtual goods
•    $200 million from self-service ads.

What we hear now

Facebook’s sales force has been bringing in more revenue directly, rather than through its long-time ad deal with Microsoft. Some of this money is coming in through large brand advertisers, through their experimentation with Pages, and related social ads.

But, Facebook’s self-serve ad system is a hit with a few new constituencies. “Performance advertisers,” the sorts of businesses like online education company University of Phoenix, are finding that ads on Facebook can be targeted so precisely that they are getting a clear return on investment. The right sorts of people see the ads, click, and sign up for an online course or whatever.

There’s another group also getting in on these self-serve ads now: Local advertisers. These small businesses are finding that they can bring in new customers by targeting people who live nearby.

Note: Some likely substantial portion of self-serve advertisers is from social gaming companies on the platform, especially Zynga. We hear that company might make up to $200 million in revenue this year, driving new users and revenue through spending tens of millions on Facebook’s self-serve system. This spending is obvious, as countless Facebook users have reported seeing ads for games like “Mafia Wars.”

There is a lot of churn among first-time advertisers, sources say. But, those advertisers with initial success tend to continue pumping money in, if not upping their Facebook ad budgets, these sources add.

Facebook advertising, in other words, hasn’t been working for everyone, but it’s working for some key groups. Performance marketers, for example, were some of the earliest users of Google’s search and keyword advertising products. Facebook, through its own profile and activity-based methods of targeting, is creating new value for these people.

In terms of how what we hear versus what the July reports said, we believe that brand ads and especially self-service ads are driving almost all new growth. As one source put it, the advertising team is “beating the shit out of its numbers.”

Advertising is the Strategy, For Now

Facebook’s leadership is almost entirely focused on ads for the time being, from what we hear. There has been a lot of speculation about its efforts to create some sort of virtual goods or payment system. Internally, it is seen as something to keep on the back burner. Virtual gifts, which the July reports heard accounted for up to $75 million in revenue this year, is a “tiny fraction” of revenue, says one of our sources. The caveat here is that Facebook may be accounting for gift store revenue as advertising, as one way it monetizes this feature is through selling “sponsored gifts” to advertisers.

In general, from what we understand, any sort of large-scale payments system or virtual goods expansion is likely a year or two off, if not longer. Facebook has no doubt been watching the explosion of this revenue stream among developers on its platform — we have separately heard virtual goods revenues could account for more than $300 million in platform revenue this year, money Facebook isn’t seeing any of.

Certainly, we expect Facebook to keep experimenting with its young “Credits” virtual currency system. But, for now, the company appears happy to let the ecosystem of social gaming companies, mobile payments services, offer-based advertisers, and others in the emerging ecosystem handle application monetization on their own.

Advertising is Paying the Bills

The other angle here is that Facebook is now financing its own growth, and through this new advertising revenue. Last year, for example, the company was apparently both losing money and taking out debt to fund capital expansion projects like a new data center in Silicon Valley.

Earlier this week, Data Center Knowledge reported that Facebook is making a big new investment in its existing Virginia facility. The publication cited analysts who estimated that the center could cost up to $125 million over the course of several years. It’s not clear how Facebook is accounting for that expenditure, but the term “free cash flow positive” signifies that the company is able to cover its own capital expenses. It appears that the company’s new revenue growth is paying for at least a portion of the new data center investment.

The conclusion? Facebook, more than ever before, is competing on its own terms.