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Investing in Facebook – Have You Signed Up?

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Facebook, Inc. (FB) is at the epicenter of the flourishing social media industry. With hundreds of millions of users accessing the platform each day to connect, share and communicate with each other, the company has witnessed stellar growth over the past few years.

It has also been successful in turning its free service into a sturdy, revenue-generating business; as can be gauged from the rapid growth reported in its revenues from advertisements, its successful monetization of mobile users, and the growing number of advertisers who use its platform to reach out to their customers.

User Base: Trends and Engagement

Facebook had more than a billion monthly active users (MAUs) at the end of fiscal year 2012 (FY12; ended December 31, 2012), and new users continued flocking to the company’s website through the first three quarters of 2013, albeit at markedly lower rates than before.

During the year, it was noticed that users were increasingly using mobile devices to access their virtual profiles. Mobile users now make up 73% of Facebook’s total MAU base, and their share looks set to continue growing as smartphones and tablets proliferate.

In the third quarter (3Q) of FY13, MAUs in North America and Europe increased 5% and 9% over the comparable year-ago period. On the other hand, MAUs increased by much higher rates of 27% and 26% in Asia and the rest of the world in the same period.

The slower growth in MAUs in western markets gave rise to concerns that teenagers are quitting Facebook in favor of other social media apps, such as WhatsApp and Snapchat. iStrategy Labs estimated the number of Facebookers who have left the platform since 2011 at 11 million; however, this should not be much of a worry for investors for now, considering that additions to Facebook’s user base every quarter still outstrip the dropout rate.

It was also estimated in 2013 that internet users spent more than a quarter of their time online browsing the social media website. In September 2013, each internet user spent an estimated 1,419 minutes online, out of which time spent on Facebook accounted for 28% of the total – the highest among all websites. In comparison, Google Inc’s (GOOG) search engine and YouTube (also owned by Google) accounted for 16% and 14% respectively.

The time spent on Facebook by internet users has also been increasing each year, which reflects the growing popularity and high engagement of the platform.

Revenues and Costs

Facebook currently generates around 88% of its revenues from advertisements. Ad revenues grew in the last six consecutive quarters as the social media website leveraged its growing popularity to charge higher rates per ad. Revenues from advertisements were up 66% in 3QFY13 over the year-ago quarter.

Advertisement revenues differ by geographic region, and are tracked by the average revenue per user (ARPU) metric. In 3QFY13, Facebook's ARPU in North America was $4.19, $1.76 in Europe, $0.74 in Asia, and $0.65 in the rest of the world.

Given that the company is garnering more users with time, it is expected to record higher revenues each quarter. However, it might face headwinds going forward, as most of its growth will now be in Asia and the rest of the world, where ARPU is currently the lowest.

Facebook’s cost per 1,000 impressions (CPM) – the average cost paid by the company to get 1,000 views on ads placed on its platform – increased 42% in 3QFY13. Simultaneously, total ad impressions fell in the third quarter as more users shifted to mobile devices, on which Facebook can show only a few advertisements without cluttering up the user interface.

Advertising Market

The global online advertising market reached an estimated worth of $112.8 billion last year. It is expected to grow to around $197.4 billion by 2016, of which mobile ads will account for 14%.

Latest Quarter Earnings (3QFY13)

Facebook released its most recent financial results on October 30, 2013. It reported revenues of $2.02 billion for 3QFY13, topping consensus estimates of $1.91 billion. Its per share earnings (EPS) of $0.25 also beat consensus estimates of $0.19.

Growth in its revenues (60% over the earlier year) was driven by an increase in revenues from mobile advertisements (which accounted for 49% of total ad revenues), a 16% increase in ad impressions, and a 42% increase in the average price charged per ad.

Results for the fourth quarter will be released on January 29, 2014. Analysts expect revenues of $2.35 billion in the three months through December 31, 2013 (a 48% increase YoY), and EPS of $0.27 (an increase of 58% YoY).

Major Deals in 2013

Facebook acquired Onavo, a mobile analytics company, last year. Onavo makes various apps for the iOS and Android platforms, which help users reduce network data usage, optimize device performance and enhance battery life. It has been speculated that by acquiring the company, Facebook is trying to increase its reach to a global user base by tweaking its app so that users can access the platform even on slow networks while saving on mobile data charges.

Facebook had also been eyeing Bangalore, India-based startup Little Eye Labs near the end of 2013. The company offers analysis and monitoring tools for Android app developers. If it acquires the company, Facebook’s app developers will look to use Little Eye Labs’s technology to gauge the impact of their app on a phone's battery, memory and display. With the number of mobile MAUs increasing faster than other user groups, and Android remaining the most widely-used smartphone operating system, this will help Facebook optimize its mobile app for the majority of smartphone devices in the market.

In 2013, Facebook also made an attempt to acquire Snapchat, a photo and video sharing app. However, its $3.2 billion offer was rejected by the owners of Snapchat, so Facebook responded by introducing a new feature in Instagram called Instagram Direct, which allows users to send photos directly to a maximum of 15 people, and also has a feature that enables conversations. Instagram was also upgraded with a video sharing service, which Facebook will eventually monetize, Instagram videos play automatically – a feature Facebook may use to introduce video ads.

Facebook has also acqui-hired Branch Media, a social media startup, and it will form Facebook's new Conversation group in New York City.

Key Developments

Yandex NV (YNDX), the Russian search engine giant, and Facebook reached a deal under which Facebook's public social content will be displayed in Yandex's search engine. By allowing Yandex to do so, Facebook will be able to increase its visibility in emerging markets and therefore attract a larger user base.

Facebook had already introduced the hashtags made popular by Twitter Inc. (TWTR), and it has now launched a trending feature, which shows trending topics on the right hand side of users’ newsfeeds. Trending topics will be personalized for every user, as the company wishes to eventually become a highly personalized digital newspaper. To achieve that, Facebook will also be focusing on promoting content that people actually want to read.

One other key development is that the company has decided not to increase the space it dedicates to ads on users’ newsfeeds. Revenues from newsfeeds generate most of the company’s earnings, but Facebook says it is now aiming to improve the relevance and quality of ads instead of increasing their quantity. Apparently, the company wants to focus more on ad impressions instead of clicks, since clicks do not drive sales as much as impressions do, according to a few tests conducted by the company itself.

Stock Price Performance

Facebook outperformed both the Nasdaq 100 and the Global X Social Media ETF (SOCL) between January 20, 2013 and January 20, 2014. The latter two increased 31.4% and 58.7% respectively over the one-year period, while Facebook’s share price appreciated 89.8% on the back of strong revenue growth, successful mobile user monetization and the other factors discussed in this report.

The Bottom Line

Facebook's revenues increased by an average 50% each quarter in the first three quarters of 2013, while revenues from advertisements rose around 56% each quarter over the same period. The company also seems to be consolidating its position in order to maintain earnings growth by making large investments in the mobile segment.

According to estimates, global social media advertising was worth around $8.8 billion in 2012, of which Facebook netted 48%. Global social media advertising is predicted to grow at a compound annual rate of 49.9% to $31.8 billion in 2015, and Facebook’s share price is expected to move in tandem.

Facebook is currently trading at a twelve-month blended forward price-to-sales ratio (P/S) of 13.5x, which is slightly higher than its competitors’ average of 13.2x. In comparison, Twitter’s shares are trading at a P/S of 31x.

Of 50 analysts covering Facebook, 43 rate the stock as a Buy, while the remaining seven rate it as a Hold. We’ll be siding with the majority here, and recommending the stock as a Buy.

 

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