March 26, 2014 – Facebook: Dream Until Your Dreams Come True
In its first year of trading, FB struggled to transition to mobile, delivering lackluster growth and failing to get back to its $38 IPO price. However, with its 2Q13, the company demonstrated a new ability to monetize its increasingly mobile user base, benefitting from a turning point in the acceptance of mobile, social and online video within the ad community. Moreover, we applaud FB’s strategic shift toward a suite of focused but interrelated apps, all leveraging the company’s powerful social graph. Separating previously bundled functions into distinct apps will deliver cleaner experiences for users and better context for advertisers, while co-opting a larger share of smartphone home screen real estate. WhatsApp can further FB’s ambitions, adding new users, particularly in markets where FB is weak, ideally drawing engagement to its more easily monetized services, but the deals for WhatsApp and Oculus are risky and expensive. Within this period of extraordinary growth, we believe that FB can absorb the considerable dilution from both acquisitions without risk disappointing vs. extremely conservative consensus expectations. While FB’s valuation is a significant hurdle for many investors and greatly sensitive to assumptions about longer term growth, we believe continued performance will keep investor dreams alive for quarters to come.
Stumbling out of the gate. In January, 2013, we published a cautious FB piece, noting that its “one app for all things” approach left it vulnerable to integrated mobile platforms and focused 3rd party apps offering cleaner user experiences and a better context for advertisers. This echoed concerns over mobile monetization and user engagement that had dogged the stock since its 2Q12 IPO and would remain a serious overhang for another 6 months. Then FB crushed its 2Q13 earnings report, sequentially accelerating sales growth from 38% to 53%, with mobile rising from 30% to 41% of total ad sales.
2Q13 inflection point. FB shares rose 19% after hours on the 2Q13 numbers, and the stock has barely looked back since, up nearly 170% in less than 8 months. Sales growth accelerated further to 60% in 3Q13 and 63% in 4Q13, handily beating estimates for both quarters. While daily active users (DAU) continue to grow, up 22% for 2013, FB has excelled in raising its revenues per user via increased ad density, and higher ad prices. We believe there is considerable opportunity for more.
Online mobile, social, and video ads go main stream. FB’s accelerating mobile ad sales have tracked with similar stories from GOOG, TWTR, and other ad driven app companies, as the big agencies and their clients have begun to incorporate the medium more fully into their campaigns. Improved measurement tools from NLSN, SCOR and others have played an important role, as has the embrace of social media as a synergistic companion by traditional TV. Online ads are now just over 25% of global measured media ad spend, but still just 15% of total marketing and advertising budgets. With superior targeting, tracking, and interactivity, we believe online has plenty of runway to grow and that FB is well positioned to capture a disproportionate share.
The multi-app strategy promotes engagement. After its 2012 deal, FB kept Instagram separate from its primary platform, and since, it has more than doubled its user base to nearly 200M, all linked to FB’s social graph, driving new engagement and offering a potent venue for new advertising. With this success, FB has backed off its commitment to a single integrated app and plans to launch an archipelago of focused apps. For users, now barraged by a cacophony of disparate voices in their highly edited news feeds and inconvenienced by the multi-click process to reach functions buried in the FB app, focused apps will improve the experience and promote engagement. Users will be able to move directly to the content or services that they want, likely spending more time and making deeper use of the service in the process. Moreover, multiple FB apps will squeeze potentially competing apps off of precious smartphone home screen real estate and co-opt more engagement from platform defaults.
The multi-app strategy will also better serve advertisers. Users have many reasons to visit their FB news feeds – finding friends, sharing photos, playing games, viewing media content, entering discussions, messaging, checking archived posts, etc. Some of these purposes are more conducive to advertising than others, and some are suggestive of particular ads rather than others, yet FB is not aware of the purpose until the user begins to interact with the app. Separating the monolithic FB newsfeed into focused apps will provide advertisers better context for placing their ads, driving improved effectiveness. This could drive higher ad prices, greater ad volumes, and advertiser stickiness for FB.
WhatsApp makes STRATEGIC sense, but carries risk. Offering dramatic savings vs. carrier text messaging service, WhatsApp’s users have more than doubled YoY to nearly 450M. Moreover, those users are concentrated in many markets, like India, Mexico and Africa, where FB has relatively poor penetration. FB will look to monetize WhatsApp by pulling new users to its more lucrative apps. With small switching barriers for messaging and with the primary value driven by carrier texting rate arbitrage, WhatsApp’s hold on users may be relatively fragile, so delivering synergistic value to users across apps will be critical to building longer term loyalty and sustaining monetization. The $2.2B deal for Oculus VR is a head scratcher, and we are not sure that the deal will add value to investors in either the near term or the long run given the significant obstacles to virtual reality technology entering the mainstream.
FB’s valuation implies significant long term growth and profitability. We expect the deceleration in FB sales growth to be fairly gentle, with room for modest improvement in gross margins and expenses relative to sales as the rate slows. Despite our optimism, the current valuation suggests fairly aggressive expectations beyond the next 5 years – a scenario that may be subject to increasing skepticism over time. While we see not specific catalyst that could result in a significant revaluation, many investors may be unwilling to take that risk with a business that has proven volatile in the past.
Near term expectations appear conservative, even considering dilution. While FB may be fully valued relative to its long term prospects, the immediate expectations look extremely conservative in light of accelerating online ad spending and the company’s business momentum. We expect FB to beat consensus in coming quarters on users, engagement, ad sales per user, revenues, margins and net earnings. The biggest threat is on the EPS line, where the nearly 9% bump in shares from the WhatsApp acquisition represents significant dilution. However, we believe that the trajectory of FB’s organic business will be more than sufficient to absorb this dilution without risking quarterly misses. In this context, we believe that further outperformance is available in FB despite its valuation.
For our full research notes, please visit our published research site.