Quick Thoughts: FB 3Q14 – “A Significant Investment Year” or Zuckerberg’s Bezos Envy

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–        FB delivered $0.43 in 3Q14 EPS on $3.20B in sales, topping consensus ($0.40 on $3.14B) on 59% sales growth, but spooked investors with guidance for decelerating sales and high expenses

–        User metrics were impressive for a base the size of FB. MAUs up 14% YoY, DAUs up 19% YoY, mobile MAUs up 29% to 83% of total MAUs, Asia/ROW MAUs up 19% to 63% of total.

–        FB killed it on monetization. US/Canada and Europe ad sales grew 63% YoY combined despite just 5.7% MAU growth, as ARPU grew 58% and 51% respectively. Average $/ad was up 274%!

–        Management set 4Q sales guidance for 40-47% growth, with 2015 OPEX projected up 55-75%. Dilutive WhatsApp shares are also now registered to trade. OOPS! another after-hours sell off.

Facebook delivered yet another solid quarter fueled by growth in mobile advertising, which was up a stunning 122% YoY and now stands just shy of $2B for the quarter and a $5.4B run rate. Not bad for a business that didn’t exist when the company IPOed in May 2012.  Top line revenue came in at $3.2B, handily beating the $3.12B expected. Earnings also beat with $0.43 in EPS versus the $0.40 expected. With 1.3B+ users, FB is still growing users in the double digits with Daily Average User (DAU) growth at 18.7% YoY and Monthly Average Users (MAU) up 13.7%. Faster DAU growth points to greater engagement with the ratio of daily to monthly actives growing to 64% from 61% last year. Monetization was also looking good with strong ARPU growth across all regions, but especially strong in FB’s largest markets. FB shares barely moved after the bell, but then came the earnings call. Cue the spooky Halloween music.

Kicking off the call, CEO Mark Zuckerberg rehashed his 3, 5, and 10 year plans for the business and shed some light on plans for his two largest acquisitions to date: WhatsApp and Oculus Rift. The 3 year plan includes enhancing the user experience, growing the ad business, and investing in ad tech including the new Atlas offering, while the 5-year horizon calls for taking existing businesses like Instagram, WhatsApp, and Messenger to the next level. The 10 year plan includes longer term international development goals around connecting every human on the planet with internet through initiatives like internet.org and planning for new platforms. To this end, Zuck gave some insight into the Oculus acquisition, which he sees as a long term bet on future computing platforms around augmented and virtual reality. With Google having led a large round of VC financing for a similar augmented reality startup last week called Magic Leap, non-nausea inducing VR experiences are looking promising. Zuck also noted Oculus sold some 100K developer kits. While not accretive, it’s not likely the acquisition will be written down soon. After Zuck wrapped, the stock barely budged below -1% of the closing price.

Next on the horn was COO Sheryl Sandberg, who gave an overview on product progress and investments in ad tech.  She emphasized FB’s reach and targeting capabilities giving examples of success stories with clients like MetLife, which saw ROI grow by targeting look alike audiences that were similar to current customers. She also expressed the company has been deliberate in scaling auto play ads and Instagram slowly. Measurement is a core part of the FB story and its appeal to advertisers. Ad tech efforts around Atlas and the audience network are centered around creating an accurate picture of measurement across devices and locations, which ultimately will drive deeper advertiser relationships and bring new advertisers to the platform. The ad world has always been heavily focused on relationships and continues to be slow-moving when it comes to allocating spend across media. It took marketers nearly a decade to realize newspaper audiences were declining before spend abruptly and dramatically came crashing down. Sandberg correctly pointed to an imbalance between mobile marketing spend and eyeballs given only 11% of marketing spend goes to mobile, with some 25% of consumer time spent on mobile devices. FB continues to be the most popularly visited mobile app globally, while its stable of secondary branded apps including Instagram and WhatsApp also see high utilization. Mobile still has plenty of runway and FB is making the key investments to make the business work. All in all, good news so far, and the stock was down just a few bps.

Next at bat was rookie CFO David Wehner to dive into the numbers and deliver guidance. Uh oh, the spooky music gets a bit louder. Sure after reiterating the 1.1B mobile user number and growing WhatsApp and Instagram usage, all was good, but then BAM! The first hit: dilution. Wehner delivered news that FB shares allocated as part of the WhatsApp deal would be registered and tradable, taking shares outstanding of FB from 2.6B (incl. restricted shares) to 2.8B. While the dilution should have already been priced into the stock when the deal closed on October 6, investors never like surprises like that. The music gets louder.

Then, Wehner delivered the company’s most detailed guidance to date forecasting revenue growth between 40-47% in the all important holiday quarter, a striking deceleration from YoY growth rates north of 58% over the last five quarters. MAYBE investors would see the guidance as a typically Silicon Valley low ball guidance to set up an easy compare, but the spooky music gets even louder, this time with shrieking violins. Wehner continued, guiding to 4Q14 OPEX up 45-50% YoY (both GAAP and non-GAAP), largely on non-deductible SBC expenses related to WhatsApp. But wait, that’s not the end just yet. Wehner signaled that 2015 will have huge growth opportunities and to plan on a “significant investment year” in Bezosesque fashion. OPEX could be up as much as 75% for the year. In the course of less than 10 minutes, FB stock was down more than 8%.

Investors are right to be a bit concerned. The $22B WhatsApp acquisition came out of left field last year, bringing 450M users, but just $10M in annual revenue. Zuckerberg gave 10% of the company to a team that has no apparent plan to EVER monetize its user base. If the 2015 brings more acquisitions like that, Halloween may last all year.

FB’s data center CAPEX is well below its larger cloud rivals, and some increased investment may go over better with investors than another high priced and dilutive acquisition. Facebook is a strong and well positioned business with a lot of runway to increase monetization, but the temptation to reinvest profits looms. Investors may no longer have the stomach to write blank checks to founders pursuing their manifest destiny – ask Amazon CEO Jeff Bezos. Zuckerberg is a wild card and his short track record as CEO of public company does little to reveal where the “significant investment” may go.

For our full research notes, please visit our published research site.

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