Uncertainty Over Facebook's Emerging Model Will Keep Things Interesting

By Stephen D. Simpson, CFA | January 27, 2013 AAA

It wasn't so long ago that Facebook Inc. (Nasdaq:FB) was a Wall Street pinata, but the shares found their footing in November and have risen roughly 50% since then. While the company's fourth quarter results do show the impressive growth potential in the business, there are still significant questions left unanswered as to whether the company can better monetize its user base, while maintaining that delicate balance with customer service. Given the wide spread in analyst estimates, it seems likely that Facebook is going to remain an interesting and volatile story for a while yet.

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Good Growth in the Fourth Quarter, but not a Perfect Quarter
Facebook reported 40% revenue growth for the fourth quarter, a bit ahead of the average estimate. Even so, ad revenue came in a little disappointing. Ad revenue was up about 41% (the same constant currency growth rate as in the third quarter) and a few percentage points shy of expectations. While the company's 46% growth in impressions seemed fine, ad pricing dropped about 4%. At least some of this decline appears due to lower minimum threshold bids in emerging markets, but it is the first reported decline and looks like the main source of weakness.

Facebook is still at a stage where most sell-side analysts (and, presumably, many investors) don't worry all that much about profits and profitability. Even so, gross margin weakened on a year-on-year basis, while GAAP operating income declined 5%. Non-GAAP operating income increased 18%.

Mobile Still Coming Along
Mobile is the dominant topic these days for any ad-based business model, and Facebook showed progress here as well. The active mobile user count increased 12% sequentially, while mobile ad revenue rose about 135% sequentially and now makes up close to one-quarter of the company's ad revenue.

Will Graph Search Be the Next Big Thing, or Just an Incremental Improvement?
Facebook's new Graph Search has gotten ample attention (as with almost anything Facebook does), but it's going to take quite a while to see how much difference this approach really makes. Combining the company's marketing database with Internet search sounds potentially powerful, but I'm not sure there's really going to be a large amount of utility for the user. I could see how this service/feature could offer some incremental benefits over what Yelp Inc. (NYSE:YELP) or Angie's List Inc. (Nasdaq:ANGI) (assuming you share your friends' tastes), but I don't see how this really dents Google Inc. (Nasdaq:GOOG).

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A Long-Term Plan, or Trial and Error?
One of my long-term concerns on Facebook is the extent to which the company really is operating with a long-term playbook or simply coming up with ideas on the fly and trying them out. In fact, I'll go so far as to say that I've sometimes wondered whether Facebook's plan is to rely on customer outrage as a default to shape its decisions, as the company has made several blunders (changing contact emails, changing Instagram policies, cracking down on pictures of users' children, and so on) that riled up the user base. Likewise, did any user ever say "what I really need is a way to use Facebook to send money or gifts to my friends, because gift cards, email, snail mail, et al just don't get the job done"?

Whereas Google, Amazon.com Inc. (Nasdaq:AMZN), Apple Inc. (Nasdaq:AAPL) all seem quite adept at anticipating customer needs, Facebook sometimes seems to follow a policy of "let's see what happens when we try this." Certainly it hasn't pushed users off the service in any real numbers, but it does add unpredictability to the model and stock.

The Bottom Line
There's still a wide range of opinions on what Facebook is going to become as it grows up. While that's not surprising, it does add volatility - multiple academic studies have shown a strong correlation between stock volatility and the size of the spread between the high and low analyst estimates. With the high and low revenue estimates varying by over 40% for 2014, I expect the trading on these shares to be pretty wild.

Taking a middle path, Facebook could well deliver long-term revenue growth of 20% and free cash flow (FCF) growth of 40% from 2012 levels. At those growth rates, the shares look fairly valued. Remember that wide spread on estimates, however - investors who believe they have a strong case for better (or worse) performance are likely to see a significant corresponding amount of under- (or over) valuation in these shares today. Consequently, I don't believe anybody should own these shares if they cannot accept 5-10% daily moves or 25%-plus quarterly moves with equanimity.

At the time of writing, Stephen D. Simpson did not own any shares in any company mentioned in this article.

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