Facebook (NASDAQ:FB) will report its Q2 2013 earnings on July 24th. We expect to see growth in its mobile advertising business driven by the company’s continued efforts to integrate ads into its mobile platform. However, margins are likely to go down as Facebook is hiring aggressively to support the development of a host of features including gifts, Graph Search, custom audience and app-install ads. The average revenue per user has been growing, and we expect this trend to continue despite the negative impact of expansion in emerging markets where the figure is relatively low. Facebook’s user base growth is likely to be lower compared to that observed in the second quarter of last year.
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Mobile Advertising Is Likely To See Growth
For the last few quarters, Facebook has stepped up its efforts to improve mobile monetization. The revenue contribution of mobile platform increased from about 14% in Q3 2012 to 30% in Q1 2013.  We expect this trend to continue as Facebook is seeing some success in promoting ads without hampering user experience on the mobile platform. Its feed based ads and app install ads have done well and will continue to be the focus in the near term.
The number of ads within Facebook’s mobile feeds have increased significantly and better effectiveness is also driving the ad pricing higher. For instance, the company launched a huge mobile advertising campaign for Wal-Mart (NYSE:WMT) during the holiday season, and around 50 million ads focusing on deals and discounts were rolled out to millions of Facebook users. The idea is to make advertisements a natural part of Facebook’s content to minimize disruption and tackle the problem of the lack of real estate for ads on the small mobile screen.
The company’s mobile ad business is seeing growth across geographies, especially in Asia. The mobile app install ads are doing very well and the company will continue to promote them. It makes sense for advertisements to direct users to apps instead of websites on the mobile platform. About 3,800 app developers used Facebook’s app install ads to drive close to 25 million downloads during the first quarter.  Moreover, about 40% of top 100 apps on iOS and Android operating systems were using these ads. 
Advertisements Are Becoming More Effective On Facebook
Besides increasing the number of ads on mobile, Facebook has to fundamentally make its ads more effective in order to drive monetization growth. The company can leverage a vast amount of user data to help advertisers reach the right audience, and it is certainly doing so. Certain measures suggest that the effectiveness of advertisements on Facebook’s social networking platform is increasing, and that bodes well for the company’s Q2 results.
Facebook’s study showed that Bud Light’s ads, which were posted on its Facebook page, were highly effective. These ads reached 20% of U.S. households and improved sales by 3.3%, thus offering a six times return on the ad spend.  Another study showed that when measured holistically, the cost per acquisition on Facebook is 68% less than the cost on other online channels.  The company’s ‘custom audience’ product, which basically combines its user data and advertisers’ customer data to increase the effectiveness of the ads with improved targeting, is seeing good traction.
But Margins Can Come Under Pressure
Facebook’s users are increasingly accessing the social network on mobile devices where there isn’t much real estate space to put ads. Although the company has made significant improvement on this front, the pressure on monetization is visible. Facebook’s ad revenue per page view has declined significantly since 2009. To counter this situation and improve monetization, Facebook is making efforts to improve user engagement and roll out ads on mobile platform. A host of features including gifts, graph search, etc. are meant to encourage users to interact more with Facebook’s platform, which bodes well for its advertising business. The company needs to invest in R&D to do this, and that’s leading to some cost pressure. Facebook is being aggressive in recruiting talented programmers and designers, which led to almost 90% increase in R&D costs compared to a 40% increase in revenues in Q1 2013.  Operating margins declined notably and we can see similar results in Q2 as well.
Our price estimate for Facebook stands at $23.30, implying a discount of about 10% to the market price.Notes: