Facebook (NASDAQ:FB) had another strong quarter with revenues surging 60% as mobile advertising continued to ramp up. The slight sequential acceleration in ad revenue growth was a positive surprise, and most of it can be attributed to an attractive ROI (return on investment) on Facebook’s feed-based ads that helped the company command a much higher ad pricing.
We have increased our price estimate for Facebook by 25% to $38 on strong revenue growth and improving margins. More specifically, we have increased our forecast for revenue per 1,000 page views (ad monetization), which we now expect to reach $0.63 by the end of our forecast period, up from our previous estimate of $0.54. Additionally, we expect research & development expenses (R&D), general and administrative expenses (G&A) and sales and marketing expenses (S&M) to decline as a percentage of revenues over the next few years. The change in our forecasts primarily relates to the substantial jump in Facebook’s ad pricing, which grew by a massive 42% in Q3 2013 over the same period a year ago.  Each of these forecast changes added about 5% to 7% to our previous price estimate, with ad monetization being the biggest contributor.
However, our price still stands 20%-25% below the market price. Facebook is certainly not devoid of significant risks as we had discussed previously: Key Risks For Facebook As Stock Continues To Climb. We are concerned that although the company had a strong run in the past few quarters, it may have hit the near-term ceiling for ad monetization. Additionally, Facebook has mentioned that the usage among young teens has declined, which may be an indicator of social networking fatigue and growing competition from other platforms.
Mobile Fuels Another Strong Quarter For Facebook
Mobile will continue to be the core of Facebook’s strategy going forward. Approximately 74% of Facebook’s overall monthly active users also accessed the network through their smartphones in Q3 2013.  The mobile platform accounted for roughly 49% of the company’s overall ad revenues during the quarter, up from 41% in Q2 2013.  The figure stood at just 30% during the first quarter of the year which indicates the incredible success that the company has seen on mobile devices. There is still a long way to go, as mobile represents roughly 12% of consumer media time but only 3% of the ad budget is directed to this channel. 
The reason why Facebook has done well here is the successful integration of news feed ads. These ads are designed to mingle naturally with regular Facebook feeds and updates, thus minimizing the negative impact on user experience and increasing their efficacy. The company has leveraged its vast data to make these ads as relevant as possible, which is why it is charging so much more from its advertisers now. Facebook’s ad revenues jumped 66% during the third quarter due to a 16% increase in the number of ad impressions and 42% growth in ad pricing.  In some geographies the prices increased even more. While the U.S. and Canada saw a decline in the number of ad impressions, the pricing went up by 60%. 
But The Growth Can Slow Down Next Year
We believe that there is a good chance that Facebook’s growth can materially slow down next year. The company has mentioned that it will not increase the density of news feed ads (ads as a percentage of total news feeds) beyond the current levels.  This essentially implies that future growth will be much more reliant on how the ad pricing trends, which has already gone up substantially. There will be less room for improving the relevance of ads which will result in a slowdown in ad pricing growth.
Additionally, there exists risk from users migrating to mobile platform as Facebook reaches optimum ad density. The monetization levels on mobile are still meaningfully below the desktop levels, and that’s not going to change in the foreseeable future. However, there is a clear trend of mobile usage increasing at the expense of desktop usage. This might look encouraging at the surface due to Facebook’s recent ramp-up of mobile advertising, but could put pressure on overall monetization growth. Facebook seems clear about not increasing the news feed ad density, which is the only way it earns ad revenues on mobile.
As revenue growth slows down, there may be some pull back in the market valuation which has gone up significantly this year.
Our price estimate for Facebook stands at $38, implying a discount of about 20%-25% to the market price.Notes: