Facebook’s Monetization Sees A Bigger Jump In Q1 2014

Facebook (NASDAQ:FB) posted a record quarter with revenue jumping 72% due to a substantial increase in the average ad pricing. ^[1] We previously expected the company’s year-over-year growth to fall when compared to Q4 2013, considering there was a tougher comparison and no meaningful change in the density of feed-based ads. As it turned out, Facebook continued to increase the number of ads in its feeds alongside improving their efficacy as well. Accordingly, the company surpassed our expectations. In the light of recent results, we have updated our price estimate to $52.50, implying close to 15% jump over our previous estimate. This still stands roughly 10%-15% below the market price. We attribute the bulk of our revision to improved ad monetization and higher gross margin. While the ad pricing increased by 118%, the gross margin for the quarter stood at more than 80% compared to 72% for Q1 2013. ^[2]

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Explosive Ad Pricing Growth Came As A Surprise

Facebook saw 82% growth in its ad revenue during the first quarter of 2014, which was primarily driven by an astonishing 118% increase in its average ad pricing. ^[1] This eclipsed last quarter’s ad pricing growth of 92% which is a bit surprising considering tougher year-over-year comparison. Facebook attributed this success to the growing proportion of feed-based ads. The company has been moving advertisements from banner form to its news feed as these feed-based ads have much higher engagement and therefore, command a higher pricing. Still, this was unexpected, considering that Facebook had earlier mentioned that it is nearing the desired ceiling for ad density as far as its feed-based ads were concerned.

Mobile has been the primary focus of this shift in ad strategy and instead of launching new ad products, Facebook seems to be focusing on improving the current ones. More specific audience targeting, higher engagement and better click through rates can give Facebook strong leverage when it comes to negotiating ad prices with advertisers. The company mentioned a couple of successful cases to project how Facebook is becoming increasingly important for advertisers due to its high ROI (return on investment). About 55% of daily active users are logging in only from mobile devices, and mobile platform accounted for 59% of Q1 2014 ad revenue. ^[1]

Is The Market Reaction Justified?

Following a fluctuation that lasted for a short period, the stock traded more or less flat despite a record quarter that surpassed expectations of many. We think that price increase over the last year and a half and the recent correction indicate close to fair assessment of Facebook’s expected growth. Our price estimate of $55 assumes that Facebook will increase its revenues five-fold to almost $40 billion by 2020. This will result in EBITDA (earnings before interest, taxes, depreciation and amortization) increasing by a higher percentage due to operating leverage gain. This price estimate also implies that free cash flow will jump from an estimated $2.63 billion in 2013 to $15.16 billion by 2020. These are very optimistic forecasts and Facebook’s strong quarterly performance seems to have become the norm. This implies that a slowdown in the growth could hurt the stock meaningfully. We also think that the fact that Facebook doesn’t expect video based ads to make a significant contribution any time soon also added to “indifferent” market sentiment.

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1. Facebook’s Q1 2014 Earnings Transcript [↩] [↩] [↩]
2. Facebook’s SEC Filings [↩]