How Facebook Has Evolved Since The IPO And Where Is It Headed?

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Facebook (NASDAQ:FB) has made a remarkable journey since its inception, and more so since its IPO in early 2012. The biggest achievement of the company so far, besides connecting over 1.2 billion users, has been cracking the code of monetizing a mobile platform. This is something that drove its stock price from $18 to where it is today at nearly $80 per share. A clear inference that can be drawn from Facebook’s success is that if you have a sufficiently large user base and the right model of engagement, you can achieve the exceptional and make seemingly improbable advancements. Surely this is the impetus that drives startups to focus on gaining users over profitability. Facebook’s average revenue per user has risen significantly in recent quarters and we expect the trend to continue. But the question that remains is:  how will the revenue growth rate trend going forward? In this article, we analyze the drivers that have been responsible for Facebook’s success over the past two years, and how the company may fare going forward. One of the observations that we make is that Facebook’s average ad pricing growth may be nearing its peak and the growth in overall ad revenues could dip below 40% in 2015.

Facebook reports growth in its average ad pricing and the number of ad impressions, but not their actual values. However, we estimate that the company’s average ad pricing stood at roughly $1 per 1000 impressions in Q2 2014 and the total number of ad impressions was somewhere around 2,266 billion during the same period.  (See the  appendix below to understand how we make these estimations.) An increase of 10% in average ad pricing can result in ad revenues going up by 10%, assuming that the number of ad impressions doesn’t change. Considering that ad revenues account for slightly over 90% of Facebook’s revenues, the overall impact on revenues would be close to 9.1%. This translates into EPS increase of roughly 9.3% and 9.2% for 2014 and 2015 respectively. Therefore, if the average ad pricing for 2014 were to jump 10% over what we currently expect, it would result in our estimates for non-GAAP diluted EPS for 2014 and 2015 going up to $1.89 and $2.62 respectively. Our current estimates stand at $1.73 and $2.40 for 2014 and 2015, respectively (versus consensus estimates of $1.69 and 2.04).

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See our complete analysis for Facebook

Facebook’s Initial Public Offer And The Aftermath

When Facebook launched its IPO back in 2012, we were concerned that the pricing of the deal could not be justified by the company’s business model. Our concerns were indeed warranted  as the shares upon hitting the market crashed from IPO price of $38, falling to as low to as low as $17.55 during the same year. [1] Much of this was driven by investors’ doubts around Facebook’s ability to monetize its ever growing mobile base. At that point, we expected that Facebook’s revenue per 1000 page views would continue to decline due to the growing mix of international users and the ongoing shift to mobile users. Additionally, we believed that Facebook needed to stimulate e-commerce growth on its platform alongside increasing sales of virtual goods to revive its valuation and improve investor sentiment. We founded our expectations on the fact that, not only was social gaming picking up rapidly, but e-commerce was witnessing global adoption and Facebook’s platform seemed ideal for promoting online transactions.

Despite the immediacy of these trends, the situation remained subdued for Facebook throughout 2012 and only started to improve mildly towards the end of the year, when the company started making efforts to create a sustainable mobile monetization model. At that instant, we believed that if Facebook could crack the mobile advertising puzzle, its stock could easily bounce back and it could be worth much more than it was at that time. However, we did not think that its mobile strategy would become as successful as it is today. We thought that, considering the lack of space on mobile devices for display advertisements, Facebook would  continue to struggle in terms of revenue growth.  We can now say that we were—in a word—disproved.

Mobile Strategy Was Formed And Feed-Based Ads Became A Hit

Facebook continued to believe that ads are the way to go. It figured out the recipe for mobile devices and rolled out feed-based ads, which essentially solved the problem of lack of availability of real-estate on mobile screens for putting banner and text ads. Facebook innovated. At that point, it was hard to imagine that clogging up Facebook’s regular feed with sponsored posts and ads will not deteriorate user experience. However, the company was careful in terms of design and targeting by leveraging user generated data. These advertisements became a natural part of Facebook’s feeds and attracted a lot of advertisers due to their highly targeted nature and impressive click-through rates. Some studies and estimates suggest that click-through rates for Facebook’s feed-based ads could range from 2% to 6%. [2] [3] Taking an average figure of 3% will imply that Facebook’s feed-based ads experience 3 clicks per 100 impression. This is why Facebook’s ad revenue growth accelerated in 2013 as the proportion of mobile in overall ad revenues grew. The charts below show how Facebook’s performance on mobile has improved over the past eight quarters.

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Facebook Continued To Surprise Us With Its Ad Pricing Growth

The primary reason behind Facebook’s revenue growth and subsequent stock price jump was an astounding increase in the average ad pricing. The number of ad impressions, in fact, declined due to the roll out of feed-based ads. As an example, the company’s ad revenues jumped 82% in the first quarter of 2014. This was primarily attributable to a growth of 118% in Facebook’s average ad pricing. This was much higher than Q4 2013′s ad pricing increase of 92%, despite the tougher year-over-year comparison. The figure further jumped to 123% in Q2 2014. This is something that we didn’t expect, and neither did the market as the stock price went up after every earnings announcements on such positive surprises. There was widespread underestimation of ad revenue potential on social platforms.

Facebook proved the earlier concerns of investors wrong by demonstrating an extremely strong return on investment for marketers on mobile devices. How did it achieve this? For strong ad pricing growth, Facebook needed to demonstrate that through its platform, marketers could reach a relevant audience faster and more efficiently. This was made possible by analyzing a massive amount of user-generated data to identify user traits and interests. This data generation was accelerated due to increased interaction of users on Facebook, which itself resulted from continuous feature enhancements. The acquisition of Instagram, the introduction of the timeline, the ever increasing app store, promoted content, company and celebrity pages, integration with third party sites,  . . .  all of these were all part of Facebook’s strategy for increasing traffic and user engagement. 

The Key Question Is – Will Facebook Hit Ad Pricing Ceiling Anytime Soon?

The heading title asks an extremely important question from valuation perspective. Historically, Facebook has managed to beat market expectations.  But if that doesn’t happen going forward, the stock price may not have much room for further appreciation. To understand this, we have to look at how Facebook’s ad pricing growth and number of ad impressions have trended. The chart below demonstrates a significant change in trajectory around second quarter of 2013.

Until Q3 2013, the number of ad impressions was growing alongside moderate growth in average ad pricing. However, Q4 2013 saw a turn around with ad pricing jumping by 92% and number of ad impressions declining by 8%. The phenomenon intensified over the next two quarters. This can be attributed to a greater proportion of feed-based ads on mobile devices, which essentially replaced traditional banner and text ads on the desktop. While there were fewer being shown, the pricing increased phenomenally due to highly targeted nature of feed-based ads that helped advertisers generate strong return on their investment. From the graph, it is easy to understand that the ‘growth in average ad pricing’ is hitting a ceiling, and overall ad revenue growth has started to come down. If we extrapolate this trend to the future, the graph may look something like this.

This essentially suggests that Facebook’s ad revenue growth may come down to less than 40% in 2015 and considering that virtual goods sales are slowing down, the overall revenue growth could also stay well below 40%. These projections imply that Facebook will not be able to make any drastic innovation in the advertisement business and any incremental ROI (return on investment) generation will become increasingly difficult.

However, we note that the company is experimenting with new ad formats which may become significant.  Still, there is little evidence to make any conclusion at this point. For instance, Facebook is testing video ads that will be roughly 15 seconds long, which is shorter in duration  than the ad slots typically sold on TV networks. To distribute these ads to all its users, the company will charge about $2 million a day to an advertiser. The advertisers are likely to roll out their video ads to a specific demographic, and so we expect the actual fee charged per advertiser to be much lower than $2 million per day. Facebook is also testing ‘missed call’ ads in India, in a bid to connect advertisers with a large untapped market of feature phone users in the country. The feature allows users to press a button to place a call to relevant advertisers and then disconnect it. The user then receives a call back playing a pre-recorded message, detailing offers and discounts by the advertiser. The ‘missed call’ ad feature has been primarily launched in India because of the relatively low smartphone penetration in the country.

Social Commerce May Play Strong Role In Facebook’s Growth Several Years Down The Line

E-Commerce, which in context of Facebook can be termed as social commerce, has been a small part of the company’s business. However, the potential is huge. We believe that at this moment Facebook does not want to clutter its interface with features that can essentially promote sales of merchandise through its platform as it may adversely impact user experience. However, it is subtly moving in that direction through cleverly weaved advertisements and company pages. There is opportunity for Facebook to venture into the marketplaces business where it will have a unique advantage of leveraging social data, user connections and its advertiser network to connect merchants with relevant buyers. Needless to say, e-commerce is witnessing strong growth globally. There is no greater evidence than the success stories of Amazon (NASDAQ:AMZN), eBay (NYSE:EBAY) and Alibaba (NYSE:BABA). The chart below shows historical data as well as our forecast for e-commerce sales in the U.S. and international markets.

It is hard to believe that Facebook will not make most of this huge opportunity. While we believe that the ad business will, by far, remain the biggest segment for Facebook, the proportion of e-commerce in its total sales will increase as the ad revenue growth moderates. The company has barely ventured into this area. The sky is the limit. We estimate the U.S. e-commerce market will grow to more than $500 billion in the next five years. If Facebook is able to grab even 5% share of this market by then, it can add more than $2 billion in revenues (based on 8% transaction share estimate, similar to that of eBay).

Our Valuation And Forecasts

We value Facebook at $176 billion, resulting in price estimate of about $66 based on fully diluted share count of 2,691 million shares. Some of the underlying estimates in terms of revenue and cash flow growth rates are shown in the chart below. We estimate that Facebook can grow its revenues from $7.87 billion in 2013 to close to $34 billion in the next fiver years. We further estimate that the company’s EBITDA margin will increase from an already impressive 62% in 2013 to close to 71% during the same timeframe. The company’s business is not capital intensive which suggests that free cash flow growth will remain strong.

Do you think Facebook can achieve this growth? Or do you think that revenue jump will be higher than what we forecast? You can modify the forecasts on our interactive Facebook model to see the impact of your assumptions on Facebook’s valuation.

 

Appendix:

Estimation of average ad pricing and the number of ad impressions for Facebook

An old article from Comscore states that Facebook had 346 billion ad impressions in the U.S. in Q1 2011. We further estimate that Facebook’s total page views grew by 20% in the year 2012. We apply this growth rate to the ad impression count of Q1 2011 along with multiplying by a factor of 1.3 to get the number of ad impressions in Q1 2012 as 540 billion. The factor of 1.3 is based on the assumption that year-over-year growth rate in the number of page views (and therefore the number of ad impressions) would have declined each quarter and hence we estimate growth rates of 26%, 20%, 20% and 18% for Q1, Q2, Q3 and Q4 of 2012 respectively. Together, these growth rates imply 20% growth for the whole year. We further estimate sequential growth rate of 5% to calculate the ad impression count for Q2 2012 as 567 billion.

Beginning Q2 2013, Facebook started giving the year-over-year growth rates for the number of ad impressions and the average ad pricing. We use these reported figures to calculate the number of ad impressions on Facebook in the U.S. in Q2 2014 as 608 billion. Furthermore, we estimate the number of ad impressions internationally as 1,658 billion by taking into account the proportion of international users and our estimate that international users will be half as active as U.S. users on Facebook due to lower Internet penetration, slow broadband speeds and erratic connectivity. This gives us the global ad impression count for Q2 2014 as 2,266 billion. Considering that the company earned $2,265 million in ad revenues that quarter, we arrive at an average ad pricing of $1 per 1000 ad impressions.

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Notes:
  1. Price data from Google Finance []
  2. Facebook Ad CTR Study– Newsfeed v Display: From The Wolfgang Lab, Wolfgang Digital []
  3. Facebook Ads Are Killing It. But Why?, Digiday, Oct 28 2013 []