Facebook Pre-Earnings: Expect Growth Momentum To Continue

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With Facebook’s (NASDAQ:FB) stock rising by 30% over the last six months due to impressive results, many investors will be on their heels on October 28, to see if the company can keep its growth momentum intact with Q3 2014 earnings. The company posted 61% revenue growth in the second quarter, along with a 17 percentage point improvement in the GAAP operating margin. We expect the company to show solid results in the third quarter as well, fueled by its strategy to focus on mobile devices, improve ad products and grow the number of marketers on the platform. However, the growth rate could slow somewhat in sequential terms in the third quarter due to tougher comps.

While we expect profitability to improve in the third quarter as well, we’d like to remind investors that various factors such as incremental operating costs due to closing of WhatsApp and Oculus acquisitions, along with rise in core operating expenses will weigh on the company’s profitability post Q3. In terms of revenue growth, we believe there is huge long-term potential for the company to expand its advertising revenue from the U.S. and abroad. Building out the eco-system (which comprises of several entities such as WhatsApp and Instagram) and enhancing online video advertising will further propel top-line growth for the company in the long-term.

Our price estimate for Facebook stands at $65.50, implying a discount of about 20% to the market. We forecast Facebook’s revenue and EBITDA to grow meaningfully from $7.9 billion and $4.9 billion in 2013 to over $42 billion and $30 billion by the end of our forecast horizon (i.e 2021) in our model.

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See our complete analysis for Facebook

Ad Revenue Growth To Be Solid, Driven By Pricing Gains

Facebook posted stellar ad revenue growth of 82% and 67% in the first quarter and second quarter of 2014, respectively. This was primarily driven by solid growth in average ad pricing, which rose by 118% and 123% during the first two quarters. Strengthening mobile monetization and more targeted advertising are fueling this growth. During the third quarter, we again forecast strong year-over-year growth in advertising revenue, however it could be lower than than 67% level seen in Q2 due to tougher year-on-year comparisons.

Mobile monetization increased by 151% in Q2 and accounted for 62% of total ad revenues during the quarter. Mobile daily active users (DAUs) rose by 39% year-over-year to 654 million in June, which comprised for 79% of 829 million total DAUs. We expect strong growth in mobile monetization in the third quarter as well driven by higher ad pricing. While the total number of ad impressions is decreasing, due to a continued shift from desktop to mobile, Facebook has made its platform more effective for marketers by increasing the proportion of feed-based ads and making the interface less cluttered. Its strategy is to improve ad products, target more specific audiences, and drive higher engagement and better click through rates. And this delivers a higher ROI for marketers, thus giving Facebook more leverage while negotiating prices.

Another reason underlining Facebook’s success has been its ability to bring more advertisers onto its platform. Around 30 million small businesses have Facebook pages, and over 1.5 million of them are active marketers. [1] With Facebook focusing on making its mobile ads as interesting and likeable as regular content, we believe this will bring even more marketers to the platform in the future.

Growth In International ARPU And the Eco-System Will Drive Future Demand

We expect international markets to be a source of long-term growth for Facebook. Though Asia, Africa and South America constitute for a large proportion of the world’s population, they don’t contribute significantly to the company’s revenues. While the average revenue per user (ARPU) for the U.S. stood at $6.44 in Q2 2014, the figure for Europe, Asia and rest of the world stood much lower at $2.84, $1.08 and $0.86, respectively. We believe there is a tremendous opportunity for the company to raise its monetization from the the international markets. Facebook’s strategy to open a sales office in China and launch ‘missed call’ ads in India were steps in this direction. The online advertising market is expected to show rapid growth in developing markets, and this will boost the company’s top-line. We will keep a track on ARPU growth from these geographies in the coming quarters.

Enhancing video-based advertising and increasing the ecosystem also represent significant long-term growth drivers for Facebook. The company is now delivering over 1 billion video views per day, and its initial tests of video advertising have proved successful. [2] The recent acquisition of LiveRail (an online video advertising platform) will further strengthen FB’s position in the rapidly expanding online video advertising market.

Monthly active users on each Instagram and Messenger have crossed the 200 million mark. [1] WhatsApp’s acquisition was recently completed in October, and it has more than 600 million active users. [3] While Facebook currently does not monetize these platforms in a big manner, these businesses could become huge over the long-term, in our view, and could throw open significant revenue streams for the company.

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Notes:
  1. Facebook’s (FB) CEO Mark Zuckerberg on Q2 2014 Results – Earnings Call Transcript, Seeking Alpha, July 23, 2014 [] []
  2. Facebook Highlights Its 1-Billion-Video-Views-Per-Day Reach By Adding View Counts, TechCrunch, September 7, 2014 []
  3. WhatsApp reaches 600 million active users, The Next Web, August 25, 2014 []