Facebook Posts Solid Growth But Guidance Sends Stock Down

Facebook (NASDAQ:FB) continued to ride on its growth momentum during the third quarter, with revenue growing 59% to $3.2 billion. Bottom-line results were also encouraging, with GAAP operating margin increasing to 44% as compared to 37% in the same period a year ago. However, the guidance was disappointing on both revenue and profitability fronts and this led to a drop in the company’s stock price in after-hours trading.

Facebook’s management expects revenue to rise by 40% to 47% annually in the fourth quarter, owing to difficult year-over-year comparisons. This represents a slowdown against near-60% levels seen during the previous two quarters. The management also expects costs to accelerate sharply during the remainder of 2014 and beyond. Though this outlook may seem discouraging on the face of it, we believe by making these heavy investments, Facebook is sowing seeds through which it will derive high growth over the next 5-10 years.

The company has a long-term strategy in play and investors should not look down at the business just because of this guidance. We are bullish on Facebook’s growth prospects – investments on diverse platforms (such as Messenger, Instagram, WhatsApp, Search and Oculus) could reap multi-billion dollar businesses for the company in the long-run and management hasn’t even begun scratching the surface of this potential. Facebook is still prioritizing on user experience and wants to expand the audience on these platforms before monetizing them. In addition, increasing the relevance of advertising on core platform with better and more targeted ad products will continue fuel Facebook’s top-line both in the U.S. and international markets, where it’s still under-penetrated.

We are in the process of revising our $65.56 price estimate for Facebook’ stock.

See our complete analysis for Facebook

Expenses Will Increase Significantly

In the recent earnings call, Facebook’s management forecasted total GAAP expenses to rise by 45% to 50% annually for full year 2014, against the prior estimate of 30% to 35%. And for 2015, it forecasted GAAP expenses to increase by 55% to 75% compared to 2014. In non-GAAP terms, expenses are expected to grow by 50% to 70%. ((Facebook’s (FB) CEO Mark Zuckerberg on Q3 2014 Results – Earnings Call Transcript, Seeking Alpha, October 28, 2014)) The recent closing of WhatsApp and Oculus acquisitions, as well as investments to enhance core Facebook experience and strengthen ad-tech platforms are some of the factors that will cause this steep escalation in costs.

We believe these investments will strengthen the long-term outlook for Facebook and could help accelerate revenue growth once the steam from the Facebook’s core business begins to blow off and it reaches a more mature phase.

Ad Revenues Rise By A Solid Rate But Future Growth Rates Will Be Impacted By Tougher Comps

Ad revenue grew by 64% year over year in Q3, as Facebook’s strategy continues to pay off, benefiting as the company strove to leverage the mobile platform, increase the number of marketers on the platform, and make its ads more relevant. Average price per ad rose by 274%, even while total ad impressions came down by 56% ^[1]. Ad impressions continue to decline as the company has re-designed right hand columns on its core platform resulting in fewer, albeit higher quality ads. The shift from desktop to mobile usage, coupled with an increased proportion of feed-based ads, are also both  responsible for the change in price-volume dynamics.

Mobile ad revenue grew by 114% during Q3, and comprised 66% of the total advertising revenue. We believe the proportion of mobile ad revenues in overall revenue will continue to increase at a healthy pace in the coming quarters, as Facebook optimizes its ad targeting capabilities on the mobile platform and marketers realize the benefits of advertising on mobile devices. Mobile daily active users (DAUs) rose by 39% year over year to 703 million in September, accounting for over 80% of the total daily active user base.

Though advertising revenues will continue to show strength in the future as well, we believe year-over-year growth rates will come down with tougher annual comparisons. Over the long-run, Facebook’s growth potential is immense considering the 1.35 billion monthly active user base on its core platform, along with additional hundreds of millions of users on other services such as Messenger, WhatsApp and Instagram.

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1. Facebook’s (FB) CEO Mark Zuckerberg on Q3 2014 Results – Earnings Call Transcript, Seeking Alpha, October 28, 2014 [↩]