Our Take On Facebook’s Outlook

by Trefis Team
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Quick Take

  • Our $23.30 price estimate implies a neutral stance on Facebook’s stock. While the company is doing well in several areas, it also faces some significant risks.
  • The positives include its mobile advertising ramp up, the increasing efficacy of advertisements and the promising ‘graph search’ feature.
  • The risks include high costs that Facebook is incurring to drive its monetization growth, the possible competition from Google+, the risk of social networking fatigue and strained relations with Zynga.

The past year was quite eventful for Facebook (NASDAQ:FB) as the company went public in May. Since then, its stock has been on a downtrend except for the short term gains that it saw in November and December. The optimism around improving mobile advertising did not last long. There are concerns around the company’s ability to manage its monetization in the long run and high costs that it is incurring in trying to do so.

Our price estimate for Facebook stands at $23.30, implying a slight discount to the market price. While we see several positives for the company, there are some substantial risks that validate our more or less neutral stance to the company. Let’s take a closer look at where Facebook is doing well and what risks it faces.

See our complete analysis for Facebook

Key Opportunities For Facebook

Mobile Advertising Is Ramping Up

For the last few quarters, Facebook has stepped up its efforts to improve its mobile monetization. The company saw the ad revenue contribution of its mobile platform increase from about 14% in Q3 2012 to 23% in Q4 2012. [1] In Q1 2013, this figure grew to 30%. [2]

It appears that Facebook has found the right way to promote ads without hampering user experience on mobile platform. Its feed based ads and app install ads have been successful and will continue to be the company’s focus in the near term.

The number of ads within Facebook’s mobile feeds have increased significantly and better effectiveness is also driving the ad pricing higher. For instance, the company launched a huge mobile advertising campaign for Wal-Mart (NYSE:WMT) during the holiday season, and around 50 million ads focusing on deals and discounts were rolled out to millions of Facebook users. The idea is to make advertisements a natural part of Facebook’s content to minimize the disruption and tackle the problem of lack of real estate for ads on small mobile screen.

The company’s mobile ad business is seeing growth across all geographies, especially in Asia. The mobile app install adds performed very well this quarter, and the company will continue to promote these. It makes sense for advertisements to direct users to apps instead of websites on mobile platform. About 3,800 app developers used Facebook’s app install ads to drive close to 25 million downloads during the quarter. [2] Moreover, about 40% of top 100 apps on iOS and Android operating systems were using these adds. [2]

Advertisements Are Becoming More Effective On Facebook

Besides increasing the number of ads on mobile, Facebook has to fundamentally make its ads more effective in order to drive monetization growth. The company can leverage vast amount of user data to help advertisers reach the right audience, and it is certainly doing so. Facebook offered certain metrics during its recent earnings call that advocate the effectiveness of advertisements on its social networking platform.

The company’s study showed that Bud Light’s ads, which were posted on its Facebook page (5.8 million fans), were highly effective. These ads reached 20% of U.S. households and improved sales by 3.3%, thus offering a six times return on the ad spend. [2] Another study showed that when measured holistically, costs per acquisition on Facebook is 68% less than the cost on other online channels. [2] Q1 also saw higher traction for Facebook’s ‘custom audience’ product, which basically combines its user data and advertisers’ customer data to increase the effectiveness of the ads with improved targeting.

Facebook can command higher ad pricing if it can successfully showcase and market the efficacy of ads on its platform to advertisers.

Graph Search Could Become One Of The Key Features Drawing In Audience

In January, Facebook unveiled its new Graph Search functionality that it expects to become one of the key features of its business in the future. However, the usability of Graph Search is restricted due to privacy of user data as well as inconsistent levels of activity across Facebook users. In order to make it successful and make money from it, Facebook will need to encourage users to frequently use the ‘like’ feature as well as try to integrate some sponsored search links within the results of Graph Search.

Facebook also needs to make sure that its users use Graph Search as often as possible. To do this, the company will need to make the search results more meaningful. This can only be done by including a larger data sample. While Facebook may not tamper with the privacy aspect, which greatly limits the usage of Graph Search, it may certainly encourage its users to “rate” and “like” content on Facebook. Various companies and businesses will also have the incentive to encourage their customers to like their pages, promotions or products in order to appear prominently in Facebook’s graph search results.

Main Risks And Threats

Ability To Sustain Improvement In Monetization

Facebook’s users are increasingly accessing the social network on mobile devices where there is not much real estate space to put ads. Additionally, Facebook does not serve audio ads like Pandora, and thus, is completely reliant on visual ads. Even though the problem is straightforward, the solution is not. Any attempt to significantly increase ads on a mobile platform can affect the user experience negatively due to the limited real estate on mobile screens. Although the company has made significant improvement on this front by rolling out feed-based ads and app-install ads, there is no guarantee that monetization will continue to grow in the longer run. This is something that’s needed if Facebook has to command market price anywhere close to its IPO price. The company is incurring significant costs in rolling out new features and selling ads to advertisers, and that’s expected to lower its margins for 2013. It is unclear whether these efforts to engage users and improve monetization will remain sustainable without high costs in the longer run.

In essence, there is still a chance that Facebook’s efforts to effectively monetize the mobile platform may fail, and growth in international markets further puts downward pressure on the monetization levels.

Number Of Page Views May Get Affected

Facebook’s monthly page views per user have shown substantial jump in the last few years, but higher competition and social networking fatigue can impact their growth in the future.

As of April 2013, Google’s (NASDAQ:GOOG) homegrown social network Google+ had close to 359 million active users and over 500 million registered users. In terms of scale, Google+ remains the biggest threat to Facebook in the social networking space. Competition from the network is likely to increase further given Google’s aggressive promotion as well as the seamless integration it can achieve with its other services such as YouTube. According to an August 2011 report by Gartner, a survey conducted on around 6,000 social network users revealed that 24% of the respondents were using their social sites less often than when they signed up. This may be coming about because online social media continues to see a boom, leading to users being flooded with an information overload. While we believe this to be a minor deterrent considering Facebook’s ubiquity and popularity, it can still impact the overall user engagement.

Strained Ties Between Zynga And Facebook

Zynga is now subject to Facebook’s standard policies and procedures as far as the use of Facebook’s platform and data is concerned, implying that any favoritism that might have existed is now gone. While this is certainly not a good development for Zynga, Facebook can also face the negative impact if Zynga’s own gaming platform gains popularity.

In 2011, approximately 12% of Facebook’s revenues came from Zynga. However, this proportion has been decreasing as Facebook is growing its other revenue channels and promoting numerous game developers. Additionally, some of Zynga’s games haven’t performed as well as its initial games that went viral on Facebook. In Q3 2012, Facebook’s revenues from Zynga decreased by 20% compared to the same period in 2011. However, revenues from Facebook’s remaining gaming ecosystem grew by 40%.

While this implies that Facebook is currently doing fine without Zynga, that may not necessarily be true in the future, assuming that Zynga regains its popularity with focus on mid-core games and real-money gaming. What if Google+ promotes Zynga too just the way Facebook did in its early stages? That could give the rival social network some competitive advantage.

Understand What Drives a Stock at Trefis

  1. Facebook’s SEC Filings []
  2. Facebook’s Q1 2013 Earnings Transcript [] [] [] [] []
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