One of the main fundamental arguments bears make on Facebook (FB) is that the company is secularly challenged with the migration of its user base to mobile devices. In this article, I will demonstrate why this thesis is flawed and why I think Facebook is set to significantly beat consensus expectations going forward.
The mobile monetization argument that the bears make reminds me a lot of what skeptical investors used to say regarding desktop Internet monetization during the 2000-2002 bear market. During that time, the desktop Internet represented well over 10% of a typical person's time spent consuming media, but it was less than 2-3% of total media ad spending. This spread significantly decreased over the past 10 years. While people spend over 2x more time on the desktop Internet today, the desktop Internet's share of total media ad spending has gone up by a factor of about 10x. This happened because companies like Google (GOOG), which previously were primarily concerned about user growth, became more creative about ways to monetize their user base.
Today, less than 2% of total media ad revenue is on mobile devices despite the fact that well over 10% of media consumption happens there. This is because companies like Facebook and Twitter have been primarily concerned about user growth instead of monetization. Over the past few months, priorities seem to have significantly shifted in favor of revenue generation.
A key statement CEO Mark Zuckerberg made on the last conference call was: "We've told every product team that they're responsible for the advertising experience within each of their products." Instead of relying on a separate ad team for revenue generation, every product group is now responsible for monetization. This is unleashing a wave of creativity that was previously focused primarily on user growth but now has a more balanced approach towards profitability.
One initial success from this shift in priorities is advertisements that are placed within the newsfeed as opposed to just on the right rail. Last quarter, 75% of these newsfeed ads were mobile ads which caused mobile ad revenue to jump 600% sequentially to represent 14% of total ad revenue. Facebook seems to be introducing ways to monetize its user base every week.
I personally find Facebook's new "promote a post" offering as a great way to advertise my recently published book. The company also rolled out a new product called "Mobile App Installs," which helps app developers market their apps. "Facebook Ad Exchange" and "Gifts" are two other new revenue generating products that were highlighted on the last conference call. Other companies are following Facebook's lead for increased monetization. Twitter started placing ads inside its own feed. Google is having initial success in its "click to call" mobile ads, which seem to significantly improve conversion and ROI for customers.
Bears are quick to point out the smaller screen size of mobile devices and the fact that most mobile media consumption is done "on-the-go." These would be limitations if mobile ads were the same as desktop ads. Initial efforts at mobile monetization demonstrate that this will not be the case. Mobile ads will be embedded within the user experience as opposed to being simple display impressions. While screen size may limit the number of ads compared to the desktop, each ad impression will be much more valuable. For example, my "click-through-rates" on promoted post ads are significantly better than the ads I place on the right-rail for my book. I am finding that the ROI of advertising my book on Facebook significantly exceeds that of Google AdWords.
Mobile ads will also take advantage of location information and the ability to make phone calls with a click. Finally, mobile improves reach and usage. 70% of mobile users log on to Facebook once a day. This compares to only 40% of desktop-only users being daily users.
There are several reasons why I think Street estimates are too low in the short-term:
1) Newsfeed Ad Revenue and Easy Compares for Ad Revenue. Newsfeed ad revenue run-rate ended Q2 at over $1m per day and ended Q3 at over $4m. If one assumes, a $4.5m run-rate for newsfeed ad revenue in Q4, this implies that the Street is expecting a 10%+ y/y DECLINE in right rail ad revenue in Q4. This seems highly unlikely given the fact that the right rail ad revenue GREW at 10% y/y in Q3 and the compare is significantly easier in Q4. In Q3 2011, right rail ad revenue grew at 77% y/y. This decelerated to 44% y/y growth in Q4 2011. Moreover, the number of ad impressions on the right-rail seems to be increasing every time I check the site. The election should also likely help y/y growth in Q4.
2) Large "Stealth" Buyback. The company did not want employees to feel like they had to sell stock which vested just to pay taxes. Consequently, Facebook paid cash taxes on behalf of many employees and just gave the employees less stock. This effectively is a large buyback in Q4 of over 4% of the total shares outstanding that many analysts are missing in their models.
3) Payments Revenue (14% of Sales in Q3 2012). The company used to recognize payments revenue 1 month in arrears. This is changing so in Q4, the company will actually have to recognize 4 months of revenue. Some analysts on the Street are missing this change in their models.
4) Other New Product Revenue. The Street does not seem to be modeling any revenue from new products such as Gifts, Mobile App Installs or the Ad Exchange. These may not be significant near term, but any revenue generation from these and other new products introduced this quarter will represent upside.
Adding up these factors, I am currently modeling 15%+ upside to Q4 EPS and I think upside in Q1 2013 can even be higher. Longer term, upside will come from other new products. For example, the messaging product group will likely also come up with a creative way to monetize its users in the same way the newsfeed product group did. "Gifts" is just a start at Facebook getting into the large Ecommerce market and the company seems to be exploring new ways to generate revenue from the Search market.
Facebook has only touched the surface of its revenue potential with 3rd party app developers that are highly reliant on Facebook's social graph. Finally, Facebook's tax rate is currently at 40% while Google's tax rate is in the low 20% range. This is because of higher domestic revenue at Facebook and because Google currently has a superior tax planning effort. Over time, Facebook should be able to get its tax rate down significantly. I am currently modeling 2014 adjusted EPS of well over $1 vs the Street at 83c. Excluding approximately $4 per share of net cash and Tax Loss Carry forwards, which I believe are worth around $3 per share, the stock actually trades at a reasonable mid-teens p/e. Admittedly, adjusted EPS excludes stock compensation expense, but I believe the valuation is still reasonable if one prefers to value using GAAP EPS because of the long term growth the company can generate. Facebook has less than 1% share of the global advertising market. Over time, this market share will be more comparable to its much higher share of media consumption.
The biggest risk for Facebook will be to balance improved monetization with user experience. There will always be some users who complain but the company has done a good job so far. For example, there has been very little consumer backlash with respect to mobile newsfeed ads.
With a much increased emphasis on monetization, fundamentals at Facebook look to accelerate going forward. Short sellers should be careful.
Additional disclosure: The author may make trades in securities mentioned without notification. The information contained in this article is impersonal and not tailored to the investment needs of any specific person. You should consult with a professional where appropriate. The author shall not be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages. The Author currently pays Facebook, Twitter and Google for placement of advertisements for his book.