Seeking Alpha
Profile| Send Message|
( followers)  

Facebook (NASDAQ:FB) has been on the decline lately, bringing share value down by over 10%, and some investors are skeptical about Facebook's future as a company. There is no doubt that Facebook is popular and maintains a strong, virtually monopolistic foothold in the social media industry/sector, but there still looms the question of whether Facebook is capable of earning higher profit margins. Push has come to shove and investors want to know if Facebook can be more than just a "popular" company, and if it can compete financially with tech giants such as Google (NASDAQ:GOOG) and Apple (NASDAQ:AAPL) who have already passed the test. The future of the company lies in the answer to that question.

The concern:

On January 28, 2013, Facebook hit a high of $32.51 after its disappointing IPO this summer, which resulted in share prices depreciating to a low of $17.55 in September 2012. Then, on January 30, 2013, Facebook released its Q4 earnings report to which investors responded negatively and fear for Facebook's inability to generate revenue only worsened. Investors were hoping the earnings report would improve sentiment, but it missed the mark. Since then, Facebook has been discounted and investor doubt has caused this stock to drop about $4.00 or 12.5% from a $32.51 high in the end of January to $28.21 as of after hours on Friday February 15.


(Click to enlarge)

From examination of the price chart after the Q4 earnings report, it is evident that investor sentiment has decreased as the conference call did not quell the speculation concerning Facebook's revenue issues. However, there still looms rays of hope as the positive market corrections indicate investors trying to get in while shares are down, hoping that a simple makeover will transform Facebook into a money making machine.

Financials:

Revenue Breakdown:

Year Ended December 31,

2011 to 2012
% Change

2010 to 2011
% Change

2012

2011

2010

(in millions)

Advertising

$

4,279

$

3,154

$

1,868

36%

69%

Payments and other fees

810

557

106

45%

425%

Total revenue

$

5,089

$

3,711

$

1,974

37%

88%

(Taken from Facebook)

Advertisement Revenue:

According to the annual report, the grand majority of Facebook's revenue is derived from advertisement on the Facebook website and its mobile app platform. Depending on the contract signed with the buyer of the ads, Facebook generates revenue from marketing foreign products by either charging a "user click" based methodology in which Facebook will realize revenue for every click made on the add. Or, Facebook may charge advertisement fees via an "impressions" based methodology in which a company incurs fees once the user sees the ad or an "impression." Facebook shows different numbers of ads on any given page based on the number of ads and types of ads purchased, and the structure for advertisement is continually being modified and restructured to increase the value and revenue of the ads.

Payments and other fees:

Facebook also earns revenue by taking a cut of the payments users make with real money for virtual money to use in online games such as FarmVille, an online game created by Zynga (NASDAQ:ZNGA). However, due to the upcoming cessation of the Facebook-Zynga relationship, revenue from this source will eventually deteriorate (I wrote another article detailing a possible scenario for Zynga after the dissolution of this relationship). Although the loss of Zynga games would signify the loss of the ~15% of current revenue generated through payment fees, Facebook would also save operating costs as web and data infrastructure used for the maintenance of those games would be liquidated for other use.

Analysis:

Revenue increased $1.38 billion this past year, an increase of 37% from 2011. The majority of the revenue increase originated from a 36% increase in advertisement, which comprised of 81.5% of the revenue increase year-over-year.

According to the Facebook Annual Report, advertisement revenue has increased due to a 32% increase in the number of advertisements and an average 3% increase in price of ads across the board. The pricing of these ads are affected by a variety of factors, including but not limited to, which page the ads are displayed on, the geographical location of the ads, and the number of MAUs (monthly active users) and DAUs (daily active users). In 2012, Facebook began to show ads on mobile newsfeeds, and these ads are priced higher which has been offset by the lower volume of this advertisement category. As the number of mobile MAUs continues to grow, mobile ads will begin to be of greater value and demand. Currently the number of global mobile MAUs are growing according to a chart provided by Facebook:


(Click to enlarge)

(Taken from Facebook)

As quoted from the annual report:

"We expect mobile usage to increase at a faster rate than usage through personal computers for the foreseeable future, particularly in developed markets, and our success in ramping up mobile monetization will likely have a material impact on our financial performance."

However, in order for Facebook to succeed, the company must demonstrate with reasonable confidence and unerring data that mobile advertisement has the potential to increase sales of the marketed product.

Additionally, the price Facebook charges on the advertisements fluctuates depending on where in the world the ads are purchased. For example, according to the annual report, the ARPU (Average Revenue Per User) of advertisement is 5 times greater in the United States than in Asia as demand from product ads are simply greater in North America than developing markets. However, Facebook plans to "invest in user growth across the world, including in geographies where current per user monetization is relatively lower." Investment in these emerging markets have great potential for Facebook's revenue streams, but we should maintain controlled confidence as it is unclear whether Facebook will be able to convert its investment into further profit. Additionally, in 2012, ARPU in Europe has been significantly lower as the economic turmoil has decreased demand for advertisement services. Thus, if Europe is able to begin recovering its financial situation within the next year and raise GDP, then demand for advertisement will gradually increase, increasing Facebook's opportunity to increase 2013 revenue in Europe. Under certain positive contingencies, Facebook has great potential to reap great reward from many diverse markets.


(Click to enlarge)

(Take from Facebook)
Referencing the above charts, the U.S. and Canada are currently representative of more than 50% of total global revenue. Global revenue in Q4 FY2012 increased by 40.1% from the same quarter a year ago while revenue in U.S. and Canada, Europe, Asia, and rest of the world increased by 36.6%, 22.2%, 76.8%, and 97.5% respectively during the same time period. These are great numbers as the growth in Asia and other emerging markets demonstrates that Facebook is on the verge of exponential growth in these countries. Furthermore, if North America continues to generate at least 30-40% growth year-over-year and Europe's economic situation begins to brighten, Facebook's revenue stream will be nearing close to $2 billion for Q4 FY2013. With those Q4 numbers, total earnings for the 2013 year could be approaching the $7-8 billion range.

Cost of Revenue:

2012

2011

2010

(in millions)

Consolidated Statements of Income Data:

Revenue

$

5,089

$

3,711

$

1,974

Costs and expenses:

Cost of revenue

1,364

860

493

Research and development

1,399

388

144

Marketing and sales

896

393

167

General and administrative

892

314

138

Total costs and expenses

4,551

1,955

942

Income from operations

538

1,756

1,032

Interest and other income (expense), net

(44

)

(61

)

(24

)

Income before provision for income taxes

494

1,695

1,008

Provision for income taxes

441

695

402

Net income

$

53

$

1,000

$

606

Revenue Costs as percentage of Revenue

2012

2011

2010

Consolidated Statements of Income Data:

Revenue

100

%

100

%

100

%

Costs and expenses:

Cost of revenue

27

23

25

Research and development

27

10

7

Marketing and sales

18

11

8

General and administrative

18

8

7

Total costs and expenses

89

53

48

In Income from operations

11

47

52

Interest and other income (expense), net

(1

)

(2

)

(1

)

Income before provision for income taxes

10

46

51

Provision for income taxes

9

19

20

Net income

1

%

27

%

31

%

(Taken from Facebook)

Analysis:

From 2010 to 2011, net income increased by $394 million or by 65% and from 2011 to 2012, net income suffered a loss of $947 million, a 94% loss. However, it is worthwhile to note that operating costs have increased by 107.5% from 2010 to 2011, compared to an increase of 133% from 2011 to 2012. This high increase in operating costs from the two intervals is due to the high increase year over year in the category of Research and Development. From 2010 to 2011, Research and Development costs increased by 169% while compared to the year over year increase from 2011 to 2012, R&D costs for Facebook increased by a whopping 260.6%. In terms of operating costs, all categories maintained near constant growth between the two intervals except in Research and Development. The large spike in R&D was due, in large part, to expenses related with 2011 pre-IPO Restricted Share Units (RSU) totaling $729 million which were triggered to exercise after the May 2012 IPO. As the share value quickly began to drop after the IPO, holders of the RSUs wisely decided to cash out, and thus inflicted a one-time expense on Facebook. According to the annual report, Facebook expects "research and development expenses will rise in 2013 at a lower rate than it rose in 2012" due to the large RSU related expenses generated in Q2 of 2012. The heavy operating burden seen in Facebook's 2012 financials will not be seen in future years. In effect, the significant drop in net income for the year concluded on December 31st, 2012 compared to the year before is not due to a loss of consumer confidence or value of the product Facebook produces. Rather, the loss in net income year over year is a result of the abnormally and non-cyclical, one time payout of RSU related expenses after the May 2012 IPO. Thus, with the expected increase in revenue for 2013, as mentioned above, coupled with a dramatic decrease in operating costs (in terms of percentage), investors can expect strong net income next year.

Furthermore, Facebook plans to focus R&D on improving the quality, design, and management of their products for investment in the future. If R&D costs are utilized effectively over the next year, Facebook may see much higher operating margins in future years as Facebook is focusing on increasing its global footprint by employing a greater global sales force in Asia and other emerging markets.

In Conclusion:

Facebook is, without a doubt, a front runner in the industry of social media and with the newest introduction of the Graph Search feature, investors should be confident that Facebook is not ready to be complacent anytime soon. The secret to the tech industry is innovation, and Facebook is in on that secret. However, now as investors have acknowledged Facebook's potential as a powerful company, the question now becomes whether or not Facebook can innovate to achieve higher operating margins -- margins much higher than the meager $53 million in 2012. However, as I mentioned earlier, I believe the disappointing earnings for 2012 can be attributed, at least to a significant portion, to the high expenses Facebook incurred due to the RSUs after the May 2012 IPO event. Considering that the event occurred towards the latter half of the year, and the strongest revenue from Facebook occurs during the last quarter of each year (as indicated by the above charts), there is strong reason to believe the expenses in R&D played a crucial role in limiting net income for 2012. With that in mind, I think we can expect a much higher operating margin for 2013 as the RSU expenses have been taken care of, Facebook has invested $896 million in global marketing and sales to target foreign markets, the increase in mobile MAUs, and the potential economic recovery of Europe all will stimulate a higher margin of profit. Of course there are always contingencies, but as I have outlined the situation, I believe 2013 will be a year worth mentioning on investors' newsfeeds.

Source: Facebook: Is It Capable Of More Revenue?