Facebook: Long-Term Prospects Strengthened By Niche Social Sites

Oct.11.13 | About: Facebook (FB)

Niche social sites have seen massive gains in the recent past. Pinterest, for instance, has announced that it will soon start displaying ads, signaling traffic growth and increased user engagement. Pinterest has clearly defined community groups that enhance ad targeting and improve efficiency from the advertiser's perspective. Unlike Facebook, niche social sites are narrowed down to focus on the needs of otherwise alienated online communities. Ostensibly, this poses a huge threat to Facebook (NASDAQ: FB). Interestingly, however, niche social sites don't threaten, but rather strengthen, Facebook's long-term prospects.

Niche social site concept consistent with Facebook's graph search

The typical Facebook user's news feed not only fails to present new insight, but is also predictable and highly routine. This is one of the key drivers behind the development of Facebook's graph search, an interest based search model that allows users to discover brands, organizations or friends with similar interests.

How is graph search important to Facebook's future?

Graph search is aimed at identifying the overlaps in users' interests. Users can then be clustered according to interest groups. This allows Facebook to rank different clusters, or interest-based communities, according to their size, user engagement levels, and contribution to the top line. Going forward, this model will allow the social media giant to target ads to the right interest groups, improving efficiency and meriting higher payments from advertisers.

To complement search graph, Facebook has also stepped away from the typical practice of using monthly active users to demonstrate size. Instead, it has started giving statistics based on daily activity. The chart below, which present daily active users (both PC and mobile), offers deeper insight.

(click to enlarge)Click to enlarge

Source: TechCrunch

In the future, the user break down will go beyond regions and perhaps give country specific statistics. Such a sophisticated break down, paired with interest-based communities, will allow Facebook to understand its users even better. This will allow it to improve ad efficiency and more importantly, charge premiums to advertisers

Where do niche social sites come in?

Niche social sites are good acquisition targets for Facebook. The Instagram acquisition is a testament to this. Instagram photo and video ads are already on their way. Instagram, which was acquired last year, has more than 150 million users, up from 130 million in June. Facebook has waited for over a year before monetizing Instagram to allow users to establish clearly defined patterns that fit into the already existing interest groups in Facebook. This strategy promises more ad dollars for Facebook.

When stacked against startups, Facebook not only has bigger margins, but more cash on hand. In the second quarter, it increased its cash and cash equivalents by $6.7 billion. Facebook's cash pile, and not to mention its market share, gives it leverage over startups. Budding and established niche social sites will therefore be more inclined to accept acquisition offers from Facebook going forward. This will allow it to acquire niche social sites that have the potential to serve the interests of its different interest-based communities.

Google + is growing notably and seems to be outpacing soon to go public Twitter. As of April, Google + had more than 359 million active users and over 500 million registered users. This growth poses a huge threat to Facebook's interest-based approach. Through Google+ circles, users build communities where they share relevant insights in an ad free environment. Because it is integrated with other Google (GOOG) services, Google can use information it gets from the social platform to improve on ad targeting.

U.S. advertisers spent $3 billion on mobile ads in the first six months of the year, signaling a huge upturn from $1.2 billion a year earlier, according to Interactive Advertising Bureau. In the second quarter, Facebook's mobile ad revenue constituted 41% of total ad revenue, up from 30% in the previous quarter. The social giant's mobile prospects appear to be coming into greater focus at a time when mobile ads are on the rise.

Investor's takeaway

While the prospects offered by Facebook's interest-based model are engaging, investors should be concerned about the stock's valuation. Facebook's P/E ratio of 220.52 is significantly high compared with the industry average of 31.11 and Nasdaq's average of 22.9. However, future earnings growth overshadows the valuation concerns. Facebook is a good investment for the long haul.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.