Facebook - Strong Earnings Growth Will Continue Unless New Challenges Arise

Apr.29.14 | About: Facebook (FB)


Subscriber growth, mobile advertising and global ARPU are all strong.

Annual run rate of earnings of $6 billion should be possible in one or two years.

Zuck's acquisition binge might be pricey and risky in the short term, yet it might be crucial in the long term.

Last week Facebook (NASDAQ:FB) opened its books for the first quarter of 2014. While results were strong, shares sold off after the release of the report as investors continue to avoid technology names and questions arose about the sudden departure of its CFO.

In the wake of the report, shares have sold off some 10%, creating possibly a nice entry point for long-term believers in the company's social network and Zuckerberg's aggressive acquisition strategy.

First Quarter Highlights

Facebook reported strong topline revenue growth as revenues came in at $2.50 billion, up 71.6% on the year before. The sales increase resulted in a big boost to Facebook's earnings.

Operating earnings nearly tripled to $1.08 billion as Facebook's business model allows for these incredible fat operating margins. GAAP earnings nearly tripled as well to $642 million, with diluted earnings per share increasing towards $0.25 per share. The rapid growth in reported earnings is despite a very high effective tax rate of 40% in the past quarter.

Operational Highlights

Operational metrics remain very strong as well. The number of monthly active users increased by 15% to 1.28 billion users of which little over a billion access the social network via their mobile phone.

Advertising revenues were up by 82% to $2.27 billion, implying that Facebook generates $1.77 in average revenue per user (ARPU). Of these revenues, an incredible 59% is being generated through mobile advertising, a ratio which has been unthinkable two years ago.

Crucial for Facebook is to close the ARPU gap between the most developed North American markets, Europe and the rest of the world. Global ARPU including payments revenues came in at $2.00 per user, up from just $1.35 last year. Users in North America generate by far the most revenues, as they are most interesting for advertisers.

Facebook generates ARPU of $5.85 per North American user which is huge. However, a little over 15% of Facebook's users reside in this continent with the vast majority of users logging in from Asia and the rest of the world. ARPU in those areas is just $0.93 and $0.70 a quarter, respectively. It is exactly this gap which creates much more potential for Facebook going forwards, that is if it manages to narrow the gap significantly in the future.

Back Of The Envelope Calculations

It is not at all unthinkable for Facebook to have 1.5 billion users one or two years down the road. A challenge and target should be to drive ARPU towards $3 at that moment, creating a recurring annual revenue base of $18 billion. With operating margins approaching 50%, operating earnings of $9 billion should be attainable, resulting in GAAP earnings of roughly $6 billion per annum.

With shares trading at $56 per share, the market values Facebook at $143 billion, or at roughly $130 billion when excluding its net cash position of $12.6 billion. This calculation would value the business at roughly 22 times earnings in about 1-2 years ahead in time.

Risks To The Valuation

The assumptions used in the calculation as performed above should be quite easily attainable if current trends are sustained, and Facebook's popularity across the world remains intact. To remain relevant and offer the best and broadest services to its customers, Zuckerberg has gone on an acquisition spree in recent times. Instagram's purchase which was once seen as a very expensive addition has been widely applauded by now.

The $16 billion deal to acquire WhatsApp has been less widely applauded. Yet recently the service announced that it already passed the 500 million subscriber rate and its popularity could be crucial for Facebook's so-important mobile applications as well as ambitions. With the text messaging service, Facebook has laid the foundation in combination with its own operations to expand services in the future, possibly even creating a payment provider similar to eBay's (NASDAQ:EBAY) PayPal.

Besides Instagram and WhatsApp, Zuckerberg relies on Facebook's own messaging offerings, smarter news feeds which boost advertising efficiency and even more spectacular new ventures. The latter category obviously includes the recent $2 billion acquisition of Oculus in order to join the race for the wearable technology market.

Takeaway For Investors

At levels around $56, shares of Facebook have lost little over a fifth of their value from their highs of $72 per share. The general technology sector sell-off and the acquisitions of WhatsApp and Oculus have spooked some investors, despite continued strong operational performance.

The continued healthy trends in engagement, user numbers, mobile success and ARPU shows a nice growth trajectory for the coming quarters which should result in a continued profit explosion.

As a result, the valuation based on let's say 18 months ahead looks fair at 22 times earnings, especially when considering the growth profile and prospects of the firm. A lot of the valuation depends on Facebook's ability to boost ARPU by boosting the success rate of advertising on its platform, and the continued popularity of its network. In such a scenario, more upside might lie ahead.

While this might be a plausible scenario, the strong recovery following the public offering disaster has pushed up the valuation significantly. This is especially the case in combination with new stock being offered down the road. While Facebook has overcome the challenges to succeed in mobile, yet unknown new issues might arise thereby putting significant pressure on the prospects and Facebook's valuation.

Good luck to you all.

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.