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Few companies are as controversial as Facebook (NASDAQ:FB). For some investors, Facebook is a long-term investment in a more social, more connected world. And to others, Facebook is seen as a definition of the excesses of Wall Street. Facebook's Q2 earnings report, which occurred at the end of July, was the most anticipated earnings release of the season, and Facebook failed to deliver. As we reported back in July, the numbers themselves were not the issue. Facebook met EPS estimates, and actually delivered a slight beat on revenues. The issues arose from what the company said on its call, or rather, what it did not say. CFO David Ebersman was vague about the company's expense growth, and given what occurred with the company's IPO, investors assumed the worst. Facebook has lost control of its narrative, and in order for its stock to recover, it needs to recapture control of the story that is being told about the company.

But, on October 23, Facebook will have a chance to redeem itself with its Q3 2012 earnings release, set to be announced after the markets close. In this article, we will provide an overview of expectations, as well as what Facebook needs to say to investors.

Overview: Swinging from Wild Optimism to Wild Pessimism

Sell-side analysts are a very interesting category of market participants, and few companies define one of the key issues in sell-side analysis better than Facebook. Fundamental equity research is an art, not a science, and it will never be perfect. However, that does not mean that there is room for improvement. With many companies, analysts often inflate their expectations of earnings and revenues to unrealistic levels, and then ratchet them down to unrealistic lows, unable to find a proper equilibrium.

Facebook may very well be affected by this trend. As of this writing, the consensus Reuters EPS estimate for Facebook is 11 cents per share (based on an average of 34 analyst estimates).

Click to enlargeThat represents a slight sequential decline from Q2 2012, but we believe that Facebook has room to beat those estimates, for several reasons:

  1. Analyst uncertainty: After the company's Q2 results, even analysts that were bullish on the company noted that it was difficult to gauge estimates for the second half of 2012, due to the company's vagueness regarding its expenses. It is possible that Facebook has been more disciplined with expense controls this quarter, which could leave room for an upside surprise
  2. Mobile revenue growth: While we will discuss this topic in more detail later, this is another avenue for a potential earnings beat. On its Q2 call, Facebook noted that its mobile revenue run rate was at $500,000 per day, and that was when its mobile advertising solutions were not fully rolled out across the company's international markets. Now that a full quarter has passed with Facebook's mobile advertising tools in the field, it is possible that the company's' mobile revenue run rate has accelerated, which could help the company surpass expectations.

In our view, Wall Street's reaction to Q3 results will once again be dominated not by the numbers that Facebook posts, but by what it's executives say.

Mark, Sheryl, and David: 3 Executives, 3 Perspectives

Earnings conference calls often serve to define the relationship between a company and its investor base. Given that CEO Mark Zuckerberg has majority control of the company, this becomes even more essential. Facebook needs to take a page from Google's (NASDAQ:GOOG) playbook, one of the pioneer's in Silicon Valley's drive towards CEO /management control in how it manages its relationships with its investors. Google does not provide guidance, and it does not really care about what its investors think in the short term. But, CEO Larry Page takes great care to articulate the company's long-term strategic vision, and CFO Patrick Pichette gives walks investors through the company's finances in a clear and detailed way.

At Facebook, CEO Mark Zuckerberg, COO Sheryl Sandberg, and CFO David Ebersman all have important roles to play, and they need to be at their best when the company releases its Q3 earnings. Each has a role to play, a perspective to provide, and a message to deliver to investors.

  1. Mark Zuckerberg: No one expects Zuckerberg to field detailed questions regarding Facebook's financials, or the state of its advertising business. That is not his area of expertise, and frankly, it would be a waste of time to have Zuckerberg discuss these issues. Rather, Zuckerberg needs to repeat what he did during Facebook's Q2 results. He needs to lay out the company's long-term strategic vision, especially how it relates to the company's push into emerging markets. How will Facebook build profitable user bases in new territories? How is Facebook approaching China? And perhaps most important of all, how is Facebook working to keep users engaged?
  2. Sheryl Sandberg: More than ever, investors and critics are questioning the potential of Facebook's advertising business. The optimism that was prevalent leading up to the company's IPO has given way to large levels of pessimism, and it is up to Sheryl Sandberg to prove to investors that such pessimism is unwarranted. As COO, Sandberg is, in some ways, more important than Zuckerberg to Facebook's long-term success. She is the one responsible for turning Zuckerberg's vision into a business reality, and we believe that this is one of the toughest jobs in Silicon Valley. Sandberg needs to articulate that the company's advertising solutions are working, with a particular emphasis on the company's growing mobile business. She needs to showcase client successes with mobile advertising, as well as discuss how user engagement within the company's mobile applications has been affected (if at all) by the growth of mobile advertising. In recent interviews, Sandberg has already stated that mobile users are 20% more likely to return to Facebook on any given day then desktop users, and that mobile ads have 10x the recall of their desktop counterparts. On the call, Sandberg needs to provide exact figures regarding engagement in the company's mobile applications (as well as the desktop), and lay out the company's roadmap for ramping up its advertising platforms.
  3. David Ebersman: After Facebook's Q2 earnings conference call, many were quick to assign the blame for the stock's selloff to what David Ebersman did not say during that call. While we think it is unfair to blame Ebersman entirely for Facebook's stock drop, we do believe that he has a role to play. The kind of vagueness regarding expenses that he displayed during Facebook's Q2 earnings is unacceptable. That may work for Peter Oppenheimer and Apple (NASDAQ:AAPL), but Facebook is not Apple, and unlike Apple, the company is not known to have a penchant for secrecy. The fact that Facebook is growing its expenses and investing in its business is, on its own, not the issue. The issue is that Ebersman provided no insights into expenses other than the fact that they will accelerate in the second half of 2012. That kind of uncertainty needs to disappear from the company's Q3 call. CFO Ebersman should provide clear insight into how the company is investing in its future, as well as provide a timetable as to when growth in operating expenses will abate. Even when expenses associated with the company's IPO (such as payroll taxes) are excluded, Facebook's expenses soared 60.05% in Q2 2012, and Ebersman should provide some indication of when this trend will end.

In our view, what these 3 executives say matters just as much, if not more, as what figures the company posts for revenues and earnings. Facebook needs to take a more proactive role in addressing criticism of the company's business model. The burden of proof rests with Facebook, and the markets view Facebook as guilty until proven innocent when it comes to its ability to translate its huge user base into top-line and bottom-line growth.

Addressing the Issues

Aside from a need to provide excellent commentary about Facebook's vision, products, and finances, the company's top three executives also need to discuss several key issues. In this article, we highlight the 3 issues that we believe Facebook's management must address on the company's Q3 earnings call.

  1. Instagram: Facebook's acquisition of Instagram closed on September 6, making the photo-sharing network an official subsidiary of Facebook. So far, Facebook has been silent about exactly what it intends to do with Instagram. However, there is certainly potential there. At the end of September, Instagram surpassed Twitter in the number of active mobile users it has, with 7.3 million people using Instagram daily. Given that Facebook paid $736 million (the number dropped from the $1 billion price tag given when the deal was announced due to the drop in Facebook's stock) to take control of Instagram, investors will likely want to hear exactly what Facebook plans to do with the photo-sharing network? Will it be folded into Facebook's existing mobile applications? Or will Instagram remain as a standalone entity, operating independently of Facebook?
  2. ARPU: Facebook needs to address the monetization of its users, a source of concern for many investors. We, however, believe that for the time being, Facebook's ARPU growth rates are acceptable. Below is a table of Facebook's Q2 ARPU and ARPU growth rates.

ARPU grew in the double digits in all regions except Europe, and the United States and Canada, Facebook's most profitable markets, posted the second highest regional growth rate. ARPU also grew sequentially as well, with the United States and Canada again coming in at #2 in terms of growth rates. With Facebook's mobile advertising products now out for a full quarter, we expect that ARPU in geographies outside Europe and Asia will continue to rise, given the disproportionate use of mobile devices to access Facebook in those geographies. We believe that as Facebook matures, it will become more and more important to monetize its users, as opposed to growing the user base. With the billion users mark crossed at the start of October, Facebook now has around 1 out of every 7 people in the world using its service (the Census Bureau estimates the world population to currently be just over 7 billion). In any case, Facebook's user growth rates will likely peak sooner rather than later, and the reason is simple demographics. Much of the world still lives without access to the Internet or a computer (the global Internet penetration rate stood at 32.7% at the end of 2011). Facebook's growth rate will soon begin to change, for two reasons. As Facebook reaches more and more users in its developed markets (the company has almost 168 million users in the United States), it will eventually reach a point where every person who might use Facebook already does. When that point is reached, Facebook's growth rate will become tied to population growth rates; new users will join Facebook as they reach the "appropriate" demographic profiles. And on a global basis, Facebook will become more dependent on a rise in Internet penetration rates. But, these trends are not negatives. While adding new users is certainly an important aspect of what Facebook does, monetizing existing users is essential as well

  1. Mobile advertising: As we stated in our prior article on Facebook, the company already has the world's second largest mobile advertising business, behind only Google. At a $500,000 daily revenue run rate, Facebook's mobile advertising revenues amount to $182.5 million in annualized revenue, a figure we expect will rise when the company announces its Q3 results. Unlike many companies attempting to build a sustainable mobile business, Facebook is cash flow positive, profitable, and has all the resources needed to invest in its mobile business. On the company's Q3 call, COO Sheryl Sandberg will have to state explicitly that the company is working to monetize its mobile users, and present, in an articulate way, first-party data from Facebook that corroborates third-party studies highlighting the success of Facebook's mobile advertising. Facebook's mobile advertisements have click-through-rates that are 11x higher than that of traditional desktop advertising, and even with lower costs-per-click, the market potential of mobile advertising is, on a global basis, far larger than that of traditional desktop advertising. In addition, we would like to hear Sandberg discuss Facebook's reported mobile advertising network for third parties, which is a potentially lucrative new revenue source. Facebook, using the vast amounts of data it collects, could help solve one of the problems many software developers in the mobile space face: the fact that mobile applications cannot "look" at cookies that lie within a browser. But, the fact that many applications are integrated with Facebook could go a long way to solve this problem. Facebook has already surpassed Pandora (NYSE:P) as the world's 2nd largest mobile advertising business just a few weeks after launching it, and we believe that Facebook is on the right path with regards to monetizing its mobile usage. Sandberg needs to highlight Facebook's success to date in mobile, and lay out, in detail, how the company will ensure that its momentum in mobile remains intact.
  2. Zynga: Much has been made over Facebook's connection to Zynga (NASDAQ:ZNGA), and how that company's weakness may or may not bleeding into Facebook's top and bottom lines. Facebook needs to quantify its relationship with Zynga, and explain what kind of exposure Facebook has to that company. Facebook's IPO filings stated that Zynga accounted for 12% of its revenue in 2011. We believe that Facebook needs to quantify what that figure is today. Given what has happened, investors are naturally assuming the worst when it comes to the Zynga-Facebook relationship. This issue, which CFO David Ebersman should take time to address (since it relates directly to financial metrics), has created a fairly tight relationship between shares of Zynga and Facebook over the past 3 months, and in order to break it, Facebook needs to address the issue of its exposure to Zynga head on.

Whether Facebook's executives like it or not, the burden of proving that it is succeeding lies with them. There is an enormous amount of skepticism regarding the company, skepticism that, while unwarranted in the long term, needs to be addressed head-on in the short term. Facebook has been allowing critics of the company to control the narrative, and it needs to rectify the situation. By addressing these 4 issues, and ensuring that each of its top 3 executives says exactly what needs to be said, we believe that Facebook can go a long way towards containing the skepticism that is surrounding the company.

A Word on Valuation

Much of the criticism levied at Facebook has been rooted in the company's valuation. As of this writing, Facebook trades at $19.48, which values the company at just over 40x estimated 2012 EPS of $0.48.

Facebook is set to grow its earnings by 29.167% in 2013, and based on estimated 2013 EPS of 62 cents per share, Facebook trades at 31.419x estimated 2013 earnings, which in our view, is not a dramatic overvaluation when compared to Facebook's expected growth rate. And, should Facebook surprise to the upside with its Q3 earnings, we believe that analyst estimates for 2013 could prove conservative.

A Word on Observational Bias

In investing, allowing your emotions to distort your thinking is perhaps the most dangerous threat to consistent profitability. Investors should not let personal beliefs and viewpoints about things such as the role of government or the "morality" of a particular business to cloud their judgment about a potentially profitable investment.

But another aspect that investors need to be cautious of is personal observational bias. Many readers of articles regarding Facebook here on Seeking Alpha, as well as other news sources, argue that Facebook is a poor investment because it is not a useful product or that they have never thought Facebook's ads are effective. Such personal observations, in our view, need to be discounted. If Facebook's advertising tools weren't useful, the company would never bring in a single dollar of revenue. Could they be better? Of course they could. That is why Facebook is working each day to improve its advertising tools, both on the desktop and in mobile. Personal observations rarely make for sound investing decisions. Simply because you may prefer an Android smartphone over an iPhone does not mean that Apple's stock should be avoided. And even though you may visit Starbucks (NASDAQ:SBUX) every day, and the baristas know what you will order as soon as you walk through the door, it does not mean that you should go out and buy Starbucks stock. A decision on Apple and Starbucks needs to be made using an objective analysis of their financial results, market opportunity, and the risks that they face, not how someone feels about these companies. Investors regularly buy shares of companies that they will likely never directly do business with, such as Lockheed Martin (NYSE:LMT) or Annaly Capital (NYSE:NLY). The fact that they don't interact with such companies does not preclude them from investing in these companies. And personal observations should not preclude (or be the reason for) an investment in any company. Such a decision needs to be based on other factors.

Conclusions

Facebook's best days are ahead of it, not behind it. That is the message that Facebook needs to deliver loud and clear when it announced its Q3 2012 earnings. CEO Mark Zuckerberg, COO Sheryl Sandberg, and CFO David Ebersman need to take control of the narrative regarding this company. They need to address Facebook's strategic vision, what it plans to do with Instagram, what is going on with average revenues per user, how it is succeeding in mobile advertising, and what the state of its relationship with Zynga is. We continue to believe that an investment in Facebook will be a profitable one, but think that investors should hold off on buying shares until after Q3 earnings are released. Even if Facebook rallies on the back of solid earnings and a solid conference call, there will still be upside to be realized in the long term. Facebook is certainly a controversial company. But for investors who have the conviction to stay with the company, it is one that we believe will deliver solid returns in the long run.

Source: Facebook Q3 Earnings Preview: Recapturing Control Of The Narrative, And What Needs To Be Said

Additional disclosure: We are long shares of Google via the Fidelity Growth Company Fund.