Facebook Rallies On Impressive Results

| About: Facebook (FB)

On Tuesday afternoon, Facebook (NASDAQ:FB) reported its fiscal third quarter earnings. The company beat on both the top and bottom line, and some internal numbers appeared to be very good. That sent shares soaring on Wednesday, finishing the day up 19%. With Facebook shares having their best day since going public, the entire space rallied, something that hasn't happened much. After this report, analysts seemed very willing to jump on the Facebook train, and investors may not be as concerned now about upcoming lockup expirations.

Third Quarter Results:

Facebook reported revenues of $1.262 billion, beating estimates for $1.23 billion. Non-GAAP earnings per share of $0.12 beat by a penny. On a GAAP basis, the company lost 2 cents per share.

To break down the overall numbers, I'll first show a margin table and then describe how these numbers came to be. For purposes of this discussion, the margin numbers below, and analysis afterwards, will be based on the reported GAAP results.

*2011 profit margins for Class A and B shareholders would have been 15.72%, after reducing the net income by $77 million for "net income attributable to participating securities".

For the quarter, Facebook reported a revenue increase of $308 million, a rise of 32.29%. However, Facebook's cost of revenues increased a little faster, a rate of 36.44%. Thus, gross margin dollars rose by just 30.92%, leading to the decline in gross margins above.

On the operating side, R&D expenses were up nearly 126% for the period. Sales and marketing rose more than 47%. General and administrative expenses rose by more than 84%. Overall, operating expenses rose by 85.20% over last year's period. That led to a 9% drop in operating income. As you can see above, operating margins for the period plunged.

Now, Facebook stated that part of the large rise in expenses was due to share based compensation expenses. Third quarter costs and expenses (including the cost of revenues) were $885 million, an increase of 64% from last year's period. Excluding share-based compensation and related payroll tax expenses, non-GAAP costs and expenses were $737 million, an increase of 57%.

In the prior year period, Facebook had net income of $227 million, or $150 million after taking out the above mentioned $77 million. However, in this year's period, the company lost $59 million on a GAAP basis. The huge decline was due to a 183.6% rise in the company's tax provision. As Facebook stated, their effective tax rate was nearly 116%. However, if you take out the portion of payroll tax expenses and share based compensation expenses that were not tax deductible, their non-GAAP effective tax rate was about 40%.

Other Important Metrics:

When it comes to Facebook, it is not just about dollars and cents. It also is about the user base. Facebook reported the following data:

  • Monthly active users were 1.01 billion as of September 30, 2012, an increase of 26% year-over-year.
  • Daily active users were 584 million on average for September 2012, an increase of 28% year-over-year.
  • Mobile monthly active users were 604 million as of September 30, 2012, an increase of 61% year-over-year.
  • Instagram registered users surpassed 100 million, up from 27 million at time of acquisition.
  • News feed ads on $4 million per day run rate, and three quarters of that was from mobile.

Obviously, the increases in the user base are good, but only if you can make money off them. Facebook has been criticized by those who don't believe the company can properly monetize its user base, but it appears this quarter was decent.

Balance Sheet:

Facebook's balance sheet looks very good, and perhaps maybe that is due to the IPO, which might have raised a bit too much money. The following table shows some key ratios, both before the IPO, and the two quarters after it.

Facebook had nearly $10.5 billion in cash and marketable securities at the end of Q3. The company had roughly $2.48 billion in cash alone, well more than the $1.86 billion in total liabilities.

So what should Facebook do with that amount of cash? Well, I see two possibilities. First is acquisitions, and this makes the most sense for a company with a growth oriented strategy. A number of people have discussed the possibility of Facebook buying out Zynga (NASDAQ:ZNGA), and it certainly is possible. With all of the troubles Zynga has had, the market cap had dropped to just $1.6 billion at Wednesday's close. Facebook has more than enough cash to make this acquisition. Zynga will be a little more expensive to acquire though after its earnings report, which came out Wednesday afternoon. With revenues beating estimates and the company announcing a buyback plan, shares were up sharply in the after hours session. Also, Facebook probably will try to make some sort of mobile related acquisition, to beef up their presence in the space.

The second thing they could do, potentially, is return some of that cash back to shareholders. I don't think they are going to start a quarterly dividend, so it would have to be a one-time special dividend. That doesn't seem too likely. The most likely scenario would be to buy back shares. This would be a signal that the company believes the stock is undervalued, and would reduce the outstanding share count. Maybe the company does this through a privately negotiated transaction with insiders. Remember, there is a lockout expiration in November that will allow insiders to start selling more than a billion shares. Even if Facebook buys back just $2 billion worth of shares, it could be enough to move the needle in a big way.

Analysts jumping on board:

There were a number of postive analyst reports out Wednesday morning after the Q3 report.

Citigroup's Mark Mahaney increased his rating from Neutral to Buy, but did cut his price target from $35 to $30. Mahaney stated that Facebook is showing some progress in mobile, stating "The overall point is FB is showing revenue acceleration due to a mobile pricing tailwind, while other companies, such as Google (NASDAQ:GOOG), are facing mobile pricing headwinds." Mahaney raised his 2012 adjusted EPS two cents to 52 cents a share on revenue of $5.03 billion, up from $4.85 billion.

That is a very important point. Facebook is doing well where Google is struggling. I just recently covered Google's disappointing quarter, where Google widely missed on both revenues and earnings. The Motorola Mobility segment produced an operating loss, something that was not expected. Google shares had dropped about 15% from their recent high, as many are now getting used to plunging margins. Google's net margins were nearly half of what they were just a few quarters ago. That is not a very good sign.

The second positive note came from Stifel's Jordan Rohan, who raised his rating from Hold to Buy, while reiterating a $26 price target. Rohan believes that ad money is going to where the activity is, and that's mobile. Rohan raised his estimates for this year to $5 billion and 52 cents a share from a prior $4.95 billion and 48 cents a share. For 2013, he sticks with a $6.44 billion revenue estimate while raising his EPS estimate to 66 cents from 59 cents.

The last note came from Merrill's Justin Post, who raised his rating to Buy from Neutral and target from $23 to $31, but shifted that target out until 2014, writing that "3Q results suggest that FB can effectively grow revenues while usage transitions to mobile platforms from PC." Post raised his estimates for this year to $5.05 billion and 54 cents from a prior $4.99 billion and 51 cents, and raised his 2013 estimates to $6.69 billion and 65 cents from a prior $6.43 billion and 63 cents.

These are just three analyst reports, and I'm sure we'll get more upgrades, price target hikes, and estimate raises in the coming weeks. That contrasts with recent analyst negativity, which had taken revenue and earnings estimates, along with price targets, down to their lowest levels since the IPO. The 2013 revenue number had been cut down to $6.28 billion entering the Q3 report, and this number was at nearly $6.5 billion just a few months ago. The average price target, which was at $28.52 earlier this week, the lowest point since the IPO, was down to $28.07 going into Q3's results. I'm guessing it will start leveling off a bit, and may in fact trend higher in the coming weeks. But remember, the average price target was above $38 at the end of June.

Final Thoughts:

This was definitely positive news for Facebook, and if Zynga rallies like it did in Wednesday's after-hours session, Facebook shares could continue higher. Facebook did come back down a bit, as it was up about 30% in pre-market, and only finished up 19% for the day. But 19% is still a nice gain, and almost three times as much as Facebook was up in Tuesday's after hours session.

This report was certainly a turning point for Facebook shares, but only for now. This was one good quarter, meaning Facebook is now 1 for 2 in terms of public earnings reports. Facebook will have to repeat this performance next quarter, and the next, and so on. Also, there is a billion plus share lockup expiration ending in November, and that will be the next true test for shares. This report should help ease some of the concerns, but this stock is still down 39% from its IPO price. Tuesday's news was a good start, but Facebook still has more to prove.

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.

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