Facebook: Revenue Went Up, But So Did Expenses

| About: Facebook (FB)

Facebook (NASDAQ:FB) is one of the most hyped up stocks in history. The company's market valuation surely experienced effects of a roller coaster in the last year. On Wednesday evening, Facebook announced its earnings. It looks like the company has made a lot of progress in many areas such as monetizing mobile applications and increasing revenue, but it still struggles in other areas such as cost reduction. If Facebook's expenses continue to grow as fast as the company's revenue do, this will not be very pleasant for the investors of the company.

In the last quarter, Facebook earned $64 million, which is down 79% from the same quarter last year. As Facebook's revenue grew by 40%, the company's expenses grew by 80%. Basically, Facebook is spending more money to earn less money. Until recently, Facebook had very few employees and very limited costs. Now, as the company is growing rapidly, it has to hire more people, which may cut into the company's margins. At the end of the day, low margins might be a new normal for Facebook if it doesn't find a way to grow its revenue much faster than its expenses grow.

A lot of times, when a company is in a rapid growth mode, investors don't mind it spending a lot of money to finance such growth. For example, investors allow Amazon (NASDAQ:AMZN) to have a high P/E ratio because they believe that most of the company's expenses will turn into growth in the future. The issue becomes a problem when the high expenses become a permanent thing and continue to eat into a company's margins even after the growth rate slows down. This quarter wasn't the only quarter when Facebook's expenditure growth passed its revenue growth either. In the previous quarter, Facebook's revenues grew by 34% whereas the company's expenses grew by 64%.

Most of Facebook's member growth in the next decade will happen in countries outside of North America and Western Europe. In these regions, Facebook will have even more trouble with monetizing its members than it currently does in North America and Europe. Currently Facebook derives 23% of its revenue from mobile applications compared with 14% in the last quarter. Obviously Facebook wants to take advantage of the switch of users from computers to mobile applications. Outside of the U.S. and Europe, the users of Facebook's mobile application are far less likely to lure advertisers than in these regions. In the developed nations, more people have high-end smartphones, whereas in the developing nations, most people tend to have low-end smartphones.

Ideally, advertisers would prefer users with high-end phones because they have more money to spend. Just to give an example, Apple's (NASDAQ:AAPL) market share in the U.S. smart phone market is more than 50%, whereas the company's market share in countries like India, and China, is far less than that. Because Apple's users tend to be consumers with extra money to spend, advertisers love these users. In Android devices, advertisers would prefer high-end smartphone users over low-end smartphone users because the same principle applies to them as well. In other words, Facebook will make far less money in countries where fewer people have high-end phones. Interestingly enough, this is where Facebook's growth will come in the next 10 years.

Back in October, when the sentiment in Facebook was near an all-time low and Facebook was trading for $20 per share, I wrote an article saying that Facebook might be worth a look. Since then, the share price rallied too much and too fast without much support from the fundamentals. Once the investors realized that Facebook figured out a way to make money from mobile devices, they bought the stock like there is no tomorrow. The story doesn't end there though. Monetizing members in the U.S. and Europe will not be good enough to make Facebook a $70 billion company. The company will have to do a lot more than that to be worth this much. If Facebook were held to the same standard as Apple is, it would struggle to be a $10 billion company. For the time being, I would stay away from Facebook. While I wouldn't buy it, I wouldn't short it either, because the market is full of investors that love to pump stocks based on nothing but hype. If Facebook can double its revenue without doubling its expenses in the next year, I would consider it, but I am doubtful that Facebook can do that at the moment.

Disclosure: I am long AAPL. 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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