Facebook: Following Bezos' Strategy To Sacrifice Short-Term Gain For Long-Term Potential

| About: Facebook (FB)
This article is now exclusive for PRO subscribers.

Shares of Facebook (FB) have seen a good week, trading with gains of over 5% for the past week despite a modest correction in Friday's trading session.

The social networking giant reported its first quarter results on Wednesday after the close. The report reveals that under command of CEO Zuckergerg, the website is rapidly increasing its future earnings capacity. Like his highly successful colleague Jeff Bezos, Zuckerberg is happy to forego short term gain for long term potential.

First Quarter Results

Facebook generated first quarter revenues of $1.46 billion, up 37.8% on the year before. Revenues came in slightly ahead of consensus estimates of $1.44 billion.

GAAP operating profits fell by 2.1% to $373 million, sending operating margins tumbling by 10.4% to 25.6%. The company notes that non-GAAP operating profits rose from $485 million last year to $563 million, resulting in a 7.2% non-GAAP margin compression to 38.6%.

Non-GAAP net income rose 8.7% to $312 million, as non-GAAP diluted earnings per share came in unchanged at $0.12 per share. GAAP net income rose by 6.8% to $219 million, with diluted GAAP earnings per share came in unchanged at $0.09 per share. Non-GAAP earnings of $0.12 per share missed consensus estimates by a penny.

CEO and Founder Mark Zuckerberg commented on the developments in the first quarter: "We've made a lot of progress in the first few moths of the year. We have seen strong growth and engagement across our community and launched several exciting products."

Looking Into The Results

Facebook revenue growth was mainly driven by solid growth in the user base. The number of daily active users increased 26% to 665 million, while monthly average user numbers were up 23% to 1.1 billion. The majority of Facebook's users are now accessing the social network site with mobile devices, as the number of active users on a mobile platform increased by 54% to 751 million.

Revenues were driven by increased advertising proceeds, which were up by 43% to $1.25 billion, thereby making up 85% of total revenues. Yet total advertising revenues fell short compared to consensus estimates of $1.27 billion.

Costs kept increasing at an alarmingly high rate as Facebook continues to invest heavily into the future. GAAP operating costs were up 60.3% to $1.08 billion. This includes $170 million in stock-based compensation which was up 60.6% on the year as well. Facebook increased its investments in headcount and infrastructure.

On a positive note, Facebook increased its research and development efforts by 91.5% to $293 million. While these expenses are classified as operating expenses, they really are an investment into the future.


Facebook ended its first quarter with $9.6 billion in cash, equivalents and marketable securities. The company operates with $1.5 billion in long term debt, for a solid net cash position of $8.1 billion.

For the full year of 2012, Facebook generated annual revenues of $5.09 billion on which the company reported a net income of merely $53 million. Based on an extrapolation of first quarter results, Facebook could report full year revenues of between $6.5 and $7.0 billion. The company is on track to report net GAAP earnings approaching $1 billion for the year.

Factoring in the 4% bounce in Thursday's trading session, the market values Facebook around $67 billion. Excluding the net cash position, operating assets are valued around $59 billion. This values the company's assets around 8.5 times annual revenues and 59 times expected earnings.

Facebook does not pay a dividend at the moment.

Some Historical Perspective

Well-documented is the failed public offering of Facebook, now a year ago. Shares were offered to the public at $38 per share and after witnessing an initial print higher, shares managed to end the day with very small gains to lose in the following days.

The bearish sentiment was at its highs around August when shares hit the $18 mark. A recovery driven by hopes about better mobile performance send shares back to $32 in January, with shares currently exchanging hands around $28 per share.

Between 2009 and 2012, Facebook reported a six-fold increase in annual revenues, coming in around $5.1 billion over the past year. The company has been solidly profitable, but both absolute and relative profits have declined in 2012, with a recovery expected in 2013.

Investment Thesis

As Facebook has already established a massive user base of 1.11 billion monthly users, there are some key drivers which analysts and investors look for to create value. Key value drivers are engagement, average revenues per user (ARPU) and the mobile advertising performance.

Facebook's engagement hit new records which came as a surprise to some as rumors hit the markets that some users were leaving the social network. Some 60% of the monthly user base of 1.11 billion logged in on a daily basis, a new record.

Average revenues per user were up some 11.6% coming in at $1.35 for the quarter. With the growth slowing down in the user base, increasing revenues per existing user becomes increasingly more important. Important is to distinguish between geographies as well. North American ARPU hit $3.50 per user, up 20.7% on the year, while the large user base in Asia and the rest of the world generated ARPU of just $0.64 and $0.50, respectively. Note that if Facebook could generate $3.50 per user across the globe its quarterly revenues would come in around $3.9 billion for the first quarter. Key for value creation will be to close the gap, or at least rapidly increase ARPU in the rest of the world.

Last is the advertising performance. Total mobile advertising revenues made up 30% of total advertising revenues in the first quarter, which is up 700 basis points form the fourth quarter and compares to zero revenues in the first quarter of last year. Total mobile revenues of $375 million easily beat consensus estimates of $340 million, as some 189 million users only accessed the network from their mobile phone. The strong performance alleviates the fears that increased mobile adoption would hurt Facebook's revenues and profitability due to fewer advertisement possibilities.

Right now, Facebook is still in its investment phase as it reports "steady" but low non-GAAP earnings as the company is boosting its capacity to invest in new apps and tools. In a sense, the company is managing earnings, similar to likes of Amazon.com (AMZN) in its attempt to sacrifice short term profit for long term value creation.

Examples of these investment is Facebook Home which allows user to make more personalized experiences with their apps. Other large investments are the social graph and the acquisition of Instagram last year to grow the user experience in sharing their life with friends and relatives online. The company is furthermore investing in an own application store to compete against the likes of Apple (AAPL) and Google's (GOOG) Android platform. Some 25 million apps have already been downloaded over the past quarter.

With a solid growth in average ARPU, the user base and a good mobile adoption, Facebook had a solid quarter in expanding its "earnings capacity." The company could have "easily" reported double net earnings on a GAAP basis if it kept cost under control, but Zuckerberg decided to keep investing to build the franchise. This is the smart way in the long term.

Don't be fooled by the sky-high short term price-earnings ratio's but try to look three years into the future. If the company can grow revenues by 25% over the next three years it could achieve annual revenues of $10 billion in 2015. If net earnings could recover to previous levels, being around 25% of net revenues, earnings could come in around $2.5 billion for the year, making forward valuations much more acceptable at roughly 6 times annual revenues and 24 times earnings.

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.