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Facebook: High User Growth Phase Is Over

|Includes: Facebook (FB)

Facebook reported earnings on October 23 2012 beating the street's estimates by 1 cent. Analysts were surprised by the acceleration in advertising revenue as Sponsored Stories/News Feed ads gained significant traction, especially on mobile. They believe these results will set the stage for a strong 2013 and expect continued forward mobile ad trajectory. As monetization continues to accelerate Analysts are watching to ensure it does not lower individual user engagement.

As I did more research on the quarter there were 3 things that stood out to me, and drove me to build a new model:

Facebook's Strategy:

During the call Mark reviewed Facebook's strategy. 1) Build the best mobile product 2) Build a platform so apps can be social 3) Build a strong economic engine.

This sounds good on the surface, as analysts had been concerned about mobile for the 1H of the year, and this likely drove the stock price down. In the S-1 filing Facebook's first bullet point regarding strategy was to "Expand Our Global User Community." Why didn't Mark refer to this during the call? Will they continue to grow and what are the penetration rates by region? After a deep dive, growing the user base appears very limited.

Facebook's User Penetration Rates - User growth is limited:

Why doesn't Facebook disclose user penetration rates? So I came up with my own estimates. Internet Users data is from here. Facebook has been operating in the US & Canada for roughly 9 years, and I would classify it as a mature market. Therefore, I conclude max penetration rate for MAUs per region is ~75%. Which leaves a little growth in North America, and some decent growth left in the rest of the regions. The problem with this is that a User is worth substantially more in North America VS the rest of the world.

Facebook did not disclose mobile MAUs by region, like all other data. More than likely because they have already highly penetrated Mobile MAUs in US & Canada (high value regions), which leaves limited high value mobile growth.

Users Model by region)Facebook Users Model

Revenue per User is weak in all regions other than US & Canada:

I believe that Europe will be able to recover somewhat in 2013/2014 as they come out of recession driving revenue per user up, but will still lag the US revenue per users. Facebook will slowly continue to monetize their product, but it's wishful thinking that there will be a "Aha Moment" in the near future dramatically driving revenue up. Management has made it clear that their focus is not on growing the top line. The company has referenced this before:

· Simply Put: we don't build services to make money; we make money to build better services - page 68, letter from Mark

· Several times during the Q3 call management said they had not really tried to monetize yet... why not?

Mark retains voting power of the company for at least the next year as he has pledged not to sell any of his shares. Mark will continue to focus on developing products, and platforms and not growing monetization, and he cannot be challenged to do otherwise. This creates a risk that users will grow tired of the platform, competition may steal user engagement time (hello twitter), all before the company focuses on monetization. Facebook has already crammed the side bar with ads, and may face user fatigue if they further stuff the news feed with ads.

Advertisers are already growing weary of using Facebook's platform for advertising as has been seen in several public notes (ex: GM, Mark Cuban). Facebook may remain challenged to keep brands interested in advertising on their platform, appose to another platform where they can reach all their user base (twitter, tumblr, myspace).

As Facebook rolls out some new products such as FBX, Mobile App-Installs, Customer Audiences, and Gifts they will be able to drive incremental revenue from it's user base from approx $12.67 in 2012 to $19.62 in 2020 in North America. Promoted posts and other in-feed ads will continue to ramp up, but may come at cost to advertising on the side bar as it cannibalizes brand's spend on the side bar.

Revenue Per User Model)Revenue Per User

How it all boils up:

Facebook will be able to continue to drive high % of gross profit. % of operating margin, and % of net margin similar to Google's. Facebook will be challenged to grow it's MAUs substantially unless they can reach an agreement with the Chinese government. Even if they can begin to penetrate China they will have to compete against local social networks that already have strong footholds. Revenue per user will grow in the US close to that of Google's but will remain dramatically lower in the rest of the world.

If facebook is able to keep a high a bullish multiple of 40+ the stock for the next few years the stock has the ability to appreciate to the low 30s. However, I believe investors will not be willing to pay such a high multiple by mid 2013 as it becomes obvious revenue and user growth with decelerate, with stock price bottoming in the low double digits.

Rating Sell with target price $12.00

Facebook Full Model)Facebook Full Model

Disclosure: I am short FB.

Additional disclosure: After the large run up last week, it appears this is a good short opportunity.