The Social Network Is Looking Good

12/10/2012 7:45 am EST


It's been quite a ride for this stock since the company went public earlier this year, but now that the dust is settling, there is a lot of potential here, notes Rick Summer of Morningstar StockInvestor.

The Facebook (FB) community of more than 1 billion monthly users is remarkable by any measure. These users are constructing their “social graph,” building new habits in the way they communicate with friends and acquaintances while sharing applications and content. More than half of these users interact with the Facebook platform each day.

Advertisers have dipped their toes in the water, spending more than $3.1 billion last year on a platform that we would characterize as immature and prepubescent. Many agencies and marketers aren’t certain how to measure return on investment for their ad spending.

We believe this uncertainty may lead to a near-term slowdown in revenue growth. Still, Facebook is capturing data and online user activity in a comprehensive way that competitors can only dream about. We expect the company to capture a massive share of the online advertising market.

Facebook recently posted third-quarter results that were highlighted by several improving metrics, including stronger sequential growth in ad revenue, improving engagement, and a meaningful mobile advertising business that should easily generate more than $1 billion during the next four quarters. This data is largely in line with our valuation and thesis, and we continue to recommend the shares at these levels.

Advertising revenue grew 36% versus 2011, largely because of new advertising products launched by Facebook. Given the relatively arcane nature of measuring the effectiveness of social advertising, we believe this growth is extremely impressive. When the industry matures and measurement techniques become more robust, we expect revenue growth to accelerate.

Even today, we are optimistic that Facebook will continue to find new ways to monetize its user base while protecting the user experience. As evidence, users are going to Facebook more frequently than ever, with more than 58% of monthly users going to Facebook every day. Furthermore, we are seeing improving engagement across all geographies.

While mobile Facebook users have helped improve engagement, mobile ads also are generating revenue growth for the company. Seemingly, Facebook is bucking the trend of its competitors like Google (GOOG), which have been dominant in the traditional desktop Internet industry. Contrary to legacy companies that retrofit advertising for the mobile channel, Facebook’s new ad products represent incremental revenue for all advertising channels.

Management iterated that one product, News Feed, is generating approximately $4 million in revenue per day, with 75% coming from mobile ads. On an annualized run rate, this one product is generating approximately $1 billion at this point.

The primary down note is related to revenue from payments. Payment revenue declined 8% sequentially as a result of the diminishing performance of Zynga's (ZNGA) games. Zynga has been a large partner, and Facebook earns a percentage of virtual goods sales that Zynga collects from its users.

Still, payments represented 14% of revenue for the quarter, and we view advertising as the primary growth engine going forward.


Economic Moat
In our view, Facebook has a wide economic moat based on its social graph, communications layer, and competitively advantaged platform for brands, application developers, and advertisers. We look at three considerations for the company’s moat: Facebook as identity, Facebook as a platform, and Facebook as a destination site.

Largely, Facebook’s ownership and control of its user data affords the firm substantial competitive advantages. The company continues to build a rich database of friends, actions, demographics, and applications, but only shares the data with business partners. Third parties cannot track information that happens on the Facebook platform.

We believe identity is the most important component of a social network. Facebook partners can easily use the company’s login credentials through Facebook Connect instead of requiring users to separately register a new ID and password. This functionality is good for both Facebook and the partner as data can be more easily shared between the companies, allowing for better personalization, ad targeting, and social functionality, such as sharing.

Furthermore, we have seen data suggesting that Web sites convert casual users into registered users twice as often after deploying Facebook Connect login functionality. This rich data set is extremely difficult to replicate. While all partners may not benefit, we believe Facebook has an early and sustainable advantage here.

Using Facebook Connect to own a person’s identify is important, but the platform creates a virtuous circle of the sharing of data between Facebook and its partners, including brands, merchants, and developers.

Recognizing this opportunity, the company has opened up its platform to third parties, including application and content developers. For mobile applications, Apple's (AAPL) iOS platform and Android developers can connect their apps to the Facebook platform as well.

Through the social graph, third parties can distribute applications and content for “discovery” by customers, use Facebook data for better personalization (for example, TripAdvisor (TRIP) shows reviews posted by friends), and use future platform capabilities such as payment capabilities.

This value creates a virtuous circle between Facebook and its platform partners. Several tech luminaries have commented to us that Facebook integration is a best-practice equivalent to optimizing a site for search engine discovery by Google and others.

The traffic data alone is encouraging, although we believe this is the weakest pillar of Facebook’s moat. While daily users have been growing even faster than monthly users, we expect that competition for people’s time and attention will naturally pull them away from Facebook’s Web site.

However, because many people use Facebook for communication rather than simple entertainment, we wouldn’t expect users to abandon their use of the Web site. The fact that increasing numbers use Facebook on a daily basis is encouraging, in our view

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