Facebook Profits Grow but Warns Slower Growth Ahead

While Facebook surpassed all expectations once again, the company noted that the growth we have seen recently may not continue in the fourth quarter

Morningstar Equity Analysts 4 November, 2016 | 9:25AM
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Facebook’s (FB) third-quarter results came in ahead of expectations with strong user and ad revenue growth, and we think these results validate our wide moat rating on Facebook as it remains the market leader in the social-networking space and one of the leaders in the overall online ad market. We note that Facebook needs to continue to invest in innovation to further differentiate itself from competitors such as Snap Inc.

For this reason, management hinted at growth acceleration in operating expenses in 2017. In addition, as we have been expecting the last six months, the firm expects to see a deceleration in revenue growth in the upcoming fourth quarter and calendar 2017. We are maintaining our $127 fair value estimate for Facebook. Although the shares were down nearly 8% and below our fair value estimate in after-hours trading, we continue to recommend waiting for a wider margin of safety before investing in this name.

Total advertising revenue grew 59% year over year to $6.8 billion, driven by 16% and 17% growth in monthly average users and daily active users, respectively. Geographically, such growth in ad revenue was led by 64% year-over-year growth in the Asia region. Facebook’s mobile users increased by 20% from a year ago, driving mobile revenue higher to represent 84% of total ad revenue. The increase in mobile users and mobile revenue clearly demonstrate the continuing growth in demand for digital ads on mobile platforms from small and large businesses.

Operating margin expansion, mainly due to strong advertising revenue growth and higher gross margin, was encouraging. However, the combination of higher growth in operating expenses, driven mainly by higher R&D, and a sizable deceleration in revenue growth, due to lower ad loads, likely will halt operating margin expansion in 2017.

User engagement strengthened again, which we view as further indication of increasing barriers to exit, demonstrated by continuing user growth. In addition, higher user engagement could result in higher return on investment, or ROI, for advertisers. It appears that advertisers recognized this and were willing to pay, as the overall average advertising revenue per user increased 38% from last year.

Slower Growth Expected in the Future

While Facebook surpassed all expectations once again, the company noted that top-line growth at the rates that we have seen recently may not continue in the fourth quarter, as the firm faces tougher comparables from fourth quarter of 2015. In addition, in order to maintain the correct balance of user content and ads to not turn away the users, the company likely will no longer increase ad load, beginning in the third quarter of calendar 2017.

While this will affect revenue growth, we applaud such a move, as it is indicative of management’s long-term strategy: keep increasing the user base and user interaction, further strengthening the network effect.

In the meantime, the company continues to invest in live-streaming video content to attract more users and increase time spent on its ecosystem. This likely will help compile more user data through higher user interaction and engagement, which could result in sales of higher priced ad inventory.

However, such an investment, along with others in artificial intelligence and, virtual and augmented reality technology, will dampen operating margin slightly in 2017. We expect the firm to begin realising returns on those investments beginning in 2018 and beyond.

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Morningstar Equity Analysts  Morningstar stock and fund analysts cover 2,000 mutual funds, 2,100 equities, and 300 exchange-traded funds.