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By Jeremy Glaser | 02-03-2012 02:00 PM

Facebook's $100 Billion Valuation May Not Be Heroic

It will be a volatile ride, but Facebook's strong competitive advantages and growth opportunities could be the recipe for a hefty valuation, says Morningstar's Rick Summer.

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. Facebook's S-1 filing has gained a lot of attention as the social-networking giant prepares to go public. I'm here today with Morningstar senior analyst Rick Summer to take our first look at the company and see what he is thinking after reading these initial disclosures.

Rick, thanks for talking with me today.

Rick Summer: Sure. No problem.

Glaser: So, let's go ahead and start off with the business model. Before we didn't know exactly how much free cash flow Facebook would have or what its operating margins look like. What's your first impression of the financial performance of Facebook?

Summer: Yeah, it's fantastic in any way you think about it. I mean, we've looked at a lot of companies that have gone public recently. Typically when a company is in a startup mode, it's investing very heavily and it's investing in advance of profits and operating margins. We knew Facebook was profitable. The rumors were pretty rampant. The firm had not been thirsty for capital per se, but it's remarkable. So, it has $3.7 billion in profits, and $1 billion is flowing through to the bottom line at the same time. We're looking at operating margins of 47%. These are margins that aren't even hitting our widest-moat companies, like an Oracle, a Microsoft, or a Google at the same time. So, it's quite tremendous all the way around.

Glaser: So, if we see these great operating margins, is this something sustainable when you start to think of Facebook's long-term competitive advantages? Can the firm actually keep this up, or are we at kind of peak Facebook right now?

Summer: Yeah. That's a very good question. One of the things that we see is there is this big secular tailwind that will continue to persist during the course of the next five to 10 years, and that's this big shift from offline to online advertising. Google has certainly been one of the biggest benefactors of that over the course of the last decade, and search-engine advertising has really taken the bulk of that. We've seen a lot more cyclicality around display advertising, and that market has been historically plagued by fits and starts. We can remember the big banner ads of 1999 and 2000 where people were buying real estate at aol.com, and then that tailed off. Then we had more maturity and a little bit more CPM-based and even some CPC-based, which is performance-based, advertising come out with the likes of Yahoo and AOL. But still, these are not real clean or linear paths for growth at the same time.

So, now we have Facebook. We have yet another way to monetize in sort of a display and impression-based area. It's not as clean, not as transparent, and not as obvious to us that the growth path is not without potholes. We're going to see some rampant acceleration, and we're going to see companies pull off and let off the gas pedal at the same time. It's going to be challenging. Growth is going to be there, but we're going to see quarters, we're going to see years where the growth is less impressive than others.

Glaser: We see that display advertising is really the biggest part of Facebook's business. Are there other ways that the firm can monetize this huge user base it has, or do you think Facebook is really going to be focused on kind of that advertising side?

Summer: I think when you own an audience--and Facebook has 845 million monthly active users right now, 435 million-some-odd daily active users which are very impressive numbers by any sense--the best way to monetize that clearly is through advertising. In fact, when you don't have people paying you today, it's hard to change your model and say, we want you to subscribe to us tomorrow.

That being said, the firm has expanded out with what is called Facebook Platform. Obviously, Zynga, one other company we cover, is very active on that Facebook Platform. There's a lot of games that are played, and people are buying virtual goods. Well, every time they spend money on a virtual game or a virtual good within that game, they're giving money to Facebook at the same time. Fifteen percent of the revenues from Facebook are not advertising-related. So, certainly, there is a lot of opportunity beyond advertising to create these additional revenue streams for their application partners, for their content partners at the same time.

Glaser: Let's take a look at some competitive threats. Google in particular has been pushing social networking maybe with some mixed success so far, with social search as well as the Google+ platform. Is that a danger for Facebook that this network effect kind of disappears, or do you think that the firm will be able to keep expanding the number of daily users?

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