Slowdown in the Cards for Facebook?

 Facebook's (FB) third-quarter results surpassed our short-term expectations, but given today's current valuation, we are cautious about the potential for a slowdown in growth as the company searches for new advertising products and other sources of revenue. Additionally, while management comments are not cause for alarm, we believe it is prudent for investors to consider decreasing their position in this overvalued stock. Our wide Morningstar Economic Moat Rating remains intact, and we are increasing our fair value estimate by $2 to $36 to account for our revised forecast.

Overall revenue grew 60% to $2.01 billion in the quarter, propelled by 66% growth in the advertising segment, which posted $1.8 billion in revenue. Revenue growth has accelerated in 2013, as new advertising products such as mobile News Feed and Facebook Exchange, or FBX,  are helping to support increases in ad revenue per user (advertising ARPU). In fact, advertising ARPU grew 38% versus 2012 to $1.53. We would expect the growth in advertising ARPU to periodically slow as the company launches new advertising products. In particular, we expect any dramatic slowdown in revenues would likely cause a sell-off in the stock, as we admittedly have very little visibility into short-term growth opportunity.

Surprisingly, Facebook's GAAP results showed improvements in the firm's operating leverage, as operating margins grew to 37% versus 30% in 2012. While we expect this improvement to be temporary, the results are strong evidence of a lucrative operating model. However, we are reluctant to change our forecast for long-term operating margins. We are forecasting revenue growth at a 25% CAGR through 2021, and we expect this growth will require new lines of business, including advertising networks and content distribution. Other lines of business are likely to be less profitable, as we would expect the company to share a portion of ad revenue with these partners and customers.

During the earnings call, management made comments about its plans for advertising inventory that lead us to believe there will be a temporary slowdown in advertising revenue per user. Presently, advertising in the news feed represents approximately 5% of content shown, and the company does not intent to significantly increase the density of ads shown to users. In the short-term, ad revenue growth may come only from users and ad pricing. In spite of a potential slowdown, we expect Facebook's growth to frequently accelerate and decelerate, and its massive reach of 1.2 billion users and unique customer data will provide the company ample opportunity for revenue growth.

Notably, Facebook's success in mobile advertising has been nothing short of remarkable, as mobile ad revenue per month average user, or MAU, surpassed the desktop ad revenue per MAU by a marginal amount for the first time. In general, we believe this success is a validation of our mobile thesis and lack of concern about the threat of mobile cannibalization, particularly because Facebook has a critical asset in the Morningstar Smartphone Value Stack--an application that is commanding 20% of all time spent on mobile applications.

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