Facebook Posts Surprising Growth

Expense growth continues to outpace revenue growth, as management forecast, but some products, such as WhatsApp and Oculus, remain in the incubation stage, while others like Instagram have only begun to tap their revenue potential. We reiterate our wide economic moat rating and consider the shares fairly valued at this time.

Revenue grew 42% in the first quarter, paced by advertising revenue, which grew 46% (55% on a constant currency basis) to $3.3 billion, ahead of our prior forecast for 2015 growth. This outperformance was primarily driven by continued growth in engagement (as measured by the percentage of monthly users accessing Facebook every day), while total users and revenue per user continue to grow. Ad revenue per user grew 29% versus the year-ago period, while mobile revenue per user grew 46%. Total daily active users grew 17% to 936 million, while engagement grew across every reported geography. The risk of Facebook fatigue has not yet materialized. During the quarter, 65% of users accessed Facebook every day, versus 63% in 2014.

Non-GAAP operating margins came in at 52% (26% GAAP), a decline of 450 basis points versus 2014. This discretionary investment in products such as Instagram, WhatsApp, and Oculus Rift are investments that are depressing current operating margins. We continue to forecast normalized operating margins at approximately 45%, as these investments either bear fruit or management chooses to ratchet down spending.

Nurturing Networks for Advertising Innovation Facebook is building the foundation to revolutionize online advertising. The company has shown great patience in nurturing its social networks, providing unique experiences for users and unparalleled targeted audiences for advertisers.

Facebook's massive base and engagement arguably create advertising opportunities that capture reach and target based on specific criteria. Growth in Facebook's user base across geographies has been impressive. Monthly active users exceed 1.4 billion while daily active users number more than 900 million, representing the largest social network on the Web. These users are logging into Facebook at least once a month, communicating with friends, posting pictures, and using applications. We believe hundreds of millions of users face switching costs that keep them from leaving Facebook. People are unlikely to leave unless they can take their network of friends, content, and applications with them.

The company's growth in mobile usage has been equally impressive, particularly considering that Facebook was very slow to market with a downloadable application. The company's mobile usage is skyrocketing; there are more than 1.2 billion mobile users, with nearly half of monthly active users accessing Facebook only from a mobile device. There are now more mobile-only users than desktop-only users, and revenue from mobile ad products exceeds revenue from desktop. After its long delay in building mobile advertising products, we believe the company is a pre-eminent mobile advertiser.

Despite our bullishness about its prospects, the company will need to aggressively increase advertising revenue per user to justify our valuation, in our view. As it is already the most visited desktop and mobile site in the world, Facebook will have to find new and innovative ways to continue increasing advertising units and pricing. This growth is not limitless, and we believe any meaningful slowdown will have a negative impact on what the stock is worth.

Control of Data Is a Substantial Advantage 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 an identity, Facebook as a platform, and Facebook as a destination site. Largely, Facebook's ownership and control of its user data afford 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 log-in 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 websites convert casual users into registered users twice as often after deploying Facebook Connect log-in 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 identity is important, but the platform creates a virtuous circle of the sharing of data among Facebook and its partners, including brands, merchants, and developers. Recognizing this opportunity, the company has made the obvious move, opening its platform to third parties, including application and content developers. For mobile applications, Apple's 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 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 it 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 people away from Facebook's website. However, because many people use Facebook for communication rather than simple entertainment, we wouldn't expect users to abandon their use of the website. The fact that increasing numbers use Facebook on a daily basis is encouraging, in our view.

Ad Focus Can Bring Risk The company is investing in important areas, but competitive dynamics will keep it from widening its moat. Competitors like Google GOOG/GOOGL will be able to provide alternative advertising platforms to Facebook, providing some limits for the company in its advertising rates. Furthermore, we think the power of Facebook's model will be its ability to share returns with its platform partners. If the company were to attempt to exploit its competitive advantages and destroy its partners' returns on capital, the platform would become less useful and competitive platforms would emerge, in our view.

Although the revenue opportunity for Facebook is large, the company faces several risks that could ultimately prove our investment thesis to be overly optimistic. First, regulators may prevent the company from tracking its users. Significant regulatory action could detract from the value of its advertising platform. Second, excessive advertising or privacy fears could lead to a mass exodus of users. Other social networks (for example, MySpace, owned by News Corporation NWS/NWSA) have experienced declines. Lastly, if agencies and advertisers experience a permanent lack of visibility into advertiser return on investment, Facebook's advertising opportunity may be significantly constrained.