Should You Still Like Facebook?

Should You Still Like Facebook?

The third-quarter earnings report of Facebook was better than many analysts had anticipated and the company's stock reached its highest level this year. Looking forward, is the company heading toward the right direction? Let's examine the main factors that could impede its growth and reduce its value over time.

Revenues from mobile
Facebook's recent earnings report was better than expected -- Its revenues spiked by 59%. For Facebook, most of the growth in revenues was related to the jump in mobile users to 819 million, which is a 45% gain, year over year. Facebook isn't the only company that had a great quarter. Revenues of LinkedIn jumped by 56% during the third-quarter, year over year. Conversely, revenues of Google increased by only 12% during the past quarter. So Facebook has done better than or as good as its leading competitors. Alas the driving force behind its growth -- rise in mobile usage -- could also harm its valuation over time.

In a recent article in the Fool, the author shows how Facebook has managed to improve its revenues from mobile; this segment accounts for nearly half of its total revenues -- a higher rate than last year. If this trend persists, the mobile sector will become the largest revenue generator for the company. Let's take a closer look at this trend.

The sharp rise in mobile users was partly cannibalizes the number of daily active users (DAUs). The company reported that in the U.S and Europe there is a decline in personal computer DAUs. Further, revenues per personal computer user are higher than revenues per mobile user. This means, over time, the rise in mobile users over desktop users could eventually offset some of the growth in revenues. Facebook isn't the only company that suffers from this shift.

For Google, the cost-per-click has declined in the past quarter by 8%, which has curbed down the rise in revenues. One of the reasons for the drop in cost-per-click is the higher usage of mobile devices -- the average cost per-click is typically lower compared to desktop computers and tablets.

For LinkedIn, the situation is different, and its revenues are mostly generated from companies seeking employees; this segment accounts for nearly 80% of its revenues; premium subscribers, which account for 20%. Therefore, the integration with mobile usage isn't likely to impede LinkedIn's growth in revenues or reduce its profit margins.

Looking forward, Facebook expects its growth in sales to decline. Facebook's market penetration is already very high in the U.S. According to one report, Facebook's application reaches 74.3% of the smartphone audience and 84% of the smartphone app and browsing audience. These high numbers aren't likely to rise much further, so the company's growth in the mobile usage is likely to diminish in the coming quarters.

The rise in mobile use is also likely to adversely affect Facebook's profitability. Let's see why.

The company's operating profit rose from 30% last year to 37% in the third-quarter of 2013. The rise in profitability is partly related to the company's ability to maintain its expenses such as marketing and sales and G&A from spiking: In the past quarter, these provisions grew by only 38% and 13%, respectively. Nonetheless, Facebook's profitability has improved compared to its peers: In the third-quarter, Google's operating income grew from 20.5% in 2012 to 23% in 2013. After controlling the adverse impact of Motorola Mobile's operations on Google's profit margins, Google's solo profitability remained stable at 34%. LinkedIn isn't better off; its profitability remains very low at roughly 1%.

Facebook's profitability could diminish over time due to two factors: growth outside U.S and mobile users.

The company's daily active users sharply rose in the past quarter 34%. Most of the growth, however, came from outside the U.S, Canada and Europe. It came mainly from Asia. In the third-quarter, Asia's DAUs grew by 34%, while U.S and Canada DAUs rose by only 9%. Considering the high penetration rate in the U.S, this growth rate is only likely to diminish. Therefore, most of the growth will continue to come from Asia. Since this region is likely to have low profit margin , this trend may adversely affect Facebook's profitability over time.

Another point to consider is the dynamic between monthly active users and DAUs; the ratio between the two (DAU/MAU) hasn't changed much; in the third-quarter, the ratio only slightly improved from 57% in 2012 to 61% in 2013. This means, monthly users are only slowly shifting to become daily users. In other words, most of the growth in daily users comes from new users and not from monthly users becoming more active.

Mobile usage is also likely to curb down the rise in Facebook's profit margin as it did to Google. Even if Facebook improves its click thorough rate, the drop in share of desktop revenues from total revenues is likely to cut down its profit margin.

Bottom line
Facebook is improving its mobile platform, engaging its users, and reaching new regions. These factors are likely to maintain its growth rate. But the rise in mobile users over desktop users and the expansion outside the US and Europe could eventually diminish the company's profit margin.

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Lior Cohen has no position in any stocks mentioned. The Motley Fool recommends Facebook, Google, and LinkedIn. The Motley Fool owns shares of Facebook, Google, and LinkedIn. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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