Is It Time to Like Facebook Again?

Lior is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

The spike in shares of Facebook (NASDAQ: FB) has brought the stock back to its IPO pricing. This rally was triggered by the company’s better-than-anticipated quarterly earnings reports. Looking forward, is this company on the right track? What are the opportunities and perils it may face? 

Revenue

Facebook’s recent earnings report was better than many had expected:  The company’s revenue jumped by 53%. For Facebook, most of the growth in revenue was related to its sharp rise in mobile users that reached 819 million active users – a 51% increase (year-over-year). In comparison, Google's (NASDAQ: GOOG) revenue increased by 19.5% in the second quarter of 2013. On the other hand, Yahoo! (NASDAQ: YHOO) hasn’t done well and its revenue fell by 6.8% in the second quarter of 2013.

Profitability

At first glance, Facebook’s profit margin was even more impressive than the company’s rise in revenue. I expected the higher mobile operations would cut down on Facebook’s profitability. But the company’s profit margin rose in the second quarter. Conversely, Google’s profitability declined partly due to its expanding mobile operations. Even after accounting for the Motorola Mobile operations, Google’s operating profit margin fell from 31.3% in the second quarter of 2012 to 26.4% in the second quarter of 2013 –a 4.9 percentage-point drop. 

A closer look, however, at Facebook’s earnings report reveals that after controlling Facebook’s share-based compensation expenses and other tax-related expenses, the profitability (non-GAAP) remained stable at 43.8% compared to 43.5% in the second quarter of 2012. Moreover, the company cut down on its R&D provision by nearly $360 million, which could also partly explain its higher profitability compared to the second quarter last year. 

Facebook’s high profitability is related to its improved ads performance and sharp rise in mobile ads that reached $655 million in the quarter. In recent research, it was stated that Facebook improved its click-through-rate on both mobile and desktops in the past quarter. The improved CTR helped augment the company’s ad sales even though the cost-per-click rate remains low for mobile. 

The low CPC of mobile is likely to eventually negatively affect Facebook’s profit margins. After all Google’s decline in profitability is partly due to the shift toward mobile:  Google’s average cost-per-click declined by 6% in the second quarter of 2013 (year-over-year), which has adversely affected its revenue growth and profitability. 

Facebook wasn’t the only company that improved its profit margins: Yahoo!’s profitability also rose from 4.5% in the second quarter of 2012 to 12.1%. 

Future growth

Despite the spike in Facebook’s revenue in the past quarter, its future growth might rely on its ability to synergize between virtual services and hard products (e.g. smartphones, laptops etc). In recent years, companies such as Google were able to incorporate among different business segments. Google’s move toward producing its own smartphone is currently pulling down its profit margin but over time could sustain its revenue growth. Google’s upcoming smartphone and Google Glass products will enable the company to incorporate its virtual services, such as Google search.  

Currently, Facebook doesn’t have much exposure to hard products, which could, over time, hurt the company's ability to maintain its high growth rate and ward off other social media, such as Google+. Facebook continues to seek new enterprises, such as Waze, to expand its operations in the online world. But I think the company should also consider companies that are related to hard products. 

Other analysts have suggested that Facebook might be better off to offer an ad-free platform just like Pandora does. This type of price discrimination could positively affect the company’s revenue. But unlike Pandora, I think that Facebook will find it harder to sell ad-free platforms. For one thing, more browsers are capable of blocking ads at no cost. 

Yahoo! is also trying to augment its business by purchasing companies such Tumblr, a fast-growing media network. Moreover, the company’s decision from last year to sell a large portion of its stake in Chinese e-commerce Alibaba Group for $7.6 billion reduced its exposure to the Chinese market. These actions could further lift Yahoo!’s profitability and keep its focus on the American market.

Conversely, Yahoo!’s decision to expand its stock-buyback plan suggests the company believes its stock is currently cheap but also that there aren’t better investment options out there, which could impede its growth down the line.  

Research and development

Another factor that could determine growth is the allocation toward R&D. In the first half year of 2013, Yahoo! allocated nearly 20% of its revenue toward R&D. Facebook is in the middle of the pack at 15.9%, and Google’s R&D-to-revenue ratio reached only 13.6%. 

Valuation

It’s hard and unfair to compare high growth companies where most of their valuation is based on the market's future growth expectations. Nonetheless, I have used the enterprise-value-to-EBIT ratio to compare Google, Yahoo! and Facebook. 

The table below summarizes the findings of these companies’ current ratios.

<img alt="" src="http://g.fool.com/editorial/images/62203/fb-valuation_large.jpg" />

As seen above, Yahoo's! ratio is very close to Facebook’s and they are both much higher that the market average and Google’s ratio. This suggests, at face value, that both Yahoo! and Facebook are still highly priced compared to Google and the market average. 

Bottom line

Facebook is making great strides to improve its advertising platform that will sustain its growth in revenue and profitability. But the rise in mobile operations could eventually cut down its profit margin. Finally, the company should consider expanding toward hard products such as mobile devices that might cut down its profit margin but will enable the company to widen its range and strengthen its operations. 

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Lior Cohen has no position in any stocks mentioned. The Motley Fool recommends Facebook, Google, and Yahoo!. The Motley Fool owns shares of Facebook and Google. 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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