Facebook - A Case Study - Part 2

Facebook - Part 2: Facebook Financials Analysis

This is the second of my three-part Facebook research series. It provides some background numbers on how the company is doing financially based on figures on their public website at the 3rd quarter of 2016. These information would eventually build up to my market strategy analysis at part 3.

Overview

Facebook is currently the largest social networking platform in the world that has been experiencing significant growth and value. In the latest Fortune 500 report, Facebook has been listed for 4 years, and has increased its ranking from 242 to its current ranking at 157. It is also ranked number 3 in the 100 fastest growing companies(Fortune500, 2016). This paper further analyzes the current financial standing and financial stability of the company.

Background

Facebook was founded in February 2004, and it went public on May 2012 (Crunchbase, 2016). Being 12 years old since formation and 4 years old in the public market, it is currently the world’s leading online social networking platform with 1.7 billion monthly active users in 2016 (Statista, 2016). Facebook’s main business model is to provide a social networking platform to its consumers free of charge to attract and retain them, so as to leverage on user generated data to facilitate advertisers in effective targeted advertising. The graph on the right from Statista shows the number of active users steadily increasing across the years.

On February 2012 when Facebook filed its S-1 Form, the company was primarily in the display-advertising business with a net profit of $1 billion in 2011 from a total revenue of $3.7 billion (Safdar, 2013). It is interesting to note that when Facebook went for IPO, its prices were at record value of $38 a share, which equates to around $104 billion market valuation  (Wall Street Journal, 2012). This, however, did not last long as it was noted that with more users moving from desktop to mobile platforms, the initial projected revenue was misrepresented. This led to a revised S-1 where Facebook released to the public that mobile ads presented an ongoing challenge for the firm. That impacted investor’s confidence, and prices plummeted ever since. It took almost a year later in July 2013 for the prices to return to the initial price after Facebook released more features like Facebook Exchange in bids to have more targeted advertising to fulfill advertising demand (An, 2014). Much have progressed since. Facebook picked up on this area and have new solutions like Dynamic Ads and Custom Audiences that have mobile at their core and are delivering excellent results for the businesses. Developers can also access Facebook APIs to innovate and build great advertisement experiences for their brands and customers. These new solutions work so well in revenue generating that Facebook prices have been increasing ever since, and Facebook recently announce to decommission its old advertising solution, Facebook exchange, in November 2016 this year make way for new advertising solutions (Marvin, 2016).

Financial Situation – Rapid Growth

To understand Facebook’s current financial situation, I started by looking at the latest financial reports in Facebook’s official investor’s website (Facebook, 2016). My overall analysis is that Facebook is currently at a good financial situation and the information below will elaborate this finding further.

From the Assets category in the Balance Sheet, we can tell that Facebook’s total asset value has been constantly increasing over time, reaching its current peak at $55.74 billion. Also, with some calculation, the rate of increase is generally increasing over time too (i.e. from 5.17% in early 2015 to 7.04% in 2016). It is also interesting to note that most of the increase is due to marketable securities from current assets. Goodwill also takes up a significant portion of Facebook’s assets. Other assets like property and equipment takes up a much smaller amount in comparison. These means Facebook’s key assets are less physical in nature, and are increasingly on investments in marketable securities that can be easily converted back to cash later if the need arises.

 

Next, looking at Facebook’s Total Liability and Total Stakeholder’s Equity, we can tell that the company has cleared all of its long term debts for a period of time, and is highly profitable considering the continuous increase in retained earnings from around $6 .6billion in 2015 to more than two times the original amount at $13.35 billion at the last quarter. This increases the total stockholder’s equity from $37.5 billion in 2015 to the current $50.4 billion today. This is a good sign because instead of having debt in the liabilities section to pay others, money is in its stockholder’s pocket, ready to continue to invest back into the company for future growth.

Next, moving on to the income statements, Facebook’s current revenue is at $6.44 billion. Comparing the rate of increase in revenue ($6,436-$3,543 =$2,893) with total costs and expenses ($3,690-$2,610=$1,080), the company is generally making money faster than it is spending.  The chart below further elaborates Facebook’s revenue growth in comparison with the Year-Over-Year growth. We can see that the trend is positive.

    

With regards to the breakdown of figures, the following selected charts from Facebook’s quarterly earnings report is useful to provide more color. Firstly, Facebook is continuously not only increasing its user base, it is also engaging them to be active users. We can see that that this happens on both Desktops and Mobile platforms.

This is useful information because though most of Facebook’s revenue is from two categories, “Advertising” and “Payments and Other Fees”, and we can see from the chart that “Advertising” takes up a significant larger portion of the pie (i.e. 96.94% in Q2’16 ). Considering the attractiveness of a platform for advertisers is its effective outreach, the increase in active users would have a positive corelation with the amount of revenue from advertising.

Finally, it is also interesting to consider the spending power of the users that are on Facebook’s platform. For example, though the number of monthly active users in US & Canada is smaller (226 million) in comparison to the rest of the world (556 million), the revenue is $3,212 million in comparison to $614 million. In other words, every user in USA & Canada is generating $13.74/user, but the number is significantly smaller at $1.12/user in the Rest of the World.

   

Financial Stability

 To analyze Facebook’s financial stability, we can start off by looking at its expenditure. From the following chart in Facebook’s latest quarterly report, we can see that most of Facebook’s expenditure is on Research & Development (23%). This is not surprising because Mark Zuckerberg, CEO of Facebook, announced plans that in the next three years, Facebook is focused on continuing to build their community to help people share more of what matters to them. The next five years is about building our newer products into full ecosystems with developers and businesses. And over the next ten years, they are working to build new technologies to help everyone connect in new ways. This claim is supported by innovations the company bring, including Facebook Live as a video sharing platform, Facebook Lite as a light-weight mobile app that works on 2G networks, Aquila as a solar-powered aircraft that will beam internet to places that have ever been connected, DeepText as a deep learning engine to understand the context of several thousand posts per second across 20 different languages, and even a demo on interactions in Virtual Reality with the Oculus platform. (Facebook, 2016). These innovations reach out, engages and retains Facebook’s active users.

Though most Software-as-a-service companies can be analyzed with the Cost of Customer Acquisition (CAC) in comparison to the monetization in Life Time Value (LTV) (Skok, 2014), the formula for the Magic number does not fully apply for Facebook. This is probably because Facebook does not follow a subscription model, and does not seem to use Sales and Marketing expenditure as a key avenue to acquire customers. Furthermore, the lifetime of its customers can last for years, as long as the platform remains attractive to them.

Also, Facebook has a more interesting way to acquire customers. They do it through acquisitions and this move allows the company to not only purchase users, it also allows Facebook to acquire talents as employees in their firm. Some of the more famous acquisitions include purchasing Instagram for $1 billion in 2012 (Deutsch, 2015), Whatsapp for $21.8 billion in 2014, and Oculus VR for $2 billion in 2014 (Dredge, 2014).

Among these acquisitions, the most interesting one is with Whatsapp. At the time of acquisition, WhatsApp is an ad-free mobile application that is free to use, with subscription kicking in after the first year. The messaging service which reached 400 million active users in December, generated less than 3 cents in revenue per user. Though that sums up to around $10.2million in total revenue, its net loss was $138.1 million in 2013. Despite these losses, Facebook’s $21.8 billion acquisition equates to paying for $55 per user (Frier, 2014). Though the numbers do not sum up, this turned out to be a strategic move for Facebook’s overall financial stability due to a few reasons. Firstly, on user growth, by 2015, over 500 million people use WhatsApp monthly and the service adds more than 1 million users per day. Seventy percent of WhatsApp users are active daily, compared to Facebook’s 62%. Additionally, WhatsApp users send 500 million pictures back and forth per day, about 150 million more than Facebook users. Considering user growth comes first and monetisation later for Facebook, this move makes sense. Secondly, WhatsApp will help fuel Facebook growth in developing markets where internet connectivity is sparse but where WhatsApp is widely used. Facebook will then gain access to these mobile user bases. Connecting to WhatsApp users in these areas will also aid Facebook’s Internet.org initiative, Mark Zuckerberg’s plan to implement internet access to the two-thirds of the world not yet online (Frier, 2014). Finally, one of Facebook’s largest competitor, Google, was also bidding to acquire the company for $10 billion (Gelles, 2014). Outbidding a competitor would reduce risks to Facebook in the longer term.

When comparing Facebook to its competitors, we can look at the net profit margins (Analysis, 2016). From the table below, we can see that Facebook is generally doing well other than the year it IPO in 2012.

To analyze Facebook’s financial stability, investors would be interested in the ROIC (Return of Invested Capital), ROA (Return of Assets) and Return of Equity (ROE). The tables below generally show an upward trend. (Focus, 2016)

This upward trend is also further supported by the Earnings per Share (EPS) figures from NASDAQ (Nasdaq, 2016)

Other than these strengths, Facebook’s key weakness is its huge dependency on Advertising to generate revenue. In response to this, the company has put in lots of effort to attract advertisers. Sheryl Sandberg, COO of Facebook announced in its quarterly report that Facebook’s focus is to make their Ads more relevant and effective. Initiatives like Audience Network allows advertisers to include video for brand objectives. Advertisers can place brand video ads not just on Facebook and Instagram, but also across a network of apps and sites. Creating business pages on Facebook is easier than creating websites, and the pages are easily accessible on mobile by up to 60 million businesses using their products each month in the U.S. and around the world. In addition, innovative solutions like Video and Canvas Ads, Lead Ads, and Dynamic Ads also prove to be useful considering the increase in revenue from Advertisements over the last few quarters.

Claims of effective advertising on Facebook and Instagram is backed up by examples. For example, Lighting Etc., a third-generation family-owned business, used Facebook and Instagram ads to drive in-store sales. They targeted 25-45-year-old homeowners interested in interior design, living within 35 miles of their showroom in Fort Worth, Texas. It was striking to them that being on Facebook meant they could reach over 300,000 people even with such specific targeting. They have seen a 40% increase in revenue in 2016.

Though these advertisement methods prove to be working, the only word of caution is that Facebook pages is currently already filled with “Ad Load”. In other words, it has currently crammed the newsfeed of its users to a point that it thinks it can fit without turning users off (D'Onfro, 2016). Facebook needs to figure how to increase revenue from advertisements without increasing the quantity of advertisements appearing for its users. Also, more may need to be done to figure how to monetize people in other regions of the world that has less spending power. Other than this, the company’s general outlook looks great for investors considering it is still continuously growing its user base and engaging them to be active users, and balancing the expenses out by increasing its revenue through effective advertising.

Conclusion

Therefore, in summary, for Facebook’s current financial situation, its large volume of user generated data and advertisers are the biggest contributors to its financial health. With over 1.7 billion users, Facebook is able to continuously distribute advertisements on its two main platforms on Desktop and Mobile, making an average of $3.82 per user worldwide. The future outlook looks good as well for Facebook as it continuously seeks ways to increase its user base and address it with effective targeted advertising. To continue to stay attractive for investors, Facebook will need to continuously seek ways to retain the number of active users, increase the value per user not only in developed countries, but also in developing countries, while balancing the amount of advertisements shown, ensuring that it does not turn their users off.

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