Subject: Morningstar likes Facebook as an investment.

Facebook poised for massive growth

Rick Summer is a senior stock analyst with Morningstar US.

On the face of it, an immense community of more than 900 million monthly users is remarkable by any measure. These users are constructing their "social graph," building new habits in the way they communicate with friends and acquaintances while sharing applications and content. More than half of these users interact with the Facebook platform each day.

Advertisers have dipped their toes in the water, spending more than US$3.1 billion last year on a platform that we would characterise as immature and prepubescent. Many agencies and marketers aren't certain how to measure return on investment for their ad spending. Still, Facebook is capturing data and online/user activity in a comprehensive way about which competitors can only dream.

We expect the company to capture a massive share of the online advertising market while developing new revenue streams through local advertising, payments and commerce. In spite of our bullishness, we expect revenue growth to be highly variable.

Although we believe optimism is warranted, the market might not appreciate several near-term challenges facing the company. Facebook's 901 million monthly active users only tell part of the story, as more than 500 million users interact with the Facebook platform every day.

The company is already wildly profitable by most standards and generated US$3.7 billion in revenues and 47 per cent operating margins in 2011 on the back of strong growth in advertising (US$3.2 billion) and other revenues (US$550 million), which consist primarily of payments to third parties, including Zynga.

We expect the company to translate its immense user base and competitive advantages into massive growth in revenues and cash flows over the long run, but the ability to further monetise current users represents a significant hurdle which Facebook must overcome.

These challenges notwithstanding, we expect the stock to trade well above our fair value estimate after the IPO [initial public offer], though the focus on short-run challenges might lead to stock price declines and ultimately create a very interesting buying opportunity for the shares at a later date.

Even though Facebook's first-quarter results reflected seasonal weakness, the firm's revenue growth and profitability is commendable. Quarterly revenues declined 6 per cent sequentially, demonstrating that social advertising is already subject to the same seasonal weakness the broad advertising market experiences.

Still, Facebook's revenues of US$3.7 billion in 2011 increased by 88 per cent versus those in 2010, and the firm's operating margin was 47 per cent, the highest of any company on our internet coverage list. This remarkable profitability certainly demonstrates the efficiency of Facebook's business model.

Notably, sales and marketing expense was 11.5 per cent of revenues, compared with 22.5 per cent for Yahoo and 12.1 per cent for Google in 2011.

Although we don't expect Facebook to expand its operating margins, the current level of profitability allows the firm to continue to reinvest in the business to stave off competition, produce innovative forms of advertising, and support new revenue streams.

Facebook's massive base and engagement arguably creates 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 were 901 million at the end of the first quarter of 2012, 33 per cent more than reported in the year-ago period.

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 apps 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. Although the company has not actively developed its mobile advertising capabilities, we expect a substantial bulk of mobile advertising dollars to flow to Facebook within the next couple of years.

Most importantly, we believe that Facebook's real opportunity lies in its future potential for revenue growth as it has only just begun to transform the advertising industry. At a high level, we believe there are several levers for revenue growth that Facebook can exploit.

Growth in market share

We believe the marketing data that Facebook is gathering through the world's social graph will fundamentally change the advertising landscape. As advertisers have continued shifting spending to online media, large tranches have remained offline (particularly in TV advertising) because of traditional considerations, including brand-building objectives and broad reach.

We believe Facebook will take market share from companies selling offline advertising as advertisers flock to where the users are most engaged.

We expect Facebook to be a dominant player in the online advertising market, particularly in the display advertising tranche.