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Facebook Inc. (FB - Analyst Report) reported impressive second-quarter 2014 results, which again reflected its growing dominance in the mobile advertising market. Earnings of 30 cents per share were much better than the Zacks Consensus Estimate of 26 cents. Revenues also comfortably beat the Zacks Consensus Estimate of $2.80 billion. Shares increased 5.51% in after-hours trading.

Revenues

Revenues (excluding the foreign exchange effect) surged 60.5% from the year-ago quarter to $2.51 billion. The strong revenue performance was aided by robust advertising revenues that jumped 67.4% from the year-ago quarter to $2.68 billion.

Advertising revenues were driven by increasing mobile engagement, higher number of marketers, continuing investment in new products and robust performance of its newsfeed ads.

Mobile ad revenues soared 151.0% year over year and accounted for 62.0% of ad revenues, up from 59.0% in the previous quarter. Ad revenues from desktop increased 8.0% on a year-over-year basis.

Mobile-only Monthly Active Users (MAU) was 399 million at the end of the second quarter compared with 219 million in the year-ago quarter and 341 million in the previous quarter.

As of Jun 30, 2014, Facebook’s MAU improved 14.0% year over year to 1.32 billion. Mobile MAUs increased 31.0% year over year to 1.07 billion. Daily Active Users (DAU) increased 19.0% year over year to 829 million. Mobile DAUs went up 39.0% year over year to 654 million.

Ad impressions declined 25.0% on a year-over-year basis, primarily due to lower ad volumes on mobile devices. However, average effective price per ad soared 123.0% from the year-ago quarter driven by favorable mix shift toward high-priced newsfeed ads.

Average revenue per user (ARPU) increased 32.0% year over year to $2.24. India became the second largest Facebook using nation in the world, after MAUs crossed 100 million in April. (Read: India: World’s 2nd Largest Facebook User)

Payments and other fees increased 9.0% year over year to $234.0 million in the reported quarter. Payments revenues from games grew approximately 1.0% on a year-over-year basis.

Product Updates

In April, Facebook launched a location tracking mobile app Nearby Friends for Apple’s (AAPL - Analyst Report) iPhone and Google’s (GOOGL - Analyst Report) Android-based smartphones. (Read: New App, Payments Service to Boost Facebook).

During the quarter, Facebook announced a number of new features in its F8 global developer conference, which reflected its continuing focus on improving user engagement and monetization on mobile.

The social network announced a mobile ad network called Facebook Audience Network (FAN), to deliver ads to third-party apps. The network significantly expands Facebook’s total addressable market (TAM). (Read: Facebook Offers New Features at F8)

In June, Facebook launched Slingshot, a smartphone photo and video sharing app, which was touted as a prospective competitor to Snapchat. (Read: Facebook Releases Slingshot; Battle with Snapchat Heats Up)

The company updated its Paper app, which added special Trending section highlighting news and photos. (Read: Facebook Updates Paper App with Trending Section).

Margins

Total cost and expenses as percentage of revenues plunged to 52.2% from 69.0% reported in the year-ago quarter. Research & development, marketing & sales and general & administrative expenses decreased 210 bps, 250 bps and 270 bps, respectively.

Lower-than-expected increase in operating expenses drove operating margin, which improved from 31.0% in the year-ago quarter to 47.8% in the second quarter. Net income was $788.0 million or 30 cents per share compared with $331.0 million or 13 cents in the year-ago quarter.

 

Balance Sheet & Cash Flow

Facebook exited the quarter with cash & cash equivalents and marketable securities of $11.45 billion compared with $12.63 billion in the previous quarter. The company generated $1.34 billion of cash flow from operating activities compared with $1.29 billion in the previous quarter. Free cash flow was $872.0 million compared with $922.0 million in the last quarter.

Acquisitions

Facebook recently agreed to acquire San Francisco-based video advertising company, LiveRail. We believe that the acquisition will enable Facebook to offer better quality video ads around the web in the long run. (Read: Facebook to Boost Video Ads with LiveRail Acquisition)

Most recently, Facebook completed the Oculus VR acquisition. Oculus acquired a couple of companies recently that will boost its product portfolio in the long run (Read: Facebook’s Oculus Acquires RakNet)

Guidance

Facebook expects to carry on with its investments for improving the quality, engagement and value of its ads and products, which will further boost advertisers’ demand over the long term.

Management expects that year-over-year revenue growth rate will decline due to tough comparisons through the second half of 2014. Total expenses are expected to increase approximately 30.0% to 35.0% (down from 40.0% to 45.0%) for 2014. Capital expenditure is likely to be in the range of $2.0 to $2.5 billion for 2014.

For 2015, Facebook expects operating expenses to jump significantly due to acquisition costs related to WhatsApp and Oculus as well as continuing investments on products, workforce and infrastructure.

The company believes that new initiatives and products like Instagram, autoplay video and the FAN will take some time to contribute meaningfully to revenue growth. However, Facebook remains positive over their long-term growth prospect.

Our Take

Facebook has gained significant traction in its mobile ad business within a very short span of time. This combined with the massive user base and its ability to track personal details over time makes it a formidable force in the online ad market.

We believe that Instagram’s growing popularity and the new initiatives such as Internet.org will continue to boost Facebook’s user base in the long run. Moreover, the new products like Slingshot and FAN will help the company to grow ad revenues amid intensifying competition from Google and Twitter (TWTR - Analyst Report).

However, overdependence on advertising revenues for growth can be a headwind. We note that both WhatsApp and Oculus are long-term growth opportunities. The Internet.org initiative is also long-term focused. Hence, lack of revenue diversification remains a major concern in the near term.

Moreover, higher investments on product and infrastructure development will hurt profitability.

Currently, Facebook has a Zacks Rank #4 (Sell).

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