Initiating Coverage on Facebook

We are initiating coverage on Facebook Inc. ( FB - Analyst Report ) with a Neutral recommendation over the long term (6-12 months) and price target of $33.00.

Incorporated in 2004, Facebook became public on May 18, 2012. The social networking pioneer offered 421 million shares to the general public, representing a 15% float. Facebook priced its Initial Public Offering (IPO) at $38.00 per share (approximately 100 times historical earnings as per Reuters) and finally raised $6.84 billion as net proceeds.

Facebook’s IPO has been severely criticized for mismanagement and technical glitches that cost stock brokers and investors millions of dollars. IPO experts opined that Facebook’s sky-high valuation was unjustified, primarily due to unproven monetization efforts on the mobile platform, a slowing advertising growth rate and not-so-impressive first quarter results for the quarter ended March 31, 2012.

Although revenues surged 45.0% year over year to $1.06 billion, Facebook reported earnings of 9 cents, which declined slightly from 11 cents reported in the year-ago quarter. The uncertainty behind Facebook’s IPO filing has resulted in a sharp decline in share prices. Year-to-date, Facebook shares have declined 18.0% as compared to a 5.9% increase in the S&P 500.

Despite enjoying a first mover’s advantage in the social networking market, we believe that increasing competition is the primary headwind for Facebook over the long term. Besides competition from Google's ( GOOG - Analyst Report ) Google+, Twitter, Orkut in its core markets, Facebook is also fighting small regional platforms, which not only limit its expansion opportunities but also hurt its profitability.

Facebook is facing significant competition in the display advertising market from Google. Rising concerns over the effectiveness of Facebook ads as compared to Google’s AdSense has been a headwind lately. As per eMarketer, Google is set to grab the #1 position in the display market by the end of 2013. We believe that Google’s increasing popularity has the potential to limit Facebook’s ad revenue growth going forward.

Further, Facebook’s popularity is based on the engaging apps from its third party developers, particularly Zynga ( ZNGA - Snapshot Report ) . However, Zynga’s narrow product portfolio has been primarily blamed for a waning interest in social games on the platform. Zynga’s low-paying customer base and stiff competition from other established players are also hurting its top-line. This does not bode well for Facebook, as the company earns the majority of its non-ad revenue from Zynga.

Apart from increasing competition, lack of visibility around mobile monetization remains a concern. Although Facebook has made a number of acquisitions (such as Snaptu, Instagram) to boost its mobile offerings, we believe that lack of adequate ad coverage for the mobile platform will hurt its revenue earning capacity going forward.

Nevertheless, we believe that Facebook has immense growth opportunities based on its huge & loyal customer base, talented platform development team and engaging apps.

Facebook currently earns approximately 15.0% of its revenue from non-ad sources, mainly from the sale of in-game items in the social gaming apps of Zynga. As Facebook continues to gain scale and expands into new horizons, we believe that the company will increase its focus on improving monetization from other app developers beside Zynga.

We believe that Facebook has significant growth opportunities from increasing online advertising spending as compared to traditional formats. Facebook’s massive user base (around 900 million) and its ability to track personal details over time make it a formidable force in the online ad market. Facebook can use this massive database to help advertisers target relevant ads going forward.

Currently, Facebook has a Zacks #3 Rank, which implies a Hold rating over the short term (1-3 months).