Facebook, Inc. (FB)Q4 2012 Earnings Conference Call

January 30, 2013 5:00 PM ET

Operator

Good afternoon. My name is Steve, and I’ll be your conference operator today. At this time,I’d like to welcome everyone to the Facebook’s Fourth Quarter Earnings Conference Call. Alllines have been placed on mute to prevent any background noise. After the speakers’remarks, there will be a question-and-answer session. (Operator Instructions) Thank youvery much.

Ms. Deborah Crawford, Facebook’s Director of Investor Relations, you may begin.

Deborah Crawford - Director of Investor Relations

Thank you. Good afternoon, and welcome to Facebook’s fourth quarter and full-year earningsconference call. Joining me today to talk about our results are Mark Zuckerberg, CEO; Sheryl

Sandberg, COO; and David Ebersman, CFO.Before we get started, I’d like to take this opportunity to remind you that during the courseof this call, we’ll make forward-looking statements regarding the future events and the futurefinancial performance of the Company. We caution you to consider the important risk factorsthat could cause actual results to differ materially from those in the forward-lookingstatements in the press release and this conference call. These risk factors are described inour press release and are more fully detailed under the caption Risk Factors in our quarterlyreport on Form 10-Q filed with the SEC on October 24, 2012.

In addition, please note that the date of this conference call is January 30, 2013, and anyforward-looking statements that we make today are based on the assumptions as of thisdate. We undertake no obligation to update these statements as a result of new informationor future events. During this call, we will present both GAAP and non-GAAP financialmeasures. A reconciliation of GAAP to non-GAAP measures is included in today’s earningspress release.

This call is being broadcast on the Internet and is available on the Investor Relations sectionof the Facebook website at investor.fb.com. A rebroadcast of the call will be available after 6p.m. Pacific Time today. The earnings press release and an accompanying investorpresentation are also available on our website. After management’s remarks, we will host aQ&A session.

And now, I’d like to turn the call over to Mark.

Mark Zuckerberg - Chairman, CEO

Thanks everyone for joining us. 2012 was a big year for us. We made this big transitionwhere now there are more people using Facebook on mobile everyday than on desktop. Thiswas challenging for us to navigate since we started off the year with apps that weren’t ashigh quality as we wanted, and no ads in our apps at all. But now we’re coming out of theyear with a strong foundation and a lot of momentum. Just last week, comScore put out areport saying that Facebook is now 23% of all time spent on apps in the U.S, and one of thenext biggest apps is Instagram at 3%. So, put together, we’re now more than a quarter ofthe time spent in apps. Today, there’s no argument. Facebook is a mobile company. As I’vesaid before, there are three main parts of our strategy; build the best mobile products, buildthe platform and services that leverage the social graph, and build a really strongmonetization effort engine.

I am going to use our time today in the same way I will on most of these calls to give myassessment of how I think we’re doing against each of these big areas; let’s start withmobile. I think more people are starting to understand that mobile is a great opportunity forus. Mobile is the perfect device for Facebook for three reasons. It allows us to reach morepeople. We have more engagements from the people who we reach, and I think we’ll also beable to make more money for each minute people spend with us on their mobile devices. Butmobile isn’t just driving greater engagement on Facebook. Mobile enables many newexperiences, and its growing overall sharing across all apps. This creates a very dynamicecosystem, and one where there’s a lot of room for us to create even more sharing throughFacebook. Often doing a good job is just about focusing on basic issues like performance and

stability.

In December, we released a completely rewritten version of Facebook for Android. This is theAndroid version of the iOS rewrite we did earlier last year. Neither of these rewrites added bignew features, but simply by improving speed and stability, we’ve made a much better userexperience enabling people to share even more. It's a good example of how early we are inthe market that these changes make such a big difference. Photos and Instagram are doingreally well too. We had our best day ever on New Year’s day with more than 600 millionphotos uploaded to Facebook. Instagram has continued growing very quickly, and hopefullywe’ll have some new milestones to share with you all soon.

A lot of what we had to do last year was simply to improve our mobile development process;now we’re there. We move fast and ship new versions of our apps on a regular monthlycycle. You have a good version of all the Facebook features you know and want on yourphone. So, now the next thing we’re going to do is get really good at building new mobile firstexperiences. That’s going to be a big theme for us this year. If we do this well, we should beable to bring even more relevant content and connections to more people and continue todeepen their engagement.

Next, I want to talk about platform and building new services using the social graph.Normally, I’ll use this section to talk about what’s going on in the ecosystem outside of ourcompany, but this quarter, I think we built the most interesting new service using the socialgraph, Graph Search. This is an early beta product, but we're really excited about it becauseit's an entirely new kind of search. It's not Web search, its structured search over the wholegraph of content that people have mapped out on Facebook. It's good for lots of things thatyou just won't use the traditional search engine for it. Seeing where your friends have eatenor traveled to, browsing photos and content your friends posted, finding new people to meetor recruit for a job, and many other things.

So many of these are big areas where we think that there is room for much better products.Down the line if we do this well, this could potentially turn into a meaningful business for us.For now, we're going to continue working to refine the product and roll it out to everyone.Still, I think the way that Graph Search is different from normal web search is a good exampleof how there is going to be this market for a whole new crop of social services in existingmarkets today that were designed with the principles of real identity and social connections,et cetera.

One platform development that I am really excited by is seeing how well our App installadvertising product is doing. Developers are finding that Facebook is a great service forconnecting with the right people who want to use their apps and getting a lot of installs. Onmobile, our platform already enables developers to help you bring your friend to a developer'sapp. We also want to be one of the primary ways that developers get new people to theirapps in the first place, and with App install ads, we're off to a good early start in achievingthat.

Now I want to talk a bit about monetization. Last year was a big year for us here. Westarted off the year with no ads at all on mobile and we ended up with approximately 23% of

our ads revenue coming from mobile in the fourth quarter. That's a pretty amazing change.One of the big drivers of this has been that as we rolled out our ads to News Feed, we foundthat it barely affected the level of engagement on Facebook. We thought that we can makethis work over time without a big impact if we spent a long time tuning the ad, but thenumbers turned out even better than we thought without much tuning. So, this has enabledus to show people a few ads in News Feed each day. So that means that now we have thisNews Feed ads business that we barely tuned and there's a big opportunity in front of us tomake every ad that we're showing a lot better.

The biggest ways we're going to do this are by improving targeting and relevance, so we canshow everyone content that they care more about and by designing better ad products thataren't just about links and text and images. For targeting, I'm most excited about the workthat we're doing on Custom Audiences, our tool that lets advertisers upload their customerlist and target against that and information is already on Facebook at the same time. Say,my customers are in some age range and live in some state, you may not know which statesyour customer is living, but if they've shared it on Facebook, then it's possible to createthese kinds of experiences.

For new ad experiences, I'm looking forward to doing more with different kinds of media. Asour News Feed design evolves to show richer kinds of stories that open up new opportunitiesto offer different kinds of ads as well. Aside from ads, I do want to temper near-termexpectations a little bit on revenue lines coming from other areas, like Gifts or Graph Search.I think these can be big opportunities for us long-term, but for the foreseeable future, themost important thing for us is to continue building out great consumer experiences aroundthese products. We're going to invest in these, but for the next year at least, our workaround ads will have by far the biggest impact on our business.

Now, before I hand it off to Sheryl, there's one more thing I want to discuss. We're at aninteresting point in our evolution where there are lots of areas where we need to invest in.We need to build the best mobile experiences, we need to build our platforms, and we needto build a really strong monetization engine. We can easily invest our entire engineering teamjust in building out the nuts and bolts of these areas today.

But we also feel like there is an imperative to start planting seeds for tomorrow's businessesas well. Products like Graph Search that are in beta today, but will hopefully grow up to bepillars of the Facebook service and businesses, are things that we want to invest inaggressively and things we feel like it's the right thing for our business over the longer termto invest in aggressively.Based on this, we made the decision to continue to grow our headcount quickly in 2013,particularly in product development. This will likely cause our expenses to grow at a fasterrate than we expect to grow our revenue this year. This means that we aren't operating tomaximize our profits this year. We're doing what we think will build the best service andbusiness over the long term.

Finally, I just want to take a minute to thank everyone who works at Facebook. Last yearreally was an amazing year for us on many levels. We connected 1 billion people, wenavigated the transition to becoming a mobile company, and we've laid the foundation forsome great new products I'm excited to show the world this year. And this is all because we

have this unique culture filled with some of the most talented people in the world who arestill mission-driven, who want to make the world a better place and who work so hard tomake the world that place.

Thank you all. And thanks to everyone who's on this call for taking the time to be with ustoday. I look forward to being able to report on all the progress we'll make next quarter.Now, I’m going to hand the podium over to Sheryl.

Sheryl Sandberg - COO, Director

Thanks, Mark. So our ad business continued its positive trajectory in the fourth quarter.Total fourth quarter revenue was $1.585 billion with $1.329 billion coming from ads. Thisrepresents a 41% increase for advertising revenue. Ad revenue from News Feed increasedacross both desktop and mobile, and in Q4, approximately 23% of our ad revenue came frommobile, up from approximately 14% in Q3. Our focus in the fourth quarter was to continueimproving and scaling the products we launched in 2012. We know that our advertisingproducts are delivering results for marketers and one of the best indicators of this came overthe holiday season where more businesses, from big brands to small retailers used us as acore part of their holiday outreach.

Perhaps the biggest highlight in the fourth quarter was the increasing importance of mobile,not just to Facebook, but also to our clients. Marketers are realizing more and more thatFacebook is one of the best places to reach their customers on mobile because of our uniqueability to reach specific target audiences at scale.

Another highlight, is the traction, our Offers and Promoted Posts products, which are reallyeasy to use, have given us at local businesses. As I described last quarter, our strategy isfocused on three priorities. One, building products and tools that create value for every typeof marketer. Two, proving that value to marketers; and three, taking advantage of theunique opportunity we have in mobile.

Starting with the first, we build products that create value for every type of marketer. Wecontinue our focus on four key customer segments; brand marketers, direct marketers, localbusinesses, and developers. For brand marketers, we combine access to the largestcommunity of real people in the world with some of the industry’s best targeting capabilities.We now work with every one of the Ad Age Global 100 Advertisers. And overall revenue fromthese clients is growing through consistently with our ad revenue in 2012, which means thatsignificantly outpaced the estimates for overall ad spend from the industry.

In the fourth quarter, we launched a new way for advertisers to buy guaranteed adimpressions with the goal of helping them reach massive audiences on mobile. Wal-Mart usedthis target block over the important Thanksgiving weekend to deliver 50 million mobile ads totheir existing and potential customers. We think this is a very important fact in the evolutionof mobile advertising as these numbers rivaled a scale of broader web and TV campaigns.

Increasingly companies use Facebook as the exclusive channel to launch new products. Toshare one example, Michael Kors has used Facebook to launch a line of new sneakers. Manyof the sneakers sold out online and in new stores, and they achieved a 60 point increase in

awareness of the new sneakers among the 36 million people that the campaign reached onFacebook. That’s the equivalent of 5.8 million new people in the brand’s target audience whoare now aware of the new line of shoes.

For direct marketers, the products we launched in the third quarter continued to bringtraction in Q4 as well. Since we launched our Offers product at the end of September, we'veseen stronger advertiser adoption and user engagement with nearly 42 million unique usersclaiming an offer. Cost per redemption compared favorably to those from email, newspaper,paid search, and display media based on data from the Direct Marketing Association.Discounts and promotions are often important tactics for direct marketers and we think ourOffers product is well placed to compete for these media budgets.

As Mark said one of the products we’re most excited about is Custom Audiences, which letsthe marketers show their ads to exactly the right people by coupling our rich targetingcapabilities with their own customer data or data from a third party. A large retailer forexample, can send one set of ads to customers who typically buy foreign goods and adifferent set of ads to those who would purchase beauty products. This results in some ofthe best targeting available on or offline today.

To share one example, JackThreads, an online shopping site for men used Custom Audiencesto target specific segments on its customer database and target them with ads for productsthat the company knew were most relevant to them such as sneakers. As a result, thecompany achieved a 30% lower cost for acquisition than other platforms and saw a six timesreturn on advertising spend.

It's important to understand that Custom Audiences is not a separate standalone ad product,but rather a targeting capability that can be used with many of our ad products to drivegreater accuracy and efficiency. For example, when Custom Audiences is used with offers,marketers can customize discounts for exactly the right kind of customers.

The Facebook Exchange or FBX allows businesses to bid on specific ad impressions in realtime and it continues to gain momentum and drive solid results for advertisers. Despite onlybecoming available to all marketers in September, by December FBX served nearly 1 billionimpressions daily and supported over 1,300 advertisers each day. Large and small advertisersalike are seeing higher click-through rates, lower cost per conversion, and strong incrementalreaches in FBX.

Revenue from local businesses was particularly strong in the fourth quarter. We're pleasedwith the number of local business pages that advertise on Facebook nearly doubled since thebeginning of 2012. This is due in no small part to our Promoted Posts product, which makes iteasier for businesses to create and purchase ads directly from their Facebook page. Almost500,000 pages have used Promoted Posts, about 30% of these are new advertisers toFacebook, and more than 70% have become repeat customers.

Finally for developers, we continue to gain traction with our new mobile app install ads, sincetheir launch in October, they are already being used by 20% of the top 100 grossing iOSapps to accelerate growth. According to research conducted by comScore in December,Facebook is the top driver of awareness of new mobile app downloads; and among people

who learn about new apps on Facebook, 48% clicked directly from the Facebook apps todownload new mobile apps.

Cie Games uses products to drive installs of its new game Car Town Streets. As a result,they've broken to the top 10 games list on iOS in many countries while achieving a 40%lower cost per installation compared to their other advertising. In addition to gaming, webelieve this will be a very useful product to help companies and industries like retail, travel,and financial services shift their businesses to mobile.

Next, I'll also step on our commitment to provide proving value -- proving Facebook's valueto marketers. We design all of our products to deliver a strong return on investment. Giventhat we are still a relatively new marketing platform, proving that our ads are effectiveremains an important and ongoing priority for us. We work with research companies likeNielsen, Aggregate Knowledge, and Datalogix to demonstrate how our ads drive sales andhelp inform our product development.

For example, research from Aggregate Knowledge showed that Facebook is an increasinglypowerful tool to help marketers reach more people and drive sales. In the study of fourthquarter marketing campaigns, they found that media plans that included Facebook reachedpeople who would not have seen the campaigns otherwise. In fact, 45% of those reachedwere reached exclusively through Facebook. The study also found that Facebook had a 68%lower cost per acquisition and drove 24% more new sales than other online channels. Wealso work with clients directly to integrate with their own measurement systems so they canbetter understand the ROI Facebook delivers.

For example, we built a deep relationship with PepsiCo where we worked with its Lay's brandto drive significant sales ahead of plans and a 5x return on ad spend for their Do Us a Flavorcampaign on Facebook. In the fourth quarter, we also made conversion tracking available inbeta. Conversion tracking allows marketers of all sizes to more easily measure the impact oftheir Facebook advertising, whether the Facebook ad is the first ad or the last ad the personsees before taking an action.

Finally, I want to discuss how we're continuing to take advantage of the significantopportunity we have in mobile. As mentioned before, approximately 23% of our advertisingrevenue now comes from mobile. In addition, 65% of our advertisers are now using ads inNews Feed which run on both desktop and mobile up from 50% at the end of the thirdquarter. Marketers are recognizing that our News Feed is the most efficient and effectiveplace to reach their customers due in large part to the fact that ads in News Feed see ahigher click-through rate and ultimately a lower cost per conversion and ads on theright-hand side of our site.

By working with Datalogix, we have shown that as the News Feed also drives more than 8times the incremental offline sales in ads on the right-hand side. Clients also recognize thatbecause our users share their real identities on Facebook and because they are logged inwhen they use Facebook on mobile, we have a unique ability to start advertising that people

find relevant. This is an important competitive advantage for us relative to other mobileplatforms and one we think we are very unique in.

Overall, we continue to make real progress advancing our advertising strategy. Our revenueand key metrics are growing nicely, and as we look ahead to 2013, we're very confident inthe direction of our ad business.

Over 1 billion people are on Facebook, and we are enabling businesses to engage with themdirectly wherever they are. Our massive scale, accurate targeting, strength in mobile, andnew advertising products are driving measurable results for all types of businesses andtransforming the way people and businesses connect. We look forward to making even moreprogress in these areas in the year ahead.

Now, I'll hand it over to David.David Ebersman - CFO

Thanks, Sheryl, and good afternoon, everyone. We're pleased with the progress we made inQ4 against our key financial priorities, growing revenue, investing aggressively in areascritical to our future performance, and positioning the company to maximize long-termfinancial returns.

We ended the year with 1.06 billion people using Facebook, up 25% from a year-ago. InDecember, 618 million people accessed Facebook each day on average, up 28% from lastyear. and we grew monthly and daily users across all geographic regions. Mobile continues todrive our growth. 680 million people accessed Facebook from mobile devices in December, up57% versus last year. And the numbers I just mentioned do not include Instagram, whichcontinues to grow at an impressive rate. We ended 2012 with strong engagement across ourproducts. and this engagement remains a foundation for everything we’re trying to build.

Turning to revenue, in Q4, revenue was up 40% year-over-year or 42% when adjusted forconstant exchange rates. Q4 year-over-year growth would have been 34% if adjusted toexclude the additional month of payments transactions we recognized as planned. Adrevenue in Q4 was up 41% or 43% when adjusted for constant exchange rates.Year-over-year advertising growth in Q4 was the strongest of any quarter in 2012, and weview this as a validation of our recent investments in mobile News Feed ads, growing ouradvertiser base, and launching new ad products.

In the fourth quarter, ad impressions were up 46%, and average price per ad was down 4%compared to last year. These trends were driven by significantly faster impression growth indeveloping markets such as Asia and Latin America, which have relatively lower pricing, andthereby brought down our average price overall. The faster impression growth in developingmarkets in Q4 was significantly affected by product changes, primarily our decision to lowerthe market reserve price or the floor price we accept in our auction, which increased thenumber of ads shown in these markets.

We continue to see positive trends in price per ad in key developed markets, including an18% increase in average price in the U.S. and Canada in Q4. Payments and other revenuewas $256 million in Q4. As planned, in Q4 we recognized revenue from four months of

payments transactions for accounting reasons detailed in our last 10-Q. Adjusting for theextra month, payments’ revenues from games was essentially flat with the fourth quarter of2011.

This past quarter, payments and other revenue also included around $5 million from sourcesoutside of games, primarily user promoted posts and to a lesser extent from our new Giftsproduct.

Shifting now to expenses, in Q4, our total GAAP expenses were $1.06 billion. Excluding theimpact of stock compensation, total expenses increased 67% to $849 million driven primarilyby headcount and infrastructure. We ended 2012 with just over 4,600 employees, a 44%increase from last year driven by hiring in our technical groups. We were recently ranked thenumber one place to work by Glassdoor, which we view as a testament to how strong ourculture remains through this period of significant headcount growth.

In Q4, our GAAP operating income was $523 million. Excluding stock comp, our non-GAAPoperating income was $736 million representing a 46% operating margin. Our GAAP tax ratefor Q4 was 87% and our non-GAAP tax rate was 41%. For 2013, we expect our non-GAAPtax rate to be a few percentage points higher than the rate in Q4. Additionally, we ended theyear with approximately $5.8 billion in NOL tax loss carry forwards created by stockcompensation.

GAAP net income and EPS for the fourth quarter was $64 million or $0.03 per share.Non-GAAP net income and EPS was $426 million or $0.17 per share compared to $0.15 in Q4last year. We ended Q4 with $9.6 billion in cash and investments giving us great flexibilityand risk protection.

Looking forward now, we believe we've built a solid foundation for continued growth in 2013and beyond. In our ads business, we believe we have good momentum and plan to continueinvesting to grow advertiser demand and improve the quality, engagement, and value of ourads, particularly in News Feed.

In terms of 2013 expectations for payments, our games ecosystem continues to showhealthy signs of diversification with new kinds of games growing engagement andmonetization in Q4. However, we continue to face an offsetting headwind from decliningdesktop usage in developed markets since our games payments revenue is essentially all fromdesktop computers.

In terms of non-games payments revenue, while we remain excited about the long-termpotential of commerce on Facebook, current revenue from user Promoted Posts and Gifts isvery small, and we expect 2013 contributions from these initiatives to remain very small givencurrent run rates.

In terms of infrastructure, we expect CapEx spend in 2013 will be in the neighborhood of $1.8billion, as we continue to invest in servers, new data centers, and network infrastructure toenable us to bring Facebook speedily and reliably to everyone around the world.

We're pleased that planned 2013 CapEx spend is up relatively modestly compared to 2012which came in under forecast at a shade under $1.6 billion as our investments in softwareand hardware efficiency are paying off nicely.

As Mark noted, 2013 will be a year of significant investment in areas we believe are critical todrive long-term engagement and monetization, and we plan to continue to hire aggressivelyto accelerate product development and deliver new products for users and advertisers.

As a result of our hiring and investment plans, we expect that our total expenses, excludingstock comp, will likely grow by somewhere around 50% in 2013, though actual growth willdepend on hiring and project decisions we make through the year.

We believe this level of near-term investment is the right strategic decision to enablelong-term value creation. We're excited about the potential returns from investing in ourproduct. We continue to feel there's operating leverage inherent in our business, and we'recommitted to building a highly profitable cash generating business over the long term.

In summary, we believe we're entering 2013 in a strong position. We're working in very largemarkets that offer us great opportunities for growth. We have uniquely valuable assets interms of the size, identity, and engagement of the people who use Facebook and we have afantastic group of employees who have big aspirations to build on our financial performancefrom 2012.

Now let's open the call for questions.