Citigroup Inc (NYSE:C) view Facebook Inc (NASDAQ:FB) as having great potential considering its large and global audience, valuable user data, and mobile presence.


However, given the continued monetization headwinds presented by the consumption transition from desktop to mobile; challenges  of  maintaining  rapid  user/usage  growth  in  the  face  of  competition; uncertainty surrounding potentially large opportunities like video, ad network and search; expected near-term margin pressure created by the onset of an investment cycle; and valuation (6x EV/CY14 revenue), they believe the shares could continue to underperform during this transitional phase of the company’s lifecycle and are initiating coverage with a Neutral rating.

 Their 12-month target of $27 implies forward EV/EBITDA and adjusted P/E multiples of 13x and 37x, respectively, and is based on 3-year revenue and adjusted EBITDA CAGRs of 23 percent of 26 percent, respectively.

Can Facebook Maintaining User (& Developer/Publisher) Relevance

Over the past 10-15 years of the consumer Internet’s commercial existence, Citigroup Inc (NYSE:C) has seen few companies maintain their relevance with consumers. For every, Inc. (NASDAQ:AMZN) or Google Inc (NASDAQ:GOOG) there are 100 Lycos, MySpaces, Compuserves or Friendsters. Therefore, they see one of the main risks for Facebook Inc (NASDAQ:FB) and its investors as being the company’s ability to maintain relevance with users over time.

Bears might point to the recent declines in Facebook’s desktop MAUs and/or the rapid rise of directly competitive services like Instagram, Twitter, WhatsApp Messenger or Snapchat as examples of how quickly Facebook’s relevance can fade, at least in certain key use-case categories. Therefore, they believe a key question for investors is, “Can Facebook maintain, or even expand, its relevance with users (and developers/publishers)?”

Facebook Managing the Desktop to Mobile Transition

While co-founder and CEO Mark Zuckerberg in many respects is correct when he recently stated that “today there is no argument: Facebook Inc (NASDAQ:FB) is a mobile company,” desktop advertising (and to a large degree still “right-hand rail” ads) still contribute 70 percent of the company’s total advertising revenue (as of 1Q13). While the company’s mobile advertising growth has been impressive of late (from nothing in March 2012 to $374 million in 1Q 13), the near-term challenge for Facebook is whether it can meet or exceed current revenue expectations given 1) the continued declining desktop usage, and 2) the fact that mobile monetization (defined as ad revenue per MAU) was roughly half that of desktop (53 percent) in 1Q 13.


Selling the Investment Cycle

Facebook Inc (NASDAQ:FB) is still a relatively young company, with significant user and revenue growth globally, with an aggressive mission statement and goals, and with competitors that are significantly larger in revenue, cash, employees and other key areas. Facebook also went public in May of last year with trailing EBITDA margins of 55-60 percent — placing it as the most profitable public Internet company. Management’s CY13 guidance (first provided on the 4Q 12 earnings call) included an expectation for cash operating expenses to increase “around 50 percent” in CY13 and for margins to contract (i.e., “will likely cause our expenses to grow at a faster rate than we expect to grow our revenue this year”).

And, when one considers factors such as its current scale relative to competitors and the expected growth in users and revenue, it’s possible that this investment cycle and related margin pressure could persist beyond CY13 and further impact expectations. While certainly not without exception, given the typical valuations in the Internet sector, Citi noticed that stocks in their universe tend to outperform during periods of margin expansion and vice versa. This raises the question, in Citi view, “Can Facebook shares outperform during a period of heavy investment and margin pressure?” and relatedly “Can Facebook Inc (NASDAQ:FB) sell investors on its investment plans?”


Facebook Ad Network, Graph Search, Video & Other New Revenue Streams

There is great debate about what, if any, new or recently launched monetization initiatives could become material contributors to Facebook Inc (NASDAQ:FB)’s top-line. Citi see the most likely sources of big-pocket opportunities for the company being 1) the launch of an off-Facebook ad network, 2) the launch of an ad product developed around its recently launched Graph Search product; and, 3) the launch of a formal video ad product. While there is greater potential with each of these new revenue streams, Citigroup Inc (NYSE:C) see Facebook Inc (NASDAQ:FB) as having many unique advantages in each (scale/reach, data, etc.).

They also believe there remains great uncertainty surrounding both the likelihood of Facebook Inc (NASDAQ:FB) getting into these segments, the potential timing of a launch, and ultimately in their relative success.

Facebook : Peer Analysis

Citi note that their current forecasts for Facebook Inc (NASDAQ:FB) call for 33 percent and 27 percent revenue growth in CY13 and CY14 respectively, which compares to the comp group average of 19 percent and 18 percent, respectively (see figure below). Their current forecasts also call for 52 percent and 53 percent adjusted EBITDA margin in CY13 and CY14, which compares to the comp group average of 22 percent and 25 percent, respectively.

As the table below shows, Facebook Inc (NASDAQ:FB) currently trades at 12x CY14 adjusted EBITDA which compares to the comps at 14x. Citi believe this discount is unwarranted given the company’s above-average growth and profitability relative to its peers.