We continue to be amazed at Facebook’s ability to surpass expectations consistently as the firm yet again beat on the top- and bottom-lines during the third quarter of 2017. Facebook’s network effect moat source was on display as double-digit year-over-year growth in users and revenue per user continued for the firm. Management expects revenue growth to decelerate in the fourth quarter at a slower pace than we had initially anticipated. On the downside, in 2018, the firm believes its continuing investment in improving the security and transparency of its platform, along with providing more video content and overall product innovation for its users, are likely to significantly increase operating expenses from 2017, which will result in a lower operating margin. Nonetheless, based on Facebook’s strong third quarter performance, we are forecasting higher revenue and expect margins to recover to the 40% range and above starting in 2019. With those adjustments, we now value wide-moat Facebook at $163 per share, up from $155. We continue to view Facebook shares as fairly valued.
Second-quarter total revenue of $10.3 billion was up 47% year over year. Facebook’s ad revenue rose 49% over last year to $10.1 billion, driven by 16% year-over-year growth in monthly average users, or MAUs, accompanied by a 26% increase in average revenue per user, or ARPU. Regarding the bottom line, Facebook reported third-quarter operating margin of 49.6%, up by approximately 500 basis points year over year, due to slightly higher gross margin and lower growth in SG&A expenses. While the firm lowered its year-over-year operating expense growth expectation for 2017, it did note that in 2018, operating expenses are likely to increase by 45%-60% from 2017, as Facebook continues to invest in video content and higher R&D headcount. Plus, further investments in data centers around the world will push Facebook’s capital expenditure to $14-$15 billion in 2018, nearly double our estimate for 2017.
While higher Facebook ad prices (up 35% year over year) were good news, as we have mentioned before, we believe they were driven mostly by lower growth in the supply of Facebook’s ad inventory (ad impressions increased only 10% year-over-year), resulting in impressive ARPU and ad revenue growth. We still expect ARPU and ad revenue growth to decelerate in the fourth quarter and beyond. We expect Instagram’s ad inventory to accelerate growth in Facebook’s overall supply, and possibly soften the overall price increase we have seen. Further, while the possibly higher ROI for advertisers spending on Instagram or video ads may increase demand for and prices of their ad loads, such spending may cannibalize ads on News Feed, slowing down growth in overall demand and prices for News Feed ads.
On the political and public-relations front, Facebook management stated that the firm will be making large investments to increase transparency and protect its platform and users from hate speech and “fake news” which various Russian advertising groups may have used during the 2016 Presidential election. While we approve this move, we believe additional focus on growth in user monetization is more beneficial for shareholders in the long-run, which is why the firm continues to explore various monetization vehicles, including video content. Facebook plans to keep allocating capital toward making more video content available for its users to possibly increase the amount of time spent and interaction on the platform, which may yield further ad revenue. While Facebook is not yet clear on how it plans to monetize the content, we view the insertion of pre-roll ads as the most effective monetization model for short-form and more interactive video content, which we expect to represent most videos on Facebook. If Facebook goes after long-form video content, it may be able to insert mid-roll ads and implement an ad revenue share model, which we believe is likely to have lower margins.
