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Why Instagram is So Important to Facebook

By: Chris Ciaccia
Posted: 11/4/2013 10:59:00 AM
Referenced Stocks: FB

When Facebook (FB) bought Instagram in mid-2012, many people, myself included, questioned the deal. Following Facebook's second-quarter results, it's no longer a question of why, but rather a question of how big it can be in the future.

Instagram, with its 150 million+ users, recently rolled out advertising to its users, with designer Michael Kors being the first to show advertising on the social network. What's different about Instagram versus other social networks is that it is a photo-centric social network, so the quality of ads will be higher, more aesthetically pleasing, and should not disrupt the user experience.

The potential for Instagram, which Facebook ultimately purchased for a little over $700 million in cash and stock, is huge, notes Citi analyst Mark May, who rates Facebook "buy" with a $57 price target. He ultimately believes Facebook could be worth $70, with advertising from Instagram account for $3 per share.

Assuming the average Instagram user visits the social network 20 to 30 times a month, with 15 to 20 views per visit, Instagram could generate $80 million, $348 million, and $765 million in revenue for Facebook in fiscal years 2014 to 2016. "We assume only a modest 2% fill rate in CY14 to account for a slow roll out as Instagram tests and optimizes advertising in the U.S," May wrote in his note. "Our 2% fill rate roughly assumes that, by the end of CY14, Instagram’s fill rate in the U.S. will reach approximately 50% of Facebook’s U.S. fill rate today (we estimate Facebook’s U.S. fill rate is in the mid-to-high single digits today)."

Given the usage statistics as the world turns to mobile, those numbers could prove to be exceptionally conservative.

On Facebook's second-quarter earnings call, CEO Mark Zuckerberg noted that Facebook, including Instagram is dominating users attention spans on mobile. "Facebook including Instagram, just one in eight minutes people spend on the desktop, but one in five minutes on mobile," Zuckerberg said on the call. "According to comScore, Facebook and Instagram have more mobile time spent than many of the next largest services including YouTube, Pandora, Yahoo, Twitter, Pinterest, Tumblr, AOL, Snapchat and LinkedIn combined."

Facebook earned 25 cents a share during the second-quarter, generating $2.02 billion in revenue. Mobile revenue accounted for 49% of total advertising revenue, about $881 million. That doesn't include anything from Instagram. Judging by the reaction on the Michael Kors ad, (over 229,000 likes), it's a good bet that Facebook can see significant upside from Intagram ads to its advertising revenue. May assumes standard ads could be worth $1.50 to $2 effective Cost Per Thousand views (eCPM), but that may prove conservative, assuming all Instagram ads look as well done and as glamorous as the initial Michael Kors ad.

Facebook COO Sheryl Sanderbg notes there's a lot of interest in advertising on Instagram from brands. Sandberg noted she wants the ads on Instagram to be as good as the user shared content. "And we are excited about it because there is a lot of interest and a lot of excited brands," Sandberg said on the call.

With a lot of questioning surround valuations of technology start-up, such as Pinterest, Snapchat and others, Instagram's enormous user base, and relative low purchase price for Facebook will likely prove to be a steal for Facebook and shareholders for years to come.