Facebook’s New Graph Search: Everything Investors Need to Know

The following is an excerpt from a report compiled by Michael Pachter of Wedbush Securities.

On Tuesday, Facebook (NASDAQ:FB) unveiled Graph Search, a curated search tool that allows users to access information from Facebook’s Social Graph that gives them more relevant search results. The new Graph Search bar will appear at the top of the page when the user accesses Facebook. With the new tool, users will be able to search for people, photos, places, and interests, with the relevant results shown below the bar. Examples of search phrases provided by the company include “friends of friends who have been to Yosemite National Park”, “Indian restaurants liked by my friends  from India,” and “languages my friends speak”, among others.

Search results can be derived from the wider Facebook universe and not just from friends, if that is the user’s preference. However, posts and interests that were private before Graph Search will remain private going forward. Graph Search is currently in a beta period, and the rollout is expected to take some time as the company learns how users engage the new tool, and how to improve it. Graph Search is currently available in English only, but other languages will eventually be introduced, as well as a mobile version and an API.

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We believe Facebook is uniquely positioned to provide relevant search results to its users, displaying more meaningful results than other more established search engines (such as Google and Yelp!). Facebook already has detailed information on many members of its Social Graph.  Graph Search allows Facebook to track user activity real time, allowing the company to collect information on interests of its users unobtrusively.  This information is likely to be highly desirable to advertisers, and should serve to allow the company to better monetize its user activity going forward.

A side benefit of Graph Search is…

that the user experience will be stickier.  A user who spends time looking at Graph Search results is likely to spend more time on the Facebook site.

Facebook also announced a partnership with Microsoft (NASDAQ:MSFT) involving its Bing search engine for data points not included in Graph Search results. For example, the “weather in Menlo Park” is unlikely to show up in Graph Search results, but it is easily accessible through Bing instead. We believe the inclusion of Bing search results increases the appeal and relevancy of Graph Search, as the user will not be constrained by information within his own Facebook universe. Instead, the user gets a strong search engine for the worldwide web from Microsoft with a powerful search engine for the Facebook universe layered on top. In addition, because Graph Search results are derived from a user’s friends, the user is more likely to trust those search results than ones from Google’s (NASDAQ:GOOG) search engine. On a per user basis, “trusted” search results will command a much higher price than those coming from an anonymous source. According to the company, Facebook did not team with Google as it was not willing to do what Facebook wanted in terms of privacy concerns.

We believe that Graph Search has the potential to drive significant long-term revenue growth for Facebook. In our Initiating Coverage note from May 2012, we estimated that curated search could comprise a $3 – 4 billion revenue opportunity by 2015 for the company. We believe revenue could be generated in a number of ways, such as: (1) placement within search results, (2) sponsored search results, (3) inclusion in search results, and (4) piggybacking onto a related search item. For (1), if the user searched for an Italian restaurant that his friends had enjoyed, and his friends had enjoyed several, one restaurant may be willing to pay more to appear at the top of the search results. For (2), Italian restaurants that had not been visited by the user’s friends may be willing to pay for a sponsored placement within the search results. For (3), a Greek restaurant could pay to be included in results for a lower fee on the random chance that Greek food sounds good to the user instead of Italian. And finally…

for (4), a publisher of Italian cookbooks may be willing to pay for its books to be placed in or around a user’s search results as that user may want to learn how to cook Italian food at home.

In our view, investor reaction to Graph Search appears to be “sell on the news”, as Facebook shares closed down ≈ 3% for Tuesday’s trading session. Although not made clear by the announcement, we believe that Graph Search could be a significant source of revenue growth for the company as it scales. In our view, “trusted” search results will command a premium and transform the advertising landscape.

Maintaining our OUTPERFORM rating and our price target of $35. Our price target reflects a value of $60 per MAU at Facebook’s peak MAU level with a conservative monetization assumption of $1 per MAU per month for five years.

Risks to the attainment of our share price target  include increased competition, changes in advertiser or consumer preferences, mobile advertising growth, changes to the terms or economics of its agreements with partners, and legal and regulatory risks.

Michael Pachter is an analyst at Wedbush Securities.

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