Facebook Files 10-Q With SEC, Details Mobile Users, Zynga, Lawsuits, Other Issues

Following its second-quarter earnings call last Thursday, Facebook filed its 10-Q quarterly document with the Securities and Exchange Commission Tuesday, addressing, among other topics, increased mobile usage, revenue from game developer Zynga, and the status of various lawsuits.

Following are some of the highlights from the 10-Q:

Mobile Usage

Worldwide mobile monthly average users increased by 67 percent from 325 million as of June 30, 2011, to 543 million as of June 30, 2012. In all regions, an increasing number of our MAUs are accessing Facebook through mobile devices, with users in the U.S., India, and Brazil representing key sources of mobile growth over this period. Approximately 102 million mobile MAUs accessed Facebook solely through mobile apps or our mobile website during the month ended June 30, 2012, increasing 23 percent from 83 million during the month ended March 31, 2012. The remaining 441 million mobile MAUs accessed Facebook from both personal computers and mobile devices during that month.

Growth in use of Facebook through our mobile products, where our ability to monetize is unproven, as a substitute for use on personal computers may negatively affect our revenue and financial results.

We had 543 million MAUs who used Facebook mobile products in June 2012. While most of our mobile users also access Facebook through personal computers, we anticipate that the rate of growth in mobile usage will exceed the growth in usage through personal computers for the foreseeable future and that the usage through personal computers may continue to decline in certain markets, in part due to our focus on developing mobile products to encourage mobile usage of Facebook. For example, the number of daily active users using personal computers was essentially flat, and it declined modestly in certain key markets such as the U.S. and Europe during the second quarter of 2012 compared with the first quarter of 2012. We believe increased usage of Facebook on mobile devices has contributed to the recent trend of our DAUs increasing more rapidly than the increase in the number of ads delivered. We have historically not shown ads to users accessing Facebook through mobile applications or our mobile website. In March 2012, we began to include sponsored stories in users’ mobile news feeds. However, in the first half of 2012, we generated only a small portion of our revenue from the use of Facebook mobile products, and our ability to increase mobile revenues is unproven. If users increasingly access Facebook mobile products as a substitute for access through personal computers, and if we are unable to successfully implement monetization strategies for our mobile users, or if we incur excessive expenses in this effort, our financial performance and ability to grow revenue would be negatively affected.

Facebook user growth and engagement on mobile devices depend upon effective operation with mobile operating systems, networks, and standards that we do not control.

There is no guarantee that popular mobile devices will continue to feature Facebook, or that mobile device users will continue to use Facebook rather than competing products. We are dependent on the interoperability of Facebook with popular mobile operating systems that we do not control, such as Android and iOS, and any changes in such systems that degrade our products’ functionality or give preferential treatment to competitive products could adversely affect Facebook usage on mobile devices. Additionally, in order to deliver high-quality mobile products, it is important that our products work well with a range of mobile technologies, systems, networks, and standards that we do not control. We may not be successful in developing relationships with key participants in the mobile industry or in developing products that operate effectively with these technologies, systems, networks, or standards. In the event that it is more difficult for our users to access and use Facebook on their mobile devices, or if our users choose not to access or use Facebook on their mobile devices or use mobile products that do not offer access to Facebook, our user growth and user engagement could be harmed.

Additionally, we are actively supporting platform developers’ efforts to develop their own mobile apps and websites that integrate with Facebook. Unlike apps that run within the Facebook website, which enable us to show ads and offer payments, we generally do not directly monetize from platform developers integrating their own mobile apps and websites with Facebook. Therefore, our platform developers’ efforts to prioritize Facebook integrations with their own mobile apps or websites may reduce or slow the growth of our user activity that generates advertising and payments opportunities, which could negatively affect our revenue. Although we believe that there are significant long-term benefits to Facebook resulting from increased engagement on Facebook-integrated websites and mobile apps, these benefits may not offset the possible loss of revenue, in which case our business could be harmed.

Zynga

Payments and other fees: We enable payments from our users to our platform developers. Our users can transact and make payments on the Facebook platform by using credit cards, PayPal, or other payment methods available on our website. We receive a fee from our platform developers when users make purchases from our platform developers using our payments infrastructure. We recognize revenue net of amounts remitted to our platform developers. We have mandated the use of our payments infrastructure for game apps on Facebook, and fees related to payments are generated almost exclusively from games. To date, games from Zynga have generated the majority of our payments and other fees revenue. In addition, we generate other fees revenue in connection with arrangements related to business development transactions and fees from various mobile providers; in recent periods, other fees revenue has been immaterial.

10 percent of our total revenue for both the second quarter and the first six months of 2012, and 12 percent of our total revenue for both the second quarter and the first six months of 2011, came from a single customer, Zynga. This revenue consisted of payments processing fees related to Zynga’s sale of virtual goods and from direct advertising purchased by Zynga. Additionally, Zynga’s apps generate pages on which we display ads from other advertisers; for the second quarter and the first six months of 2012, we estimate that an additional approximately 4 percent of our total revenue was generated from the display of these ads. In May 2010, we entered into an addendum to our standard terms and conditions with Zynga pursuant to which it agreed to use Facebook payments as the primary means of payment within Zynga games played on the Facebook platform. Under this addendum, we retain a fee of up to 30 percent of the face value of user purchases in Zynga’s games on the Facebook platform. This addendum expires in May 2015. Additionally, the addendum allows Facebook to display ads on Zynga.com, and in the second quarter of 2012, we began delivering ads on Zynga.com. The revenue associated with these ads was immaterial for the second quarter and the first six months of 2012.

In the first six months of 2012 and the full 2011 year, we estimate that up to 14 percent and 19 percent of our revenue, respectively, was derived from payments processing fees from Zynga, direct advertising from Zynga, revenue from third parties for ads shown on pages generated by Zynga apps, and Facebook ads and sponsored stories displayed on Zynga.com. If Zynga does not maintain its level of engagement with our users, or if we are unable to successfully maintain our relationship with Zynga, our financial results could be harmed.

Lawsuits

On March 12, 2012, Yahoo filed a lawsuit against us in the U.S. District Court for the Northern District of California, claiming that we infringe 10 of Yahoo’s patents that Yahoo claimed relate to “advertising,” “social networking,” “privacy,” “customization,” and “messaging,” and on April 27, 2012, Yahoo added two patents to the lawsuit that Yahoo claims relate to “advertising.” Yahoo sought unspecified damages, a damage multiplier for alleged willful infringement, and an injunction. On April 3, 2012, we filed our answer with respect to this complaint and asserted counterclaims that Yahoo’s products infringe 10 of our patents. On July 6, 2012, the parties entered into a settlement agreement resolving all claims made in the litigation. On July 9, 2012, the parties filed a stipulated dismissal of the litigation with the U.S. District Court for the Northern District of California, and this litigation was dismissed on July 10, 2012. We have no payment obligations under this settlement agreement.

Beginning on May 22, 2012, multiple putative class actions, derivative actions, and individual actions were filed in state and federal courts in the U.S. and in other jurisdictions against us, our directors, and/or certain of our officers alleging violation of securities laws or breach of fiduciary duties in connection with our initial public offering and seeking unspecified damages. We believe these lawsuits are without merit, and we are vigorously defending these lawsuits. In addition, following our IPO, the events surrounding our IPO became the subject of government inquiries, and we have received requests for information in connection with certain of those inquiries.

We are also currently parties to multiple other lawsuits related to our products, including patent-infringement lawsuits brought by both other companies and non-practicing entities, as well as class-action lawsuits brought by users and advertisers, and we may in the future be subject to additional lawsuits and disputes. We are also involved in other claims, government investigations, and proceedings arising from the ordinary course of our business. Although the results of these other lawsuits, claims, government investigations, and proceedings in which we are involved cannot be predicted with certainty, we do not believe that the final outcome of these other matters will have a material adverse effect on our business, financial condition, or results of operations.

In the opinion of management, there was not at least a reasonable possibility we may have incurred a material loss, or a material loss in excess of a recorded accrual, with respect to loss contingencies relating to the matters set forth above. However, the outcome of litigation is inherently uncertain. Therefore, although management considers the likelihood of such an outcome to be remote, if one or more of these legal matters were resolved against us in the same reporting period for amounts in excess of management’s expectations, our condensed consolidated financial statements of a particular reporting period could be materially adversely affected.

Paul D. Ceglia filed suit against us and Mark Zuckerberg on or about June 30, 2010, in the Supreme Court of the State of New York for the County of Allegheny, claiming substantial ownership of our company based on a purported contract between Mr. Ceglia and Mr. Zuckerberg allegedly entered into in April 2003. We removed the case to the U.S. District Court for the Western District of New York, where the case is now pending. In his first amended complaint, filed on April 11, 2011, Mr. Ceglia revised his claims to include an alleged partnership with Mr. Zuckerberg, he revised his claims for relief to seek a substantial share of Mr. Zuckerberg’s ownership in us, and he included quotations from supposed emails that he claims to have exchanged with Mr. Zuckerberg in 2003 and 2004. On June 2, 2011, we filed a motion for expedited discovery based on evidence we submitted to the court showing that the alleged contract and emails upon which Mr. Ceglia bases his complaint are fraudulent. On July 1, 2011, the court granted our motion and ordered Mr. Ceglia to produce, among other things, all hard copy and electronic versions of the purported contract and emails. On Jan. 10, 2012, the court granted our request for sanctions against Mr. Ceglia for his delay in compliance with that order. On March 26, 2012, we filed a motion to dismiss Mr. Ceglia’s complaint and a motion for judgment on the pleadings. We continue to believe that Mr. Ceglia is attempting to perpetrate a fraud on the court, and we intend to continue to defend the case vigorously.

Instagram And Other Acquisitions

In April 2012, we entered into an agreement to acquire Instagram Inc., which has built a mobile phone-based photo-sharing service, for 22,999,412 shares of our common stock and $300 million in cash. The value of the equity component of the final purchase price will be determined for accounting purposes based on the fair value of our common stock on the closing date. Following the closing of this acquisition, we plan to maintain Instagram’s products as independent mobile applications to enhance our photo product offerings and to enable users to increase their levels of mobile engagement and photo sharing. This acquisition is subject to customary closing conditions, including the expiration or early termination of all applicable waiting periods under the Hart-Scott-Rodino Antitrust Improvement Act of 1976, as amended (HSR), and is expected to close in 2012. We have agreed to pay Instagram a $200 million termination fee if governmental authorities permanently enjoin or otherwise prevent the completion of the merger or if either party terminates the agreement after Dec. 10, 2012.

As part of our business strategy, we have made and intend to make acquisitions to add specialized employees, complementary companies, products, or technologies. For example, in April 2012, we entered into an agreement to acquire Instagram Inc., the closing of which is subject to closing conditions and regulatory clearance. Our ability to acquire and integrate larger or more complex companies, products, or technologies in a successful manner is unproven. In the future, we may not be able to find other suitable acquisition candidates, and we may not be able to complete acquisitions on favorable terms, if at all. Our previous and future acquisitions may not achieve our goals, and any future acquisitions we complete could be viewed negatively by users, developers, advertisers, or investors. In addition, if we fail to successfully close or integrate any acquisitions, or integrate the products or technologies associated with such acquisitions into our company, our revenue and operating results could be adversely affected. Any integration process may require significant time and resources, and we may not be able to manage the process successfully. We may not successfully evaluate or utilize the acquired products, technology, or personnel, or accurately forecast the financial impact of an acquisition transaction, including accounting charges. We may have to pay cash, incur debt, or issue equity securities to pay for any such acquisition, any of which could adversely affect our financial results. The sale of equity or issuance of debt to finance any such acquisitions could result in dilution to our stockholders. The incurrence of indebtedness would result in increased fixed obligations and could also include covenants or other restrictions that would impede our ability to manage our operations.

Fake Or Duplicate Accounts

The numbers of our MAUs and DAUs and ARPU (average revenue per user) are calculated using internal company data based on the activity of user accounts. While these numbers are based on what we believe to be reasonable estimates of our user base for the applicable period of measurement, there are inherent challenges in measuring usage of our products across large online and mobile populations around the world. For example, there may be individuals who maintain one or more Facebook accounts in violation of our terms of service, despite our efforts to detect and suppress such behavior. We estimate that “duplicate” accounts (an account that a user maintains in addition to his or her principal account) may have represented approximately 4.8 percent of our worldwide MAUs as of June 30, 2012. We also seek to identify “false” accounts, which we divide into two categories: user-misclassified accounts, where users have created personal profiles for a business, organization, or non-human entity such as a pet (such entities are permitted on Facebook using a page, rather than a personal profile, under our terms of service); and undesirable accounts, which represent user profiles that we determine are intended to be used for purposes that violate our terms of service, such as spamming. As of June 30, 2012, we estimate that user-misclassified accounts may have represented approximately 2.4 percent of our worldwide MAUs, and undesirable accounts may have represented approximately 1.5 percent of our worldwide MAUs. We believe the percentage of accounts that are duplicate or false is meaningfully lower in developed markets such as the U.S. or Australia and higher in developing markets such as Indonesia and Turkey. However, these estimates are based on an internal review of a limited sample of accounts, and we apply significant judgment in making this determination, such as identifying names that appear to be fake or other behavior that appears inauthentic to the reviewers. As such, our estimation of duplicate or false accounts may not accurately represent the actual number of such accounts. We are continually seeking to improve our ability to identify duplicate or false accounts and estimate the total number of such accounts, and such estimates may be affected by improvements or changes in our methodology.

Security Issues

Our efforts to protect the information that our users have chosen to share using Facebook may be unsuccessful due to the actions of third parties, software bugs, or other technical malfunctions, employee error or malfeasance, or other factors. In addition, third parties may attempt to fraudulently induce employees or users to disclose information in order to gain access to our data or our users’ data. If any of these events occur, our users’ information could be accessed or disclosed improperly. Our data use policy governs the use of information that users have chosen to share using Facebook and how that information may be used by us and third parties. Some platform developers may store information provided by our users through apps on the Facebook platform or websites integrated with Facebook. If these third parties or platform developers fail to adopt or adhere to adequate data security practices or fail to comply with our terms and policies, or in the event of a breach of their networks, our users’ data may be improperly accessed or disclosed.

Any incidents involving unauthorized access to or improper use of the information of our users or incidents involving violation of our terms of service or policies, including our data use policy, could damage our reputation and our brand and diminish our competitive position. In addition, the affected users or government authorities could initiate legal or regulatory action against us in connection with such incidents, which could cause us to incur significant expense and liability or result in orders or consent decrees forcing us to modify our business practices. Any of these events could have a material and adverse effect on our business, reputation, or financial results.

Computer malware, viruses, and computer hacking and phishing attacks have become more prevalent in our industry, have occurred on our systems in the past, and may occur on our systems in the future. Because of our prominence, we believe that we are a particularly attractive target for such attacks. Though it is difficult to determine what, if any, harm may directly result from any specific interruption or attack, any failure to maintain performance, reliability, security, and availability of our products and technical infrastructure to the satisfaction of our users may harm our reputation and our ability to retain existing users and attract new users.

In addition, spammers attempt to use our products to send targeted and untargeted spam messages to users, which may embarrass or annoy users and make Facebook less user-friendly. We cannot be certain that the technologies and employees that we have to attempt to defeat spamming attacks will be able to eliminate all spam messages from being sent on our platform. As a result of spamming activities, our users may use Facebook less or stop using our products altogether.

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