Detailing FB's Longer-Term Revenue Drivers and Bear Case

This is the second of a three part series detailing the key topics that institutional investors are talking about on Facebook (FB). Facebook will report earnings on Wednesday, November 4.

 

Part 1: Detailing FB's Near-Term Revenue Drivers

Part 2: Detailing FB's Longer-Term Revenue Drivers and the Bear Case

Part 3: What Investors are Focused on Ahead of FB's 3Q Results

 

Facebook's Longer-Term Drivers Include Messaging and Oculus

Facebook is a widely loved stock among both the buy-side and sell-side analysts. One of the reasons for the optimism is Facebook's near-term revenue growth drivers in video and Instagram, as I detailed yesterday. Beyond these factors, the company also has a number longer-term sources that hold a significant amount of potential. Specifically, Facebook's messaging apps, Facebook Messenger and WhatsApp, have an even greater number of users than Instagram and could unlock further growth beyond 2016. Additionally, Facebook's virtual reality company, Oculus, holds potential beyond PC and mobile as the next computing  platform.

 

The Opportunity in Messaging

Facebook owns two messaging platforms in Facebook Messenger and WhatsApp. The audience for both has grown significantly, as both Messenger and WhatsApp have become two of the top four most downloaded apps on the iOS system. Messenger now has over 700 million users, while WhatsApp has over 800 million. 

Management continues to invest into new features for both platforms. With Facebook Messenger, Facebook recently opened up the platform to developers this March, and rolled out features such as high definition calling and video, payments, e-commerce, and business integration. With WhatsApp, management continues to roll out VoIP calling and other features to grow the user base. Facebook may eventually roll out similar features from Facebook Messenger into WhatsApp. 

While Facebook has yet to try to ramp its monetization of either platform, management has stated that the messaging platform is in the product grouping that is expected to deliver an impact in 5 years. There are a number of existing business models that exist around messaging platforms that would be lucrative, including advertisements, subscription pricing (either to businesses or consumers), stickers, or payments.

How much could Messenger and WhatsApp potentially deliver in revenue? While several years away, analysts estimate that the two platforms could each deliver at least $1 billion in revenue. These calculations are based revenue generation at other messaging platforms, like Kakao, WeChat, or Weibo, where they've been able to achieve an annual revenue per MAU of at least $1, with some delivering an estimated $3+. Assuming a similar margin to current levels, Facebook's messaging platforms could add $0.24, or 7% to current 2017 consensus estimates of $3.59. Note that these estimates are illustrative and could be delayed should Facebook decide to monetize the platforms at a later time. However, the point is that these two platforms represent another potential source of EPS upside longer-term (as analysts are currently not projecting any upside from messaging in their estimates).

Read more about the video and instagram upside in part 1 of my Facebook series.

Read more about the video and instagram upside in part 1 of my Facebook series.

 

Oculus is a Long-Term Wildcard

Back in early 2014, Facebook acquired virtual reality device maker Oculus. Oculus makes the Oculus Rift, a virtual reality headset that displays immersive, 3D video. The device is extremely popular among  online gaming communities and has received significant media attention despite the fact that it hasn't yet shipped a consumer version of the product.

Predicting the potential impact of the Oculus Rift is not easy. The Rift will go on sale in 1Q16 and is expected to cost over $300. The device is popular among niche communities online, but the consumer reaction and adoption of the device remains in question. Those who are skeptical point to the high price, the high computing requirements (with a PC that fits the requirements likely costing another $1,000), virtual reality's lackluster history, the social stigma around wearing a device on your head, and the technological barriers that remain. The skeptics believe that the project will not gain significant consumer traction, and instead will depress margins as the company invests heavily into the platform over the coming years. 

Those who are bullish would point to the power of the experience as something that consumers would be willing to pay for. Additionally, while technological barriers remain, they are seen as solvable as the device gains mainstream acceptance and scale. Ultimately, those who are most bullish on virtual reality believe that the device could change the way people communicate, watch movies, and interact with computers. If this scenario plays out, it's not hard to imagine the upside for Facebook - Microsoft and Apple both built $100+ billion dollar companies off of new operating systems.

Analysts currently do not project much from Oculus in 2016 or even 2017. As mentioned earlier, Facebook groups Oculus into the "10 year" product grouping and have been clear in noting that the product is not expected to move the needle for some time. In the near-term, some bears believe the Oculus launch could potentially hurt expenses in 2016 (detailed further in the following section), while bulls see Oculus as a call option on an exciting platform with a lot of potential. 

Note: Oculus is a favorite topic of mine, and this section could go on for much longer... but I'll save this discussion for a later date.

 

The Near-Term Bear Thesis: Expenses and Instagram Cannibalization

What is the bear thesis for this widely-loved stock? In the near-term, some investors believe that expenses in 2016 could be higher than expectations. Consensus expectations appear to be ~40-50% expense growth in 2016. However, some fear that the expense growth could be well above this figure, especially with the Oculus shipping in 1Q16. Recall that one year ago, Facebook gave expense growth guidance of 50-70%, surprising the Street and tanking the stock. Some investors believe this initial guidance may have been elevated due to a possible Oculus launch. As the year went on and it became clear that Oculus would delay its consumer launch, Facebook eventually lowered its expense guidance down to 50-55% (in 2Q15). With the Oculus launch now penciled in for 1Q16, investors believe 2016 expense guidance could potentially come in high again.

 

Timing here is important. In the previous two years (2012 and 2013), Facebook gave expense guidance during their 4Q earnings call, as many companies generally do. Last year, Facebook gave next-year expense guidance during its 3Q earnings call. As a result, there is the possibility that the company may give expense guidance during their 3Q results. However, most investors do not believe this will occur this year, thereby limiting the expense risk somewhat (pushing it to more of a 4Q concern).   

One other near-term argument/concern is that the gradual ramp up of Instagram could potentially cannibalize Facebook ad revenue. While investors are expecting incremental revenues from Instagram, advertisers may simply shift their Facebook ad budget towards Instagram (which would not be incremental). Investors will be watching for commentary on core Facebook advertising results vs. Instagram advertising results to see if this thesis played out. 

 

The Longer-Term Bear Thesis: Facebook is Uncool

The longer-term bear thesis that has hounded Facebook since its IPO centers on the intense competition in social media. Competitors continue to try to enter social media and pick at the Facebook ecosystem, whether through pictures (Instagram, before it was acquired by Facebook), ephemeral content (Snapchat), or user-generated snippets (Twitter). Several of these competitors have managed to gain significant traction. Most notably, Snapchat now has over 100 million DAUs and is aggressively rolling out additional features. It is well publicized that Facebook is not as ubiquitous among younger audiences, where kids see Facebook as uncool. 

The bear thesis argues that competition will eventually catch up to Facebook, slowing user growth and hurting user engagement. In turn, the declines could then pressure advertising impressions and CPMs - the two components of advertising revenue. 

The metrics have so far not supported this thesis. User engagement (measured as the percentage of monthly active users that log in daily) remains high, while average revenue per user (ARPU) continues to make progress. Other metrics such as daily share of time and CPMs support these conclusions. However, investors will closely watch both engagement and pricing metrics for any signs that the company is slowing on these fronts. 

 

Tune in to the third part of the series tomorrow where I'll detail expectations heading into Facebook's 3Q earnings report on Wednesday, as well as the intraquarter datapoints that generated those expectations.