Note: I had an issue with my email subscription button on the right. I think (and hope) that it's been fixed now. Feel free to sign up if you want emails on new posts.
There's essentially three key topics that institutional investors are talking about for Facebook:
1) What impact will the ad load drop have on ad revenue in 2H17?
Issue 1: What impact will the ad load drop have on ad revenue in 2H17?
- Much of the company's advertising revenue growth has been driven by ad loads over the last several years. Last year, the company noted that they would begin to slow ad loads in 2H17 so that they don't harm the user experience further. Since then, most of the debate, overwhelmingly, has been on what impact this will have on the advertising revenue growth trajectory going forward. As an example, there were four ad-load-related questions alone from analysts on the 2Q16 conference call.
- Before I jump into the complicated world of ad loads, let me make one point about why the hell all of this matters (skip to the bullet point below the image if you are already familiar with this). One might think that the minutiae and detailed numbers don't really matter in the grand scheme of things. This is wrong. It's incredibly important because this represents a fairly significant shift in Facebook's growth model. And shifts in the model can lead to shifts in the growth rates. Near-term changes in growth rates inform how analysts project revenue, profits, and earnings trajectories for the company.
- Big deal, you might think. Advertising growth of 40% vs. 30%? They're both fat numbers! Well, that 10% difference cascades across time, as it's the difference in 2018 growth of 30% and 20%. By the end of 2018, that difference could be $6 billion in sales. It also cascades across the income statement, as Facebook could end up growing expenses by, say, 40% in 2017. Therefore, it would mean the difference between profit margin expansion and profit margin contraction. This has huge impacts on the stock, since most of a stock's value comes from how analysts are modeling future projections of the company on the top and bottom line.
- Back to ad loads. Let's walk through ad loads quickly and how they tie to Facebook's ad revenue. Ad load represents a major component of ad impressions, which represents a major component of ad revenue. One can think of Facebook's ad revenue formula as:
- While the company has not disclosed how much ad loads have contributed in terms of growth, we can back our way into what it has been, approximately. We know that ad impressions were up roughly 49% - 50% in 2Q16-4Q16, and 32% in 1Q17. We know DAU and MAU has been growing in the high teens fairly consistently. We know that time spent per user has been up somewhere in the double digits (based on a few datapoints that the company has given us). That leaves us with ad load growth somewhere in the mid-high teens. In other words, ad load has been contributing roughly one third of ad impression growth over the last year or so. With ad pricing in the low single digits, this also means that ad loads have been contributing a third of overall advertising revenue growth as well. With loads turning flattish, how will advertising revenue growth be impacted?
Source: Conference call transcripts, my own estimates
- Bulls believe that the ad load decline will lead to a decline in ad impressions, but will be offset by a number of sources. The first, and likely the largest offset, is pricing. Recall that Facebook uses auction pricing. In an ad-constrained environment, advertisers will likely bid up pricing, which will offset much of the decline in ad loads. Furthermore, Facebook is beginning to show ads for videos as they experiment with mid-video ads. These carry higher prices and can also bolster pricing.
- We've already begun to see evidence of stronger price growth with lower ad loads in 1Q17. Ad loads decelerated (see chart above) and pricing jumped up by 14% in response. Management noted that this was in part due to the constrained supply. The jump in pricing was a notable increase as some bulls had suggested that pricing would go up by 10% with flattish ad loads. Recent results suggest that pricing could get an even bigger boost than previously thought, which could help support ad revenue growth.
Source: Conference call transcripts
- Second, many bulls (and management) believe that another offset could come in growing users and time spent per user. MAU and DAU growth has been consistently strong and has even re-accelerated after a brief deceleration in early 2015. The success of Instagram stories, and in FB's other properties, will likely support continued growth on both metrics.
Source: Conference call transcripts
- The success of Instagram Stories is worth exploring further. The company recently noted on CNBC that Instagram Stories reached 250M DAUs. This compares to 200M about 2 months ago, which is an acceleration in growth (as it took about 3 months for Instagram Stories to grow from 150M to 200M). Given the rate of growth, it's quite clear that it's gaining ground on Snapchat. In my opinion, this is a potentially underappreciated point among analysts and investors, many of whom are boring old finance people and do not use Instagram or Snapchat. Anecdotally, almost all of my friends have switched onto it. And it is clearly gaining momentum. The advantages of Instagram over Snapchat have been discussed extensively online, and so I won't belabor the point too much. The ease of use and networking effects are all significant drivers that appear to be behind the platform's growing momentum, which should boost many of the metrics outside of ad load.
- Third, Facebook will continue to drive ad effectiveness through improving ad formats, targeting tools, and ad placement. Advertisers that use Facebook heavily have noted that the platform is laser-focused on helping advertisers improve brand ROI, which has helped advertisers shift more dollars onto Facebook. These tailwinds should drive continued growth in pricing as the company continues to innovate.
- International growth is another driver of MAU/DAU. International advertising revenue recently outpaced North America last quarter. International is earlier on the monetization curve, and therefore could act as a near-term headwind on certain metrics. However, it should be a net positive longer-term as it extends Facebook's revenue growth trajectory further out.
Source: Company filings
-Let's zoom out a bit and look at tailwinds for the industry. Another bull argument that has been floated by bulls is that advertising as an industry still has significant room to grow. As a percentage of GDP, advertising has actually been flat since the recession. This is likely to grow over time.
- Another potentially underappreciated tailwind for the industry is the slow death of retail. Retail's demise has been written about extensively online as many retailers have seen the impact of e-commerce turn their same store sales negative. As a result, many have gone bankrupt, private, or have been acquired. Retail serves as both a distribution channel as well as a form of marketing. As retailers increasingly close stores and reduce their footprints, they will likely need to increase ad budgets to stay top of mind for their consumers. In other words, the new modern sidewalk is a digital one with Facebook, Reddit, Google, and Snapchat capturing more and more of consumers' attention.
- With all of these factors considered, where does this leave us for advertising revenue growth? Currently, expectations are for advertising revenue growth to drop to 38% and 34% in 3Q and 4Q, which would represent a modest deceleration from the 51% in 1Q. This appears more than achievable, as even if ad impressions drop to the 20s, pricing would need to just grow by the low- to mid-teens to achieve those estimates. Given the ad pricing performance in 1Q (+14% with moderate ad load growth), this appears to be more than achievable, and could have some upside.
Source: Company filings, brokerage estimates
Some of the counterarguments that have been raised include:
- Cut the revenue another way and look at the growth rates for desktop vs. mobile. Desktop will likely slow later this year and next year as they will be lapping difficult comparisons. Late in 2015 and all of last year, Facebook desktop ad revenue growth benefited significantly from efforts to reduce the effectiveness of ad blockers. As a result of their efforts, growth jumped from the single digits to double digits. Now, as they lap those benefits, desktop will likely turn flat and potentially negative. With desktop flat to negative, this could hold back growth for the company as a whole. And as I've written about constantly in the past, comparisons are a big deal in the investing world as they affect growth rates significantly.
- Expectations have crept higher and may now bake in the above factors. Facebook stock is now up 30% for the year compared to EPS expectations, which have been revised up by roughly 12% over the last six months. This means that investor expectations are likely even higher.
Issue 2: Where will expense growth end up for the year?
- Expenses are a key issue every year for investors. The company has given GAAP guidance of 40% - 50% expense growth for the year. In 1Q, expenses grew by 40%. Bears see some risk that their expenses could come in at the high end or above this guidance, and that 2018 expenses could also be above expectations. The company noted that they may spend more on long-form video content (with the WSJ reporting that they are already in talks to do so) and infrastructure (data centers) that would be negative to operating margin.
- Bulls argue that Facebook has come in at the low end of their expense guidance over the last two years. While there is some risk, it is also likely that spend moderates throughout the year.
Source: Conference call transcripts
- While expense growth is high, margins could still expand with enough revenue growth. Facebook's GAAP operating margins remain healthy at 45%. Management has communicated that 2017 will be an investment year for some time, and investors understand this. As a result, investors are maybe not as critical of expense growth as one might think.
Issue 3: Messaging an untouched opportunity
- As the company begins to mature its video advertising on Facebook, and rolls out more extensive advertising on Instagram, attention is now starting to turn towards Facebook's other messaging properties, WhatsApp and Messenger. Both properties have over 1 billion MAUs, high engagement, and are the most downloaded messaging apps in over 80% of countries globally.
- Investors have tried to size the opportunity in a number of different ways. Some have drawn the comparison to Tencent, a Chinese company that generates $22 billion in revenue off of the strength of its messaging platforms. The platform monetizes through gaming, payments, online advertising, and other services.
- Another way that investors have framed the opportunity is to look at the outsourced customer service industry. This industry by itself is over $500 billion in revenue, and could be disrupted by Facebook's efforts to link businesses to customers.
- An alternative framework is to assign an ARPU comparable to other social media networks. For context, Instagram has an ARPU Of ~$2.00, LINE (a messaging app in Japan) has ARPU of ~$6.50, Twitter has an ARPU of ~$8.00, and Facebook sits close to $16.00. With over 2 billion users on WhatsApp and Messenger, a tiny ARPU of $1.00 alone would generate $2 billion in revenue. This represents meaningful upside to consensus estimates (as most analysts have not baked much, if any, of this into their estimates) and could send the stock higher once Facebook begins to monetize messaging.
- Mark Zuckerberg has detailed Facebook's plans to monetize messaging. He has stated that Facebook is currently aiming to get users accustomed to communicating with businesses on Messenger before then potentially monetizing business-to-consumer interactions linked through Facebook ads. The company is also exploring advertisements, although this is a secondary priority.