Facebook’s Great Reset

Nestlé was founded in the 1860s by Henri Nestlé to solve a consumer pain point: mothers who couldn’t breastfeed didn’t have a good alternative to breastmilk. After much experimentation, Nestlé perfected the world’s first infant formula. This formed the basis for a business that grew over time—through new product innovation and acquisitions—into one of the world’s most successful consumer companies. At the base of it all: trust. Consumers came to view Nestlé’s products as worthy of their family’s trust.

Facebook, created over 140 years later, sought to solve a different problem: digitizing our most intimate human connections. Every day, nearly 1.5 billion users around the world trust Facebook with their most cherished conversations and interactions.

In its second quarter call on July 25, Facebook reported stellar results. Revenues were up 42 percent, and profits up 32 percent. The number of users—a massive 1.7 billion daily and 2.2 billion monthly—grew by 11 percent. Prices per ad were up 17 percent and ad impressions up 21 percent.

In his forward guidance, however, CFO David Wehner announced a decline in the revenue growth rate going forward (implying growth of over 20 percent by the end of the year), and a glide path towards a lower operating margin of mid 30s (from the current mid 40s) over the next two years.

These metrics are astonishingly good, but they surprised the market, and Facebook’s stock sank 20 percent the following day.

Financially, I believe the market was rational in its rapid reappraisal of Facebook. Certainly, lower revenue growth and lower profit margins—while still very high—imply a lower present value.

But let’s dig into the why.

Since the dawn of social media—when there were competitors like My Space, Orkut and Friendster—Facebook won by providing a superior user experience. The social network that sprang from a Harvard dorm room in 2004 never stopped growing for precisely that reason. Over time, through acquisitions and new product development, Facebook became a social media conglomerate spanning 2.5 billion users of core Facebook, Instagram, Messenger and WhatsApp. It’s developing an exciting slate of upcoming products such as Direct (Instagram chat in a separate app), Portal (a rumored voice assistant), and innovations from its virtual reality company, Oculus, to mention a few.

First, let’s look at the expense side of Wehner’s guidance.

As you’ve probably heard, Facebook has been used by folks who want to influence elections or spread fake news. To ensure election integrity, remove fake content and bad actors, the company is investing a lot of money into its content filtering, using both humans and machine learning to go through the billions of pieces of content uploaded every day. In fact, Facebook has been warning for several quarters that investments in security would “significantly impact our profitability.” Adding more features for protecting privacy might also impact marketers’ ability to target ads, potentially resulting in lower ad prices. All of these investments are very likely to result in a better user experience, at the expense of lower profitability.

But that’s not all. As Mark Zuckerberg explained in the Q2 call, “In light of increased investment in security, we could choose to decrease our investment in new product areas, but we’re not going to—because that wouldn’t be the right way to serve our community and because we run this company for the long term, not for the next quarter.” These new product areas include building out eight new data centers (there are currently six) to deal with what Zuckerberg called “hyper-growth” in machine learning across the products, as well as in WhatsApp and Instagram. These investments also include augmented and virtual reality, marketing, and content acquisition (Facebook has been investing aggressively in original video content and sports broadcast rights).

These investments are exactly what the long-term owner of a business would want to see. Now, let’s look at the revenue side.

Here, Wehner said that Facebook is building and promoting engaging new experiences like Stories that “currently have lower levels of monetization.” This is a bizarre excuse, given that Stories is one of the fastest-growing media formats ever. But the reason is that many advertisers aren’t yet aware of Stories, and those that are, haven’t yet figured out how to create ad content for it. This is typical of new ad formats, and because Facebook’s ad system is set up as an auction (much like Google’s), fewer bids translates into lower ad prices.

Stories—ably copied by Instagram CEO Kevin Systrom from rival Snapchat—has since eclipsed its creator:

Source: https://www.recode.net/2018/8/8/17641256/instagram-stories-kevin-systrom-facebook-snapchat

Facebook is leaning into this opportunity, emphasizing this experience for users, and this emphasis will decrease revenue growth; better user experience at the expense of short-term profitability, which exactly the right approach. Going back to the origins of Facebook and throughout its history, management’s playbook has been to first grow the audience for a particular product or feature (grow users), increase engagement (grow minutes or hours of use per user), make it sticky (create the habit, make sure users keep coming back), and only then, monetize.

Strategically, then, it seems that the reasons for Facebook’s lower revenues and margins will only serve to widen its long-term moat. Better user experience with new media (Stories), less fake news, more election integrity, and additional privacy options. It seems to me that these investments, while painful in the short term, might in fact allow Facebook to make more money in the future, because a better user experience will result in more engaged users and more advertisers.

Reset of trust

Many of Facebook’s investments are designed to reset user trust. Not widely publicized, for example, is the fact that Facebook now allows anyone to search political ads for up to seven years. Each ad is clearly labeled so anyone can see who’s paying for them. This type of transparency is unprecedented in any medium in history. If well executed, the investments Facebook is making have the potential to make the company a leader in trust and transparency.

The near-term future of Facebook

Facebook’s stated mission is to “give people the power to build community and bring the world closer together.” And that includes bringing businesses closer to consumers. One achievement of Facebook’s has been the removal of friction for small businesses; with Facebook, they have access to the same advertising tools as multinational advertisers.

I believe the near future will see more of this. One new format the company highlighted in its Q2 call is Click to Messenger ads. These allow businesses to interact directly with consumers inside Messenger, from an ad placed in News Feed, for example.

In India, Facebook’s WhatsApp has 200 million users, and the app is frequently used for commerce. Using the country’s direct payments protocol, WhatsApp is working to obtain approval to create an in-app payments system. Globally, WhatsApp Business was launched and is being tested by three million businesses, who will pay to interact directly with consumers.

Longer term, it’s interesting to think of Facebook as a toll booth on the world’s economy. Below is a chart showing revenues per user by geography. In more advanced geographies—like North America—advertising markets are more developed, consumer incomes are higher, and therefore ad prices are much higher. Notice the gap between North America and Europe, and then between North America and Asia and the rest of the world.

As broadband and smartphone penetration continues to increase; as ad markets develop; and as income levels grow, we should see a continued rise in revenue per user around the world.

Source: Company filings, Heller House estimates.