Facebook undertakes the world’s most expensive PR exercise
Facebook CFO Dave Wehner stated that operating margins will “trend towards the mid-30s” on Wednesday’s earnings call, which is well below the 2017 operating margin of 50%. This margin target doesn’t make sense. It implies Facebook either invests $40bn per year for no revenue reward, and/or is losing money outside of the US & Europe. I believe Facebook’s guidance is an expensive PR exercise to show how committed they are to protecting users’ privacy, but the costs of doing so will ultimately be less than guided. I’m holding my Facebook stock, as prospective returns from this level are still very attractive.
Facebook’s bombshell is not lower revenue
Facebook (FB) stock dropped 19% on Thursday July 26th, following their Q2 earnings release and conference call the night before. Much of the media commentary has focused on slowing revenue growth, which stemmed from this comment from Facebook CFO Dave Wehner:
“Our total revenue growth rate decelerated approximately 7 percentage points in Q2 compared to Q1. Our total revenue growth rates will continue to decelerate in the second half of 2018, and we expect our revenue growth rates to decline by high-single digit percentages from prior quarters sequentially in both Q3 and Q4.”
This is an important announcement, but not wholly unexpected as Facebook had flagged several reasons that revenue growth would be slowing, such as FX headwinds. It is not the reason for the huge drop in Facebook’s share price. That came slightly later in the call:
“Over the next several years, we would anticipate that our operating margins will trend towards the mid-30s on a percentage basis.”
Wait a second. What?
Facebook’s operating margin was 50% in 2017. I believe it should trend higher still, as it has done for the past five years, as much of Facebook’s revenue gains are from higher revenues per user (and led by pricing gains on their ads), which have little incremental cost associated with them.
But this guidance is for margins to drop by almost a third over the next 3-5 years. That is an enormous change, and, I believe, the reason for the near 20% drop in Facebook’s share price.
This guidance looks extremely conservative
I believe this guidance is extremely conservative, and it may be intentionally conservative so that Facebook can show how serious they are about protecting users’ privacy. The bill so far is the $120bn of shareholders’ capital that evaporated on Thursday, so that seems serious enough, at least to me.
I will now explain how I reached this conclusion.
Let’s start with my revenue forecast, because it is important to put the scale of the extra investment involved with this margin guidance into context. I’ve built it my forecast bottom-up, starting with monthly active users (MAUs) and average revenue per user (ARPU).
These forecasts mean that I expect Facebook’s overall revenue growth to slow to ~20% four years from now. At that point Facebook should have revenue of $127bn, and with ~$35bn of revenue in each of the US/Canada, Europe, and Asia-Pacific.
This is very healthy revenue growth, but it should not be a controversial forecast. My revenue figures for the overall company are broadly in line with sell-side analyst consensus forecasts.
The challenge comes when we look at the cost side of the equation.
The chart below takes my revenue projections and adds a “cost per user” line that shows the costs required for operating margins to fall from 50% in 2017 to ~35% by 2021/22. This requires a spike in costs per user this year and next, with 35% growth this year and 30% growth in 2019. I have then moderated these gains back to 10% p.a. by 2022, which is much closer to Facebook’s historical growth rates in costs per user.
This analysis means that this guidance implies that one of, or both, of the following statements is true:
- Facebook is losing money outside of the US/Canada & Europe; and/or
- Facebook is expecting to spend an enormous amount of money fixing their privacy problems.
Facebook’s regional profitability
A starting point for regional profitability is to make a simplifying assumption that all of Facebook’s costs should be borne equally by all users (we will adjust this soon).
On this basis we can add a line for cost per user to the user monetization (average revenue per user) chart I showed above. This is the same chart, but I’ve added the cost line as a black dashed line, and I’ve truncated the vertical axis at $80 so we can more easily see what is happening at the bottom of the chart.
On this (simplified) basis, we can see that Facebook’s costs per user are higher than revenue per user in Asia-Pacific and Rest of World, so they’re losing money in these regions. Under this scenario Facebook lost money in these regions in 2017, these loses will expand in 2018/19, and the firm will continue to lose money in these regions at least through 2022.
If these estimates are near to accurate, then these losses in APAC and Rest of World are very concerning. Facebook already has 1.65bn users in regions that are unprofitable, and these regions are costing Facebook a serious amount of capital: in 2017 these regions would have lost $3.5bn, and this number would more than triple to $12.5bn in 2020.
I understand that one of Mark Zuckerberg’s goals is to help “connect the world” but, under these estimates at least, that goal is proving to be a very expensive one to pursue.
Facebook’s enormous centralized costs
The alternative, and probably more correct, approach is to assume that some share of costs are centralized costs for platform and software development, and that these costs are required to support the very profitable US business so should not be allocated to the less profitable regions.
For this exercise, I’ve assumed Facebook’s “cost of revenue” and “marketing and sales” are variable costs, and their “research and development” and “general and administrative” are fixed/centralized costs. That means that ~50% of Facebook’s costs were variable in 2016/17, and the remainder were fixed/centralized.
This cost allocation means that all regions have a positive contribution margin (profit before fixed costs) from 2017 onward, which is probably a better reflection of reality than assuming 100% variable costs.
Unfortunately, this approach highlights a different problem: enormous cost growth in Facebook’s centralized costs.
On these assumptions, Facebook’s centralized costs were ~$10bn in 2017. But these costs would need to grow extremely quickly to meet the margin guidance given by Facebook’s CFO, as the guidance implies fixed costs growing to more than $50bn by 2022!
What could Facebook possibly spend $50bn on? Let’s assume Facebook spends 3x as much as it did in 2017 on research and development. That would expand R&D spend from $7.75bn to $23.25bn.
That still leaves $30bn of annual spend. Maybe they hire people – $30bn would hire 300,000 people at an “all-in” cost of $100,000 per year, or 30,000 people at an all cost of $1mn per year.
I cannot imagine why Facebook would need to hire that many people, or why they would need to increase their current R&D spend by more than three-fold. I cannot see how Facebook would spend $50bn on fixed/centralized costs in 2022.
I believe Facebook’s new guidance for operating margins is too low. This guidance implies massive cost growth that would either: (i) ensure that Facebook remains unprofitable outside of the US & Europe despite having more than 2bn users in those regions; or (ii) allow the firm to triple their current R&D spend and hire tens of thousands of extra people at very high salaries.
I believe that neither of these alternatives are realistic paths for Facebook to follow. This means Facebook’s new margin guidance is extremely conservative, and potentially intentionally this conservative, so that Facebook can be seen to be making the investments in privacy that ensure their users remain comfortable using Facebook’s social media platforms.
We could view this as the world’s most expensive PR exercise. But whatever it is, I expect Facebook’s operating materially higher than the “mid-30s” guidance in 2021/22. With Facebook now valued below 20x operating profits (ex-cash), I have no intention of selling my stock.
Disclosure: Warwick Simons owns shares in Facebook.