The advertising business as a gauge of the economy
One way to gauge the underlying economic sentiment of the US is by using the revenue of the advertising industry as a proxy. Companies, both small and large, advertise their products to consumers and other businesses, and the ad budgets of these companies are typically set as a percentage of expected revenues. This means that advertising spending tends to fluctuate along with the economic sentiment. If businesses have a negative outlook, then they pull back ad spending. The opposite is also true.
As a result, the advertising industry’s revenue typically remains a relatively constant proportion of the GDP. The total revenue of the industry ranges from 1 – 1.5% of the total US GDP (see Figure 1).
It is with this in mind that we analyze the Q3 earnings report of some of the largest tech companies: Google, Meta (Facebook), Amazon, Snap, and Spotify.
Is ad revenue slowness due to macroeconomic weakness or is it Apple’s fault?
When you scan the top-line growth of the giant advertising tech companies, you see slowing growth:
- Snap dropped more than 25% after it announced that it missed its 3rd quarter revenue target. In the earnings call, the company blamed it on challenging economic conditions.
- Google dropped 7% after it announced that revenue growth slowed to (gasp!) 6%, from 41% a year earlier (which is a very tough comparison since last year was a peak pandemic digital economy boom, something that Ruth Porat, Google’s CFO, mentioned in the earnings call).
- Meta plunged 24% after it reported Q3 revenue decline of 4% year-over-year (largely driven by the impact of the stronger dollar), with profits decreasing 52%. The advertising revenue decrease was primarily due to softness in gaming, CPG, and financial service advertising. The decline is also accompanied by the company’s insistence on maintaining high levels of R&D spending in developing its metaverse, pushing down profitability.
The above is a snapshot of ad revenues of some of the largest digital advertising platforms in the world. Luckily, Elon’s acquisition of Twitter was completed this past week, so Twitter didn’t have to post earnings anymore, but had it posted its Q3 earnings report, it probably would’ve posted a similar decline as Snap.
There are two possible factors at play here:
- Macroeconomic weakness: Some companies attributed weak growth to macroeconomic conditions.
- Apple’s App Tracking Transparency (ATT) reducing the efficacy of digital ads: In addition to macroeconomic weakness, there’s another factor at play, Apple’s ATT, which limits an app’s ability to perform cross-platform tracking (if a user clicks an ad on Meta that takes the user to a 3rd party e-commerce website, Meta can no longer track that conversion if the user opts out of the tracking, which results in lower ad efficiency). About 75% of all iOS users opt-out of app tracking.
Which leads to two possible observations:
- If macroeconomic weakness is the primary driver of the advertising weakness, it should happen across the board, impacting other companies (other than the three above) who have ads businesses too.
- If ATT is the primary driver, then the advertising weakness shouldn’t be observed in companies whose advertising relies on 1st party data. Apple’s ATT does not apply to companies that use 1st party data to track. For example, if a user clicks an ad on Amazon’s website, brings the user to a 3rd party seller’s page within the same website, and completes a purchase, Amazon is entitled to that data, since the conversion occurs within Amazon’s application.
Ok, sorry for the long setup, but it’s required knowledge for the next section. Let’s look at the advertising revenue of the companies mentioned above and some other tech companies.
In Figure 2, we’ve added Microsoft’s search revenue and Amazon’s ad revenue. With the exception of Amazon, all experienced the lowest growth rate in advertising sales in the past 5 quarters. If macroeconomic weakness is truly the primary reason for the slowdown in growth, then you would expect Amazon’s advertising businesses to slow down as well in Q2 2022. In fact, what you see is the opposite.
Of all the tech companies mentioned above, in terms of their advertising stack, Amazon is the most vertically integrated:
- From the demand side, customers begin their product search on Amazon first. In the US, about 61% of consumers do this (displacing Google and Bing).
- From the supply side, sellers (specifically 3rd party sellers, which represent 58% of total goods sold in Q3) sell on Amazon’s platform and advertise on the same platform.
As a result, Amazon is the least affected by Apple’s privacy changes. This, coupled with stronger earnings growth of major traditional advertising companies (WPP, Publicis, and Omnicom), which are not affected by ATT, seems to indicate macroeconomic weakness is not the culprit for the slower growth, but rather Apple’s ATT.
Why is it then that these companies do not acknowledge the ATT headwind? Some did. Meta disclosed that ATT changes negatively impacted their revenue to the tune of $10 billion in 2021 (or 8% of total revenue). The reason is that Apple’s changes are permanent. And over time, as newer versions of the iPhone are released and users continue to upgrade their phones, the worse the issue gets.
Meta’s way out of this predicament
After reading the above, one inevitably develops a bearish sentiment toward Meta. But of everyone, Meta (other than Google) is probably the one company that has the best shot in figuring out a way out of this predicament.
So far this year, Meta’s stock has dropped more than 70%. It is facing challenges at the top line due to two factors: (i) revenue growth slowdown to ATT and (ii) competitors, in particular, TikTok. In order to overcome these top-line challenges, the company has been increasing its investments: headcount is up 3x, from 25,000 to 85,000 employees, in the past 3 years, and capex is up 2x in two years, to $30 billion – more than Tesla, Apple, Uber, Snap, and Twitter combined. The high level of investments is obviously hurting its bottom line. As a result, investors are running out of patience.
There are two ways out of this predicament. The first is for Meta to invest heavily in machine learning. The second is to change its narrative.
Why Meta has to invest so heavily in machine learning
Meta is investing heavily in machine learning to solve the two problems of (i) engagement and (ii) monetization.
Before Meta can increase revenue, it must increase engagement on its platforms. In order to do that, and to beat TikTok, it has to shift from the content recommendation engine that is based on the social network, where user gets content recommendations based on who they know, to an open graph-based discovery engine, where user gets recommendations purely based on popularity and preference (similar to TikTok). This requires significant machine learning investments, especially since most of this content is video-based, which is much more compute-intensive to process.
Concurrently, to increase revenue, Meta has to improve ad efficiency and overcome Apple’s ATT. To do so, it also has to invest heavily in machine learning. With the implementation of ATT, advertisers no longer have access to the iPhone’s unique identifying number (called the IDFA). In order to improve ad tracking without the IDFA, Meta is spending significantly to improve its machine learning capabilities, to predict conversions of ads. From the latest earnings call, it seems that they are making headways. Most of the projects are still in the pilot phase, but one called Advantage+ which launched in August helped advertisers to improve their return on ad spend by 32%.
Meta needs to change its narrative
As outlined in Brad Gerstner’s letter, Meta is misunderstood. In 2021, the company changed its name from Facebook to Meta. They did it in part to shed their negative image around privacy, elections, and fake news-related issues. The other part was to communicate the company’s bold ambition to own the computing platform of the future (which it believes to be AR/VR).
“Over time, I hope we’re seen as a metaverse company.” – Mark Zuckerberg
But because of this, everyone has been overly focused on investments in the metaverse, a pursuit that may not be fruitful. Most of the news coverage on Meta is on its AR/VR progress (or lack of it) and on VR legs (or lack of them). And not enough coverage of the real progress Meta is making on the engagement and ad monetization mentioned above (here’s a good one though).
In reality, although no evidence in the top line yet, it seems that Meta is making progress on going back to growth mode on its core advertising business.
From the latest earnings call, it seems that user growth and engagement of its family of apps are growing again.
David Wehner, Meta’s outgoing CFO, has the following to say (emphasis ours):
“… in terms of aggregate time spent on Instagram and Facebook, both are up year-over-year in both the U.S. and globally.” — David Wehner
And its AI discovery engine is playing a critical role, as Mark Zuckerberg mentioned in his prepared remarks (emphasis ours):
“This of course includes Reels, which continues to grow quickly across our apps — both in production and consumption. There are now more than 140 billion Reels plays across Facebook and Instagram each day. That’s a 50% increase from six months ago. Reels is incremental to time spent on our apps. The trends look good here, and we believe that we’re gaining time spent share on competitors like TikTok.” — Mark Zuckerberg
Engagement increase is a precursor to revenue increase. So right now, it sounds like Meta’s new AI driven recommendation engine product (Reels in particular) is driving engagement, but still lagging in monetization compared to existing features.
Here’s again David Wehner, Meta’s outgoing CFO, on the subject:
“From a monetization perspective, we are still working to close the gap between Reels and Feeds and Stories, but it’s going to take time before Reels becomes a tailwind to revenue.
As Mark mentioned, we’re on about a $3 billion run rate today, but Reels was still negative overall to revenue by about $500 million in the quarter. So we expect that it should be a tailwind to the business eventually. And we’re sort of saying that’s probably in the 12- to 18-month time frame. But overall, we’re pleased with the impact that Reels has on the business, specifically on the engagement front.” — David Wehner
If management of Meta is proven to be correct (we’ll find out for sure in 12-18 months), then all the expensive capex investments in AI and machine learning would become a moat that makes the business even more defensible and would help Meta become a growth company again.