Facebook’s Competitive Moat
A very bad 2018
The year 2018 has not been kind to Facebook (FB). Still reeling from the fall-out of foreign governments using its platforms to meddle in the 2016 US elections, the company suffered several blows that affected its share price. As of the 8th of January 2019, Facebook shares were at US$ 142/share, the lowest level since April 2017, and a far cry from the high US$ 210/share in June 2018.
Figure 1: The not so great 2018 for Facebook.
What happened? The blows came from various areas beginning in March 2018, from news related to the election, user data breach, missed revenue and several PR crises. Figure 1 summarizes the major news and events that negatively affected Facebook’s share price. As you can see, the majority of these negative news are one-time events (with the exception of the sharp drop in July 2018 related to missed revenue â€“ we will discuss this later in greater detail). Notice also that these news are mostly US centric (and related to politics). Nonetheless, the only way these events can affect FB’s business in the long run is if they have material impact to the growth of users and engagement levels â€“ both in the US and globally.
User growth is stagnating in North America and Europe, but not because of negative news.
Yes, FB’s user growth in developed markets (US, Canada, and Europe) has stagnated. This could be due to two reasons: the negative news decreasing adoption, or saturation in the market. Looking at FB’s Monthly Active Users (MAU) numbers in Figure 2, the numbers for US and Canada have stagnated since Q3 2017 (back then FB’s share price was around US$ 175/share). In Europe, the MAU increased modestly from 364 to 375 million users. These numbers give FB a total monthly active user of 617 million in these regions, which has approximately 727 million smartphone users. This means FB has a platform penetration rate of ~85%, which is impressively high. Furthermore, stagnating user growth in North America and Europe (mid to late 2017) seems to have preceded the onslaught of negative news (early 2018).
Figure 2: Facebook’s Monthly Active User (MAU) growth.
Unfortunately, the stalling user base is occurring in US, Canada, and Europe, regions where FB gains the most average revenue/user (ARPU). See Figure 3 for the ARPU breakdown by region. In US and Canada, FB makes US $27.61 per user/year. In Europe, FB makes US $8.82 per user/year. In comparison, Asia-Pacific and other countries of the world only contribute US$ 2.67 and US$ 1.82 per user/year respectively. This means FB needs to gain 10 users in Asia to match revenues from a user in the US and Canada.
Figure 3: Facebook growth and ARPU by region.
Does this mean Facebook’s growth is over? Not necessarily.
User base is still growing in some of the most populous countries in the world.
The negative news does not seem to affect FB’s platforms (Facebook, Instagram, WhatsApp, Messenger) usage either in the US or elsewhere. In Q3 2018, Facebook’s fastest growing regions were India, Indonesia, and the Philippines. As a result, MAUs were up 199 million or 10% compared to the same quarter in the previous year.
Demand remains strong
In Q3 2018, ad revenue was up 33% year over year, with mobile ad revenue growing 40% to $12.5 billion, making up approximately 92% of total ad revenue. FB uses a bidding system to determine prices for the placement of ads it serves. Due to strong demand, the average price per ad increased 7% and the number of ad impressions served across its services increased 25%, driven primarily by Newsfeed Ads on Instagram and Facebook. Newsfeed Ads is FB’s primary product, where the company injects advertisements to your social/news feed. Additionally, its secondary product, Instagram stories, continues to grow rapidly. It is particularly popular amongst the younger age group.
In the medium term, profitability has gone down due to heavy investments.
This is one of the primary reasons why FB’s share price fell sharply in July 2018. During that time, FB’s operating margin dropped 3% over Q2 of the previous year. This margin contraction continued in Q3. See Figure 4.
In Q3, the company reported total expenses of $7.9 billion, which was up 53% compared to the same period last year. The company also ended Q3 with approximately 33,600 full-time employees, and that’s up 45%. Many of these hires are in tech functions for security, safety, and removal of bad content (FB has generally failed in doing this globally â€“ its platforms have been utilized for malicious actions in Myanmar, US, and India to name a few â€“ hence it is doubling down on investments on this front).
As such, the company anticipates that full-year 2018 total expenses will grow approximately 50-55%, or approximately $14-$14.5 billion. In 2019, FB plans to continue to invest aggressively across the business and expects that full year 2019 total expenses will grow another 40-50% compared to full-year 2018. However, it seems as though the expected increase in expenses is likely a medium term phenomenon. The company expects to have the biggest change in its margin structure to occur in 2019 and for it to moderate from there. As such, margin should start expanding again in 2020.
Figure 4: FB’s diminishing margin.
The products remain strong
Currently, the primary way advertisers are reaching people on FB’s services is through Facebook Newsfeed and Instagram feed. But the company has many other products that create new ad inventories (ad inventory is user’s attention that FB captures, and can therefore serve ads to) that it has yet to fully monetize. More and more people are using Stories (more than 1 billion Stories shared everyday) and private messaging, in addition to the time they spend in News Feed and Instagram Feed.
The company has many platforms and have plenty of ad inventory to spare. Future ad inventories to be monetized:
- Stories: With stories, users are sharing ephemerally (either on FB or Instagram). Currently, because it is newer, there’s less demand for ad placement on Stories. Thus, placing an ad on Stories costs less than an ad on Newsfeed. The company believes that it will take years for price parity between the two to be achieved. In the short term, ad placement on Stories may cannibalize Newsfeed revenue. In the long term, management sees both platforms, FB and Instagram, as a Newsfeed + Stories platform.
- Whatsapp: FB is entering early phases of monetizing Whatsapp (more than 1.2 billion users worldwide as of 2017 [https://www.statista.com/topics/2018/whatsapp/]). The company has started ‘Whatsapp for business’, which currently has more than 3 million business accounts. Here, the company is monetizing in two ways: paid messaging (for example: sending boarding passes or delivery confirmations to customers) and ads in stories. FB also plans to add Payments to Whatsapp (although they do not have a specific plan to profit from it directly), and will introduce ads to Whatsapp status.
- Messenger: On FB Messenger, over 10 billion messages are sent between people and businesses every month. FB is currently exploring how they monetize better on this platform, through Sponsored Messages and Inbox Ads.
- Marketplace: Marketplace is now used by 800 million people globally. It is emerging as one of the most popular places to buy vehicles online, and in Q3, FB expanded Marketplace ads to nearly 70 markets around the world.
- Watch: FB’s mobile video programming, in the form of IGTV and Facebook Watch are still in its infancy. They are still well behind YouTube, which is the leader in this space, but they are growing very quickly. FB has actually limited the growth of video consumption on its platforms, as they were seeing passive video consumption displacing social interactions. The skeptic in me believes that on a per-minute basis, video generates less revenue for FB than Newsfeed (when watching a video, you consume less ads than scrolling through your Newsfeed rapidly). So displacement of Newsfeed by video is cannibalization of ad inventory.
With the plethora of platforms, FB creates a common tool that advertisers use to buy ads simultaneously across all FB products. The tool even allows advertisers to automatically create and modify ads to be shown in multiple form factors easily.
Make no mistake, despite Facebook’s recent struggles, the company is still dominant. Globally, Google and Facebook are an advertising duopoly. Currently however, Google shares trade at P/E (price to earning ratio â€“ the higher the number, the more expensive relative to the current earning the share price is) of 40.39, while Facebook shares trade at 21.48. This means that in the public market, investors are willing to pay US$ 40.39 for US$ 1 of Google’s current earning, making FB much cheaper in comparison.
Despite stagnating growth in developed countries (due to saturation in the market) and slew of negative news surrounding the company, the fundamental of the business appears strong. The company is growing rapidly in emerging markets, and has plenty in its product pipeline to generate more ad inventory for further monetization.