Tech

Shira Ovide is a Bloomberg Gadfly columnist covering technology. She previously was a reporter for the Wall Street Journal.

Facebook Inc. confirmed Wednesday that it's the internet's hottest growth story. To stay that way, the company will have to double down in a crucial area: Selling more high-priced advertisements. 

To explain why, let me remind you of the three basic ways Facebook can increase its revenue:

  1. Sign up more people to Facebook, Instagram or other company properties, or lure existing users to spend more time there. More people or time on Facebook-owned sites translates into more opportunities to show ads. Revenue goes up.
  2. Dial up the "ad load," or the number shown to each person per minute or hour on Facebook's digital hangouts. Revenue goes up.
  3. Charge higher prices for each ad. Revenue goes up.

Facebook in the last year or so has focused its attention on number 1 and especially number 2. The company's efforts to cram more ads into Facebook and Instagram have been a major source of its extraordinary sales growth, which slowed a bit to 56 percent in the third quarter from 59 percent three months earlier. That's a remarkable pace for any large company, especially one that pulled in a record 45 percent operating income margin in the quarter.

Money Machine
Facebook's revenue growth rate peaked nearly three years ago, but it is on the march again
Source: Bloomberg

But Facebook acknowledges it can't keep dialing up the ad load. That is wise. Otherwise, we might start to feel overwhelmed by the blaring commercials and surf to quieter corners of the web, or (God forbid) put down our smartphones and speak to our families.

Running out of ad load rope will, however, mean revenue growth rates will come down next year "meaningfully," Facebook's chief financial officer, David Wehner, told analysts Wednesday. That utterance -- combined with a forecast of "aggressive" investments in engineering for 2017 -- spooked market watchers. Facebook shares fell about 7 percent in extended trading after the market close. 

The market flop shows how much Facebook has relied on ad load increases. Morgan Stanley has estimated about one-third of the company's expected advertising revenue increase for 2016 can be attributed to the growing ad load, versus about 57 percent to the rising number of Facebook daily users plus the growing amount of time spent on its properties. Again, those two factors result in Facebook serving up more ads, which generate more revenue.

As for number 3 in our blueprint to Facebook's riches, only about 11 percent of ad revenue growth this year will come from an increase in prices, Morgan Stanley estimates.

With the company running out of room to keep shoving more ads in our feeds, it will need to lean more on prices. By next year, Morgan Stanley predicts 26 percent of Facebook's expected ad growth will be generated by higher costs, and 40 percent by 2018.

Volume vs. Price
Facebook's revenue growth has largely been the result of the company showing more ads to its growing audience. But increasing average ad prices is becoming a more important contributor to revenue growth.
Source: Morgan Stanley estimates

This is in part why Facebook wants to be more like television. It's not just because TV is cool and people spend many hours a day staring at it. It's also because TV charges a lot of money for each commercial. Facebook would like some of that high-cost, high-quality TV ad money, pretty please. Its emphasis on live streaming video -- pitched loudly in TV commercials during the World Series --  and the company's devotion to video of all stripes on Facebook and Instagram are also part of the hunt for TV-like ad prices.

Room to Grow
Digital video advertisements on Facebook and its Instagram app are far less expensive than comparable ads on television, YouTube or Snapchat.
Source: Morgan Stanley estimates
Note: YouTube's "preferred" program is a collection of the site's most popular videos. "TrueView" ads are commercials shown within a broader set of YouTube videos.

Cranking up average prices won't be easy. Facebook is fully in control of how many or how few ads it shows users. Prices, however, are determined by a slew of factors, including demand from advertisers, who are also watching Facebook's average ad costs versus those of competitors like Alphabet Inc.'s YouTube and Snapchat parent company Snap Inc.

The trouble is, every other web company on the planet is chasing after higher-priced internet video ads. So far, the power couple of Google and Facebook have gobbled just about all the money in digital advertising, including video. The two companies grabbed 116 percent of U.S. digital advertising spending growth excluding web search ads in the second quarter, according to an analysis of industry data by Pivotal Research analyst Brian Wieser.

The Google-Facebook ad duopoly is unlikely to break anytime soon, but the industry's gold rush into online video could make people weary of clicking on them, while the flood of supply could push down ad prices. Either would dent Facebook's pace of sales.

The next year is a crucial stretch for Facebook to prove it can keep up its incredible stretch of revenue growth. And to do that, it will have to prove it can emphasize ad quality and not just quantity.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

  1. Facebook doesn't yet make money from its Live Video initiative. But I do enjoy the irony of Facebook using TV commercials to pitch live video, which is trying to steal video ad dollars from TV.

  2. That includes Gadfly owner Bloomberg L.P.

To contact the author of this story:
Shira Ovide in New York at sovide@bloomberg.net

To contact the editor responsible for this story:
Matthew Brooker at mbrooker1@bloomberg.net