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Within Facebook's Strength Lies a Weakness

Price increases typically indicate an erosion in natural growth potential.
Photographer: Daniel Leal-Olivas/AFP/Getty Images
FACEBOOK INC-A
-0.44
At Closing, April 23th
165.84 USD

Facebook Inc. had countless conflagrations in 2017, but financially it was on fire in a good way. Revenue climbed 47 percent through the first nine months of 2017. It generated a remarkable 46 cents of operating profit for each dollar of revenue, and its stock price shot up more than 50 percent.

Facebook is the internet's best combination of quickly increasing sales, fertile profits, large market share in a valuable category and potential future growth from fresh areas.

But Facebook's business is also in the midst of significant changes, and it's easy to imagine the company's big opportunities might instead become burdens.

King of Kings

In the last five years, Facebook's stock price has climbed more than shares of other U.S. tech giants. Stock price increases from the end of 2012:

Source: Bloomberg

One example of the promise and the danger is a shifting source of Facebook's growth. In prior years, revenue increases came mainly from a growing number of advertisements shown to people surfing Facebook. The company's finance chief said recently that ad volume was becoming less important and that revenue growth instead would "increasingly be driven" by the company's ability to extract higher prices for the ads it sells.

It's happening already. The number of Facebook ad spots increased 10 percent in the third quarter from a year earlier, while the prices climbed 35 percent. It was the second consecutive quarter in which the prices of ads rose more quickly than the number. 

Price Sensitive

Increases in the number of ads on Facebook has been a big source of the company's revenue growth. Now ad prices are becoming much more of a factor.

Source: Facebook disclosures

Rising ad prices indicate demand from companies that need Facebook to help them sell cans of soda or oddball gifts, and they could help Facebook grow for years to come. I believed this a year ago, but now I'm not sure. 

When powerful companies lean on price increases to keep growing, that behavior typically indicates they're running out of natural growth potential. Those kinds of companies don't deserve rich internet stock valuations. Also, if prices get high enough they may winnow Facebook's broad base of advertisers, which has been one of its strengths. 

Facebook's volume of advertisements is increasing more slowly for a couple of key reasons. One, the company made a conscious decision to slow the increase in the number of advertisements slotted into its news feed. It's sensible restraint to ensure Facebook fans aren't overwhelmed by too many commercials.

And two, the company has said the number of ad spots will scale back as Facebook prioritizes web videos. There are fewer opportunities to air commercials if someone spends five minutes watching a single web video on Facebook than if she spends five minutes scrolling through a stream of posts. 

Pacesetter

Facebook's rapid rate of revenue growth is expected to slow this year

Source: Bloomberg

Note: Growth rates are estimated for 2017 and 2018.

If Facebook's supply of ad spots increases more slowly than demand from advertisers, prices go up. That's in theory good for Facebook. Facebook also says it is getting better at identifying, for example, young men who might buy Axe body spray and that more effective targeting pushes up the effective cost of ads while advertisers still feel like they're getting more bang for their bucks. Prices for Facebook ads also tend to be less expensive than many other internet ad options.

This is mostly a healthy sign for Facebook, but there are niggling worries, too. If Coca-Cola is having trouble selling more soda, and raises prices on each can, that's usually seen as a negative. 1 Internet and media analyst Michael Nathanson recently wrote that companies with years of volume increases ahead of them tend to have richer valuations than those relying on higher prices to generate future growth.

Facebook's stock multiple isn't excessive at 16 times estimated earnings in the next year before interest, taxes, depreciation and amortization. But investors are paying far more for a share of Facebook than they do for Google parent company Alphabet Inc. and Microsoft Corp. If Facebook becomes less of a natural growth machine, the valuation premium is harder to justify.

Because You're Worth It?

Facebook trades at a premium to Microsoft and Google's parent company

Source: Bloomberg

Facebook's changing balance of ad prices and volume is just one of the major shake-ups that have made investors unsure whether to feel optimistic or uneasy about Facebook. The company has warned its revenue growth rate will continue to slow, it's betting big on an uncertain web video strategy, spending increases are likely to push down high profit margins, regulatory and political scrutiny is intensifying and Facebook's messaging apps and virtual reality businesses still aren't making much money. 

Facebook has been the technology industry's biggest success story of the past five years. But the reliance on higher prices is just one sign among many that it may have a tough time repeating its success. 

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.
  1. Ad prices are falling for Facebook's digital advertising rival, Google, but the company has continued to grow because it's adept at sticking in more advertising spots and luring people to click on more ads. In short, Google is relying on higher ad volume rather than higher ad prices. 

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

To contact the editor responsible for this story:
Daniel Niemi at dniemi1@bloomberg.net

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