by Clement Thibault
Facebook (NASDAQ:FB), the social media giant, will report Q1 2017 earnings on Wednesday, May 3, after the market closes. Wall Street is expecting the company to post $1.1 in earnings per share, as well as $7.84 billion in revenue.
Ad revenue slows
If you already own shares of Facebook, or are considering it as an addition to your portfolio, you're probably aware that, its social media designation notwithstanding, it's primarily an advertising platform, at least insofar as how it generates revenue. Advertising revenue accounted for 97% of Facebook's earnings in 2016. This dependence on advertising is not new—during 2015 and 2014 advertising was already 95% and 92% percent of revenue respectively. But the growth in the company's dependence on income from advertising is of concern.
Last quarter, we wrote mainly about the various channels Facebook currently has from which to grow ad revenue. Among them we mentioned video advertising, which has been one of the company's main recent initiatives and maximizing Instagram's ad load since, as of a few quarters ago, Facebook told investors and analysts their own platform was already maxed out.
At that time, Facebook management admitted that the best days of their ad revenue growth rate were behind them, and David Wehner, Facebook's CFO, reiterated during the company's last conference call that:
"[Facebook's] revenue growth rate will come down meaningfully in 2017".
Though the company was cagier about admitting by exactly how much, nor did they disclose how it will affect Facebook's overall revenue, this forces investors—and Facebook—to try and identify the next possible big revenue stream(s). Here are four that are on our radar:
1. VR – Virtual Reality
Back in 2014, Facebook bought Oculus VR, a creator of virtual reality headsets and technologies, for $3 billion dollars. With the purchase, Facebook sought to position itself at the forefront of the newest gaming segment, which is estimated to have potential in excess of $10 billion in the next few years. Unfortunately, since the purchase, that potential still hasn't panned out . In addition, Oculus has run into legal issues.
Facebook had to pay a $500 million fine to ZeniMax media, after a court ruling decided that Oculus' founder, Palmer Luckey, violated a confidentiality agreement he'd signed with his former employer—ZeniMax. Luckey has since left Oculus, which threw a monkey wrench into Facebook's development plans. However, the company remains ahead of the competition, and is set to gain substantial market share once the VR market actually accelerates.
2. AR – Augmented Reality
Two weeks ago, during Facebook's annual F8 developer conference, the company focused a considerable amount of attention on what it clearly believes is its next big thing: augmented reality. AR is the ability to layer information and virtual objects on top of our perceived (some would say actual) reality. Remember the recent Pokemon Go craze? That's the game (developed as a collaboration between Nintendo and an AR company called Niantic) which allowed players to catch Pokemon characters that were layered onto images captured by their smartphone's GPS, making it appear to the player as if the characters were in the same location as the user.
Facebook acquired the MSQRD mobile app last year for its AR masks, and this step into AR is Facebook's way of leveraging the product acquired. After Facebook's acquisition, the ball has been in the hands of developers, but the applications and business opportunities have plenty of potential. However, competition is also expected to be intense, with Snap (NYSE:SNAP) and Microsoft (NASDAQ:MSFT) already in the game, and Apple (NASDAQ:AAPL) rumored to be adding AR features to its iPhone 8 camera.
3. Workplace by Facebook
Facebook created its own business communication platform, initially to help run its own company more efficiently. A year ago it started working with a selection of additional companies to tailor the platform for commercial use.
Workplace is meant to facilitate internal communication between colleagues, in much the same way Slack's cloud-based team collaboration tool does. Slack, with its advanced search capability, option to send snippets of code to team members and ability to easily integrate existing project management software such as Atlassian's JIRA into the mix, is widely used in the business world, but especially among technology and development teams, which often need tighter, real-time communication—something slower, old fashioned email can't provide.
Workplace's user-interface will be based on Facebook's core UI, making it both more familiar and more user-friendly which may appeal more to younger audiences. It will also make it much easier to learn, for those with any Facebook experience. Workplace, priced at $3 per month per user, is less than half the price of Slack's service ($6), which should create some real competition between the two products. We think Workplace is an interesting new business for Facebook, one definitely worth keeping an eye on.
4. WhatsApp
Three years ago, when Facebook acquired WhatsApp for about $22 billion, quite a few eyebrows shot up in surprise, especially since WhatsApp generated only about $12 million in sales at that time and had recorded a net loss of $140 million. Except for data mining WhatsApp for advertising purposes, we've wondered more than once how Facebook will actually derive additional value from this acquisition.
It appears we could be about to get an answer. Facebook looks to be on the verge of incorporating a peer-to-peer payment function in India, WhatsApp's largest market.
This in response to India's Prime Minister Narendra Modi's 'war' on large cash transactions, which he views as a facilitator of corruption and tax avoidance. In December, Modi voided India's largest bank note, and announced that the central bank would stop printing it, in essence opening the the door for a payment function on popular apps including Whatsapp. This launch of this feature is rumored to take place toward the end of 2017.
Conclusion
In our view, Facebook's continued success and additional growth depends on two things. The first is the answer to the question, 'What would constitute a meaningful slowdown in growth?'. Facebook's management has been noticeably opaque on the subject, for obvious, albeit worrying reasons. The second is how fast can Facebook diversify its revenue and create additional growth engines?
It's worth keeping an eye on all this, since a gap between the slowdown in advertising growth and the development of new products might cause the share price—which closed at $152.78 yesterday—to drop meaningfully...offering safer buying opportunities. While Facebook is at an all time-high, above $150, it's also at one of its cheaper price points from a valuation perspective, with a Price-to-Earnings ratio of almost 44. At a P/E in the 43 range, owning the stock starts to make more sense, even if Facebook continues to grow at less than 50% of the rate at which it grew in the past four quarters, which would still be 25% YoY for revenue and 50%+ for net income.
While Facebook will never be a value investment, at its current price it would still be a decent growth investment. However, we expect the company's revenue growth slowdown to create a market overreaction. At that time, we plan to take advantage of the expected decrease in the share price.