Not only is Facebook (NASDAQ:FB) growing its user base, the Company is getting better at monetizing existing users, especially on the mobile side in the U.S. It seems logical that many of the monetization techniques used on mobile devices in the U.S. can eventually be employed in other parts of the world as users are moved from 2G to higher speeds.
Marketers are still trying to catch up to consumers on the shift to mobile and it looks like ad revenue growth will continue for the foreseeable future although the rate of growth should decline as ad load peaks in 2017. Key numbers have changed substantially since my August 2015 Facebook article such that the valuation process is now somewhat less difficult.
Much of the digital ad revenue is now consolidated with Google (NASDAQ:GOOG) (NASDAQ:GOOGL) on the search side and Facebook on the display side. This consolidation does not show signs of slowing down and many say it should increase in the coming years.
Facebook Users From 2016 Q4 Earnings Slides:
Daily Active Users (DAUs): 1,227 million – U.S. & Canada: 14.7%, Europe: 21.4%, Asia-Pacific: 32.3%, Rest of World: 31.6%
Mobile DAUs: 1,146 million
Monthly Active Users ((MAUs)): 1,860 million
Mobile MAUs: 1,740 million
Mobile-Only MAUs: 1,149 million
98% of the Q4’16 Facebook revenue is from advertising. The Q4’16 ad revenues are: U.S. & Canada: $4.4 billion, Europe: $2.0 billion, Asia-Pacific: $1.3 billion, Rest of World: $0.8 billion. U.S. & Canada Q4’15 ad revenue was $2.8 billion so the growth over the last year was substantial.
We see the average revenue per monthly active user (ARPU) by geography from Facebook earnings slides. ARPU in the U.S. & Canada more than doubled from 2014 Q4 to 2016 Q4.
$9.00 U.S. & Canada Q4’14
$13.70 U.S. & Canada Q4’15
$19.81 U.S. & Canada Q4’16
Q4’16 for other areas: Europe: $5.98, Asia Pacific: $2.07, Rest of World: $1.41.
Adding up all four 2016 quarters, Facebook U.S. & Canada advertising revenue came to $13,558 million.
Global Facebook Mobile Ad Revenue was just 23% of total ad revenue in 2012 Q4 per the 10-K. As discussed in earnings calls, global ad revenue on the mobile platform continues to grow in importance:
2014 Q4: $2.5 billion
2015 Q4: $4.5 billion
2016 Q4: $7.2 billion
The 10-K filings and the latest earnings call show that Facebook mobile ad revenue has been increasing as a percentage of total ad revenue: 2012 Q4: 23%, 2013 Q4: 53%, 2014 Q4: 69%, 2015 Q4: 80%, 2016 Q4: 84%.
Fortune shows that Google and Facebook have been responsible for nearly all the recent growth in U.S. ad revenues: Google Q3’15: $7.9 billion, Facebook Q3’15: $2.1 billion, Others Q3’15: $4.6 billion; Google Q3’16: $9.5 billion, Facebook Q3’16: $3.4 billion, Others Q3’16: $4.7 billion.
2016 U.S. digital ad spending: $71 billion. Google and Facebook accounted for $41 billion or 58%. 
Estimated 2017 U.S. digital ad spending: $83 billion 
Estimated 2017 global digital ad spending: $229 billion 
Percentage of global digital advertising that is mobile: 2015: 44%, 2016: 56%, 2017: 63%, 2018: 69% 
1. Salesforce Q1 2017 Advertising Index
2. Forbes State of Digital Advertising
In recent earnings calls, COO Sheryl Sandberg talks about the Company focusing on its three priorities:
1. Capitalizing on the shift to mobile.
2. Growing the number of marketers using Facebook ad products.
3. Making Facebook ads more relevant and effective.
These priorities help explain revenue growth and in some ways they overlap. The driver of Facebook’s growth is helping the advertisers shift to mobile. In some ways, this combines priority #1 and priority #2 in terms of helping new marketers make this shift. In some ways, this combines priority #1 and priority #3 in terms of making better mobile ads for existing marketers.
Another way to think about the overlap of the mobile priority with the other priorities is to start with the fact that 84% of advertising revenue now comes from mobile. This means that priorities #2 and #3 mainly happen on mobile and capitalize on the shift to mobile.
Priority #2 and priority #3 are intertwined as well. Data-driven technology that brings about more effective ads entices more marketers to join the platform and more marketers on the platform give the company more ad data for experiments that lead to better ads.
Priority #1 – Capitalizing on the Shift to Mobile
Many companies talk about mobile being a priority but Facebook has the numbers to back it up. The fact that 84% of their 2016 Q4 ad revenues came from mobile is remarkable.
VP of Global Marketing Solutions Carolyn Everson discusses the importance of mobile back in the December 2015 UBS Annual Global Media Conference. She describes mobile as the most important transformation we’ve had in marketing in over 100 years. Consumers have already made the transformation and Carolyn points out that marketing and the entire business model have to evolve.
Noting that measurement is key, she discusses the fact that cookies aren’t suited well for mobile despite the fact that they’re widely used with desktop. She talks about the Facebook pixel being better for tracking behavior across devices. She also points out that the industry originally missed the fact that mobile is the most important brand building platform in the world because of scale.
In the 2016 Q3 earnings call, COO Sandberg communicates that people have already shifted to mobile and it is time for businesses and marketers to catch up. The importance of video on mobile is highlighted when it is revealed that 3 million small businesses have posted a video on Facebook. At the 2017 Morgan Stanley Conference, she repeats that the driver of ad opportunity is about the shift to mobile and that people/consumers have already made the shift. The key is getting advertisers to follow consumers with the shift seeing as consumers are ahead of marketers.
Priority #2 – Growing the Number of Marketers
During the 2016 Q2 earnings call, COO Sandberg talks about the fact that a business does not even need a website in order to advertise on Facebook:
Over a third of small and medium businesses in the U.S. don’t have a website — and having a mobile presence is even more difficult and expensive. Creating a business Page on Facebook is as easy as setting up a personal Profile. This is why Facebook Pages are the mobile solution for many of the 60 million businesses using our products each month in the U.S. and around the world.
We’ve made it easy for business owners to manage their Facebook Page from their mobile device. Over 85% of active business Pages use mobile and 40% of active advertisers have created a Facebook ad on their mobile device. In Q2 we rolled out new tools to make it easier for businesses to promote posts and track performance directly from the Instagram app.
We’ve worked hard to make becoming an advertiser as easy as possible for these businesses. With just a few steps, and for as little as a few dollars, businesses can boost their posts to reach more people. Simplifying our ad products is key to advertiser acquisition – over 80% of new advertisers in Q2 started with simplified products, like boosted posts.
In the 2016 Q3 earnings call, COO Sandberg describes a feature that shows marketers a preview of a potential ad in News Feed. Making a few taps allows marketers to see the News Feed with ads the same way their customers would see it. She also mentions that making it easy to advertise from a mobile phone is especially important in emerging markets.
Priority #3 – Making Ads More Relevant and Effective
VP of Global Marketing Solutions Everson describes the effectiveness of dynamic ads and carousel ads at the December 2015 UBS Conference:
And so just to explain what dynamic product ads are, you can take a, let’s say, a retailer, and they can upload their entire product catalog and then without having to create individual ads for millions of products with some of these, obviously, these retailers have millions of different product offering, we can dynamically generate the right product and the right ad through the person at the time based on, potentially somebody revisiting their shopping cart and they didn’t purchase it when they were browsing for a particular product and it’s even, is sophisticated as knowing that maybe you did buy it, so make sure you don’t show that product again because that would be a waste to that. If you just purchase something, why do you need to see an ad for that again? And so, dynamic product ads have been very, very effective.
In addition, we have this format called Carousel ads, which basically show up to five images or video and it allows marketers to take a single product and show it in very unique ways over the course of five images. You could show five different products. You could tell a story. You could show a couple of products with some new stories as background information for it. So the combination of conversion pixel, Dynamic Product ads and Carousel ads have been very, very effective.
The Company has a competitive advantage because of its vast amount of data. Given all the available data, A/B tests can be concluded in a short period of time such that ads that make the most sense with the best results are implemented. At the 2017 Morgan Stanley conference, CFO David Wehner mentions that the success with dynamic ads in ecommerce can be used to experiment with travel and financial ads.
COO Sandberg talks about specific ad measurement investments in the 2016 Q3 earnings call mentioning Nielsen, Datalogix, Visual IQ and Marketshare.
At the 2017 Morgan Stanley Conference, COO Sandberg talks about options for marketers targeting areas with slower internet connections. Seeing as video does not yet work well for much of the world, Facebook engineers created Slideshow. Video uses five times more bandwidth than Slideshow so advertisers are able to target high bandwidth phones with videos and low bandwidth phones with Slideshow.
The 2016 10-K notes that the most important factor for advertising revenue growth during the year was an increase in revenue from ads in News Feed. The growth factors are broken down in detail:
Factors that influenced our advertising revenue growth in 2016 included
(i) an increase in demand for our ad inventory, in part driven by an increase in the number of marketers actively advertising on Facebook,
(ii) an increase in user growth and engagement, and
(iii) an increase in the number and frequency of ads displayed in News Feed, as well as the quality, relevance, and performance of those ads.
However, we anticipate increases in the number and frequency of ads displayed in News Feed will be a less significant driver of our revenue growth in the future.
At the 2017 Morgan Stanley conference, CFO Wehner talks about the implications of the estimate for ad load to reach its peak in mid 2017. Thinking of ads in terms of supply and demand, we classify the first growth factor above as demand and factors two and three as supply. Ad load is just one component on the supply side along with users and time spent. If the ad load goes flat or down such that the overall supply goes down then economics dictate that the price goes up meaning advertisers will have to pay more for ads.
Capital allocation is very important for shareholder value and a company needs to have good judgment with respect to acquisitions in order to be successful in this area. Many times large acquisitions can be destructive with respect to shareholder value, Priceline’s (NASDAQ:PCLN) OpenTable purchase is an example. Making up 15% of Facebook’s U.S. mobile revenue in 2016, the Instagram acquisition was a home run for shareholders.
Being more of a follow model instead of bidirectional like Facebook, Instagram is a nice complement and its potential with videos is wonderful. The impact of other acquisitions like WhatsApp, Oculus and LiveRail is less clear at this time.
Platform Revolution talks about two of Facebook’s acquisitions and the concept of companies being valuable because of the communities participating in their platforms:
The reason Instagram sold for $1 billion is not its thirteen employees: the reason WhatsApp sold for $19 billion wasn’t its fifty employees. The reasons were the same: the network effects both organizations had created.
Standard accounting practices might not factor the value of communities into the value of a firm, but stock markets do. Little by little, the accountants are catching up.
Chairman and CEO Mark Zuckerberg talks about the Facebook family in the 2016 Q3 earnings call:
Instagram, Messenger and WhatsApp each have large communities, but we have a lot more work to do on all of them. I think about our progress here in three phases. The first phase is building a great consumer experience and getting it to scale. The second phase is about enabling people to organically interact with businesses. And then the third is to give businesses tools to reach more people. That’s how we build our business.
At the 2017 Morgan Stanley Conference, COO Sandberg talks about the way incremental parts of the Facebook family like Instagram stand to benefit from the family. Advertisers are sold both Facebook and Instagram with one purchase. The ad targeting and measurement technology is plugged into Instagram:
The reason Instagram was able to get to 500,000 advertisers this quickly is that we have 4 million at Facebook and when you come into our ad flow whether you’re working with a direct representative or you’re buying online, we are able to sell you Facebook and Instagram and the advertising network in one purchase. We’re using the same targeting capabilities, we’re using the same measurement capabilities. Marketers are able to extend their reach.
Progressive did the A/B test of running only on Facebook and then both Facebook and Instagram along with the audience network. Their conversions more than doubled by adding in Instagram and the audience network. Even with the size of Facebook, we are able to provide a lot of incremental value.
Some of the early social network companies were shooting stars. MySpace is an example of this phenomenon. On the surface one could worry about Facebook suffering the same fate as MySpace, but a closer look shows some key differences between the two companies.
Chairman and CEO Zuckerberg repeatedly gives investors the sense that monetization should not be rushed or forced. It sounds like Rupert Murdoch was not in a position to be as patient after acquiring MySpace. A March 2015 article in the guardian talks about some of the problems faced by MySpace such as annoying ads. MySpace also had issues with pornography and user controls.
The 2012 10-K was the first filed by the Company. It showed the following:
$1,572 Share-based compensation
At that point in time, it was hard to predict how share-based compensation would grow with respect to revenue.
Five years later, the 2016 filing shows the following:
$27,638 2016 Revenue
$3,218 2016 Share-based compensation
Revenue is clearly outgrowing the share-based compensation expense. That expense is much less of a concern now than it was when I wrote my last Facebook article in August 2015.
The Company does not take the impact of its share-based compensation expense lightly. CFO Wehner said the following at the February 2017 Morgan Stanley Conference:
Of course we [managers] spend a lot of time talking about the compensation paid to employees regardless of what the form of that compensation is [stock based compensation vs other forms]. I don’t think you can really look at what a company is doing from a profitability perspective and ignore the major factor of stock based compensation.
I use adjusted free cash flow (FCF) as a proxy for owner earnings. As such, I treat stock-based compensation as a cash expense and subtract it from operating cash flow such that my adjusted FCF is lower than the Company’s FCF figures. The Company has 2016 FCF as $11,617 million on page 32 of the 2016 10-K but my number of $8,399 million is lower due to $3,218 million in share-based compensation.
Either way, I don’t think trailing 12-month FCF is the way to go given the growth factor. Capex is expected to increase from $4.5 billion in 2016 to $7.5 billion in 2017, and I’m not sure how much of this 2017 estimate is maintenance vs. growth [we only subtract maintenance to get FCF].
We could get a run rate based on the most recent quarter, but the most recent quarter happens to be Q4 and advertising spending is seasonal such that it is especially high in this quarter. Still, Q4 revenue of the previous year ended up being less than the average quarterly revenue of the next year in each of the last three years. It’s hard to express this with words in a way that is not confusing so let’s look at the numbers.
2013 Q4 revenue: $2,585 million. Average 2014 quarterly revenue: $3,117 million
2014 Q4 revenue: $3,851 million. Average 2015 quarterly revenue: $4,482 million
2015 Q4 revenue: $5,841 million. Average 2016 quarterly revenue: $6,910 million
Given the growth above, I am using 2016 Q4 for a run rate despite the fact that it will likely be higher than 2017 Q1 because of seasonality.
2016 Q4 Earnings Release:
4,930 net cash provided by operating activities
(831) share-based compensation
$2,830 million Adjusted FCF
Using 2016 Q4 to get a run rate, we have 2,830*4 or $11,320 million.
The diluted EPS calculations on page 70 of the 2016 10-K show 2,925 million shares after the conversion of Class B to Class A common stock.
414,560 equity market cap 2,925 million*$141.73
(20,546) marketable securities
This gives us a price to adjusted free cash flow ratio of about 34 or $385,111 million/$11,320 million. Normally, I don’t invest in companies with multiples this high, but I feel that Facebook is a special case whose growth prospects are especially strong.
It is likely that Facebook mobile ad revenue will continue to grow substantially over the next few years. Part of the growth has been due to increased ad load, which should peak in mid-2017 per CFO Wehner’s comments at the 2017 Morgan Stanley Conference. There are other factors involved in the ad revenue growth rate such that it should still be impressive even though it won’t be as high as the last few years.
Newspapers are struggling with advertising dollars. Cable customers are cutting the cord. A recent forecast from eMarketers says there will be more digital ad spend than TV spend in 2017. On the digital search side, ad revenues are largely going to Google, and on the digital display side, they are largely going to Facebook.
Mobile advertising is still somewhat new and many new businesses have a history of not working out well for investors. Airlines are an example. They have been great for consumers over the past century but lousy for investors. Some say the airline industry now has better prospects for investors given the consolidation that has taken place. Despite mobile advertising being new, the consolidation has already taken place such that Google and Facebook are the leaders and long-term prospects look good for investors in my opinion.
Special thanks to Scott and Steph.
10-Q and 10-K Filings
2017 Morgan Stanley Technology, Media & Telecom Conference
2017 Q1 Salesforce Advertising Index
December 2015 UBS Global Media and Communications Broker Conference
Forbes State of Digital Advertising
Quarterly Earnings Releases, Slides and Call Transcripts
Disclosure: I am/we are long FB, GOOG, GOOGL, PCLN, VOO.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Any material in this article should not be relied on as a formal investment recommendation.