Facebook Stumbles

Facebook this week achieved the dubious distinction of having the largest single-day drop in a company's market capitalization in history - registering a decline of 20%, which translates into $120B of value (roughly the entire market cap of Nike. It's worth noting that Intel had a drop of $90B in 2000, during the dot-com crash, that was actually larger when adjusted for inflation).  Facebook's drop happened not long after Netflix's stock crashed 14% after announcing lower-than-expected increases in overall subscribers and lowering their new-subscriber guidance. This was additionally on the heels of Alphabet's $5B fine by the EU Commission for violating antitrust rules with orders to meaningfully change their Android business practices. The narrative of tech giants marching inexorably to absolute dominance is now slowly changing.

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Facebook represents one half of the advertising duopoly and thus events of this magnitude are worth further consideration. Facebook's 2018 has been among the worst in the company's history for a number of reasons. Scandal after scandal has beset the company, including the Cambridge Analytica fallout, its usage as a tool for violence leading to human tragedies around the world - like in Sri Lanka and Myanmar, and the company's spurious decision to knowingly allow misinformation to spread on the platform and the human lives that this decision directly harms. To many, 2018 marked the year that Facebook went from charmed technology company to villain. Yet there's an important distinction about what being a villain means. Facebook makes money because people use its platforms and it advertises to them while they do so. It makes money roughly in proportion to the amount people use the platform, adjusted for the amount people are willing to spend to advertise to its various users (broadly speaking, people in richer regions with more robust digital advertising markets are worth more to Facebook because advertisers will pay more for them). The news media's perspective on the company doesn't change this basic calculus. The fundamental questions remain how many people are using the platform, with what regularity, what's the rate of growth in users and advertising dollars, and how much money does the company have to spend operating the company.

The two metrics that Facebook reports on are daily active users (DAUs) and monthly active users (MAUs). Both of these numbers exclude how much time users actually spend on the platform, which Nielsen has reported as declining consistently in the US and that the loss in time on Facebook is not being recouped by Instagram's growth. Nonetheless, Facebook reported DAUs up 11% year-over-year, to 1.47B users (short of expectations at 1.49B) and MAUs up to 2.5B users across all platforms. The growth was substantially concentrated in India, Indonesia and the Philippines - countries that are less wealthy than North America and Western Europe. For the second quarter in a row, US and European DAU growth has been nominal or negative. Facebook reports a figure called average revenue per user (ARPU), which was $5.97 in the most recent quarter. Users from the US and Canada have an ARPU of roughly $25, around 3x Facebook's European ARPU. US and Canadian users have an ARPU of roughly 10x that of Asian users. Thus declines in growth or usage in North American and Europe have a material impact on the company's overall revenue.

Declines in usage in high-ARPU regions and declines in DAUs are an unfortunate combination. The company's revenue growth declined and is expected to continue to decline. Facebook has committed to investing significantly in security, infrastructure and more - meaning its operating costs will increase significantly. The company has grown headcount nearly 50% in the past year. In fact, the company predicted in its recent earnings that its expense growth would exceed its revenue growth in 2019, and that the company would maintain lower overall margins going forward.

Facebook made changes on the platform earlier this year in part to prioritize user well-being and as a response to the fake news scandals. At the time, it reported a 5% reduction in time spent on the platform. The Nielsen report cited above shows larger decreases in the US, and it's unclear whether Facebook is citing estimates of the impact specifically due to its changes or as an overall number. Facebook has regularly stated that it is focusing on decreasing time spent on the platform to improve its contribution to society and thus it is has messaged declining utilization for at least a quarter (it's unclear whether it saw had previously seen declining usage generally and is using these changes as an excuse, but that's largely immaterial).

Facebook now faces a growing number of threats that may contribute to a destabilized share price. Regulatory concerns continue to mount. The company's position as having a huge influence on the information disseminated in any region has contributed to the belief that various governments will begin to restrict or regulate its activities. Facebook's shares fell 17% after the Cambridge Analytica fallout but recovered shortly thereafter. The company also faces the thread of privacy legislation. Facebook may have violated GDPR by bundling consent and impending legislation, including the California Privacy Act and ePrivacy Regulation in Europe further threaten its business model. There are even internal battles being fought about how the company ought to operate - whether it should abandon much of its data collection entirely.

It is unclear what exactly the usage pattern would look like if consumer sentiment were significantly impacted by Facebook's vast number of scandals nor is it clear that the company is necessarily out of the woods - negative sentiment toward the platform that is an important part of many people's day-to-day may need at least some time to percolate before it leads to changes in behavior. It does appear that there were not meaningful (double-digit) changes as a result of the scandals, privacy challenges, etc. Further, while a small handful of advertisers have changed their Facebook buying behaviors because of privacy, the vast majority have not. Thus its position in the consumption of content and advertising value chain will likely continue substantially unabated.

Facebook and Google have recently grown at a rate that effectively consumes all of the growth of digital advertising. It is perhaps the case that Facebook's slowing rate of growth opens the doors for additional market participants. Alternatively, Facebook was driving much of the growth through advanced and highly-accessible audience buying tools, and the digital advertising market simply won't grow as quickly. It's unclear what the causality is. However, as core Facebook's users spend their time elsewhere, Instagram has indeed been a beneficiary, but it hasn't been the sole beneficiary. Platforms like Snap have increasingly grown to occupy attention for younger demographics that would traditionally been on Facebook. This means that across the entirety of its platforms, Facebook is losing user attention - among the most coveted demographics - that it previously held. There are certainly positives about the overall business, including tremendous growth by Instagram and Whatsapp, Facebook Workplace's promising initial traction, and the promise of Oculus. It's also probably the case that the core Facebook platform has, from a growth perspective, hit its absolute peak.

There's a real question as to whether the market reacted appropriately. There's a belief that the market factors in the set of expectations by the investors of any given company - meaning the stock price is a weighted estimate of likely outcomes. The most fundamental change announced was a reduction in growth rate. Facebook had indeed given any number of clues in prior earnings reports that this was coming.  Indeed, as discussed above, in their Q4 earnings from last year, the company noted that it was - to a degree - deprioritizing growth and focusing on increasing the quality of time on the platform. The company expressed this theme consistently, but also achieve strong growth in certain areas that masked the effects. This was the first quarter when all the effects above began to be apparent in overall results and when the company made clear that it was officially changing its rate of growth expectations. To some degree, however, this was a relatively predictable outcome that had been telegraphed by the company. Then again, it's always easier to judge in retrospect.

For companies like TripleLift that focus on monetization outside of Facebook (excluding ContentDial), there is likely very little impact. Companies that monetize on Facebook will, in the aggregate, grow at a rate correlated with the company's overall growth. Facebook does drive traffic to many sites. It continues to explore different opportunities to compel publishers to put their content on Facebook itself (like Facebook Watch), though it remains unclear how successful any of these have been. Thus, outside of any unexpected developments, Facebook will likely continue to have roughly the same level of impact that it has had for digital publishers - which is largely as an unpredictable and unreliable source of traffic.