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2 Problems With Facebook’s Earnings

By Jamal Carnette, CFA – Jul 29, 2016 at 9:21AM

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Facebook's earnings were nearly flawless. However, there are a few things I'm watching going forward.

Facebook's Mark Zuckerberg. Image Source: Facebook.

Facebook (META -0.74%) reported a blowout quarter. The social-media site reported figures of $6.44 billion and $0.97, respectively, versus analyst expectations of $6 billion in revenue and adjusted EPS of $0.82. Additionally, the company added more monthly active users, or MAUs, than Wall Street analysts projected. On nearly every given metric, Facebook smashed consensus expectations, and investors bid up the stock by approximately 7% in the after-hours market.

Shareholders, myself included, should be elated with the results. However, it's always important for investors to identify and incorporate any potential threats to the company into their investing theses. For this quarter, it requires a finely tuned microscope to find any potential problems with Facebook's results; but there are two I'm noting going forward.

No. 1: Is ad load becoming a problem?

Ad load, the amount of advertising in users' news feeds, is something Facebook is keen on controlling. If you remember, a deteriorating user experience due to excessive ad load was a key reason why Facebook's early competitor, MySpace, lost its spot as the largest social-media site.

If anything, Facebook has taken MySpace's lessons to heart, and erred on the side of user experience over monetization. Last year, a report from social-media marketing and monitoring firm Socialbakers found only 3% of Facebook's news feed are actual advertisements. Compare that to television, in which a quarter of U.S. live viewing time is advertising.

Facebook continues to be sensitive to ad load. During the conference call, CFO Dave Wehner noted: "On the ad load front, ad load is definitely up from where we were a few years ago... We do expect that ad load will be a less significant factor driving overall growth, especially after mid-2017." Overall, this appears to be a slight note of caution from a company that has demonstrated restraint with ad load.

As a prudent investor, I'm keeping an eye on this. I feel that the narrative that the company "is running out of places in News Feed to show people ads," is overstated at this juncture. A large concern for investors is users defecting from the site on account of crushing ad loads, and that's simply not happening. Multiple times during the conference call, Facebook's C-suite mentioned healthy user engagement increases.

Additionally, the fact that daily active users, or DAUs, are increasing at a faster year-on-year clip (17%) than MAUs (15%) points to high-engagement levels. It's a new concern to be monitored, but nothing that should change your bullish investment thesis.

No. 2: Slowing developed-market DAU growth

Perhaps a bigger concern for investors is the distribution of DAU growth. As previously stated, Facebook grew DAUs 17% on a year-on-year basis. However, that growth was heavily skewed to Asia Pacific and the rest of the world, which increased 21% during this period. The developed markets of the United States, Canada, and greater Europe only had a year-on-year DAU increase of 9%.

Why is the distribution of DAU increases important? Although U.S., Canada, and greater Europe only have 38% of the company's DAU totals, these regions provided nearly 75% of the company's revenue haul last quarter. The reason why is advertisers consider a user in these regions more valuable from a marketing standpoint, as they generally have more disposable income and a higher propensity to spend.

In the event DAU growth continues to skew to developing economies, it's possible for future revenue growth to slow, especially in light of a decrease in ad load, as DAU growth will become less lucrative for the company's top line. This is a legitimate concern to be watched, but it hasn't affected the company at this point. Additionally, the company has other growth avenues to pursue in the event ad growth in its core website slows.

Facebook still has huge growth drivers

Facebook is clearly a growth stock with investors paying a huge premium to the greater market for the company's shares. The most-interesting thing about this company is that there are a great deal of untapped levers for growth. By all accounts, Instagram is still growing accounts at a rapid clip, and the company continues to increase marketing on its sister site.

On a longer-term basis, the company's Oculus virtual-reality business could be a huge growth driver. If Pokemon Go is any indication of the potential of virtual/augmented reality, it's possible Facebook's Oculus acquisition may be even more lucrative than the company's Instagram purchase.

In the short term, another potential growth factor could be search. During the conference call, Mark Zuckerberg noted that users are performing more than 2 billion searches on Facebook per day. Currently, Facebook is not directly compensated for those searches, but it could be a huge revenue driver in the future.

Overall, Facebook produced an amazing quarter, and it appears likely to continue. Investors should note these new concerns, but not worry about them at this point.

Jamal Carnette owns shares of Facebook. The Motley Fool owns shares of and recommends Facebook. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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