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Facebook Earnings and Deja Vu

By Evan Niu, CFA – Nov 3, 2016 at 3:33PM

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This pullback will also probably turn out to be a buying opportunity -- just like last time.

Mark Zuckerberg speaking at F8 2016. Image source: Facebook.

You're forgiven if you're currently experiencing an eerily familiar feeling of deja vu watching Facebook (META 1.21%) shares drop today in the wake of third-quarter earnings that handily crushed expectations.

Revenue in the third quarter came in at $7 billion, which translated into adjusted net income of $3.2 billion, or $1.09 per share. Analysts were expecting just $6.9 billion in sales and an adjusted profit of $0.97 per share. Mobile ad sales are soaring, now comprising 84% of advertising revenue. Monthly active users grew to 1.79 billion, and mobile-only users topped 1 billion for the first time ever. Margins even expanded meaningfully as Facebook's profitability improved.

Yet, investors were disappointed overall.

Stop me if you've heard this one before

The reason for the drop is that Facebook is setting the stage for a slowdown in revenue growth, combined with increased costs associated with future investments. Increasing ad load has been a key driver of top-line growth, but there's a balance between ad load and user experience. While Facebook didn't give a precise number, it expects some heavy investments in 2017. Here's CFO David Wehner on last night's call:

I also wanted to provide some brief comments on 2017. First on revenue, as I mentioned last quarter, we continue to expect that ad load will play a less significant factor driving revenue growth after mid-2017. Over the past few years, we have averaged about 50% revenue growth in advertising. Ad load has been one of the three primary factors fueling that growth. With a much smaller contribution from this important factor going forward, we expect to see ad revenue growth rates come down meaningfully.

Secondly on expenses, though it is premature to provide specific expense guidance, as Mark mentioned, we anticipate 2017 will be an aggressive investment year. Adding top engineering talent remains one of our key investment priorities as we continue to execute on our 3, 5, and 10-year roadmap. We will continue to invest in our ability to recruit top technology talent, both in the Bay Area and beyond. In addition, we expect to grow capital expenditures substantially, as we continue to fund the ongoing data center expansion effort that we have under way.

The reason this may all sound familiar is because this same storyline played out two years ago. In late 2014, Facebook similarly warned of soaring costs to come in 2015 as it would be a "significant investment year." The language is even almost identical. Much of the increase at that time was directly related to the massive acquisition of WhatsApp and the related stock-based compensation expenses. The social network had expected a 55% to 75% increase in total costs heading into 2015, which translated into an operating expense range of around $11.6 billion to $13.1 billion. Total 2015 operating expenses ended up being $11.7 billion, up 57% from 2014 levels.

Even the market reaction was comparable. Shares fell 6% on the earnings release two years ago, and shares are currently down 6% as of this writing. But here's the thing: If you had bought at that closing price two years ago of under $76, you'd be patting yourself on the back right now and enjoying gains of nearly 60%, even after today's pullback. In hindsight, it really was a buying opportunity. Who knows, perhaps in two more years this pullback will turn out the same way.

Evan Niu, CFA 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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