Facebook (NASDAQ:FB) CFO Dave Wehner has been warning about an ad revenue slowdown in the second half of 2017 for over a year. Facebook is simply running out of room to place ads as it saturates users' News Feeds. Indeed, ad impressions increased just 10% year over year in the third quarter.
What's surprising, though, is Facebook's daily active users increased 16% year over year. That implies the average user saw fewer ads during the quarter than they did last year.
Let's take a closer look at management's comments to figure out what exactly happened with Facebook's ad business last quarter.
It's not an engagement problem
If the average user is seeing fewer ads, but ad load remains constant, it would imply a decline in engagement. If people are spending less time on Facebook, they have fewer opportunities to see an ad.
But that's not exactly what's happening.
Wehner told analysts, "We do continue to see time spent growth per DAU on the Facebook family and on Facebook." Facebook's last update on time spent was in April of last year, when management said users spend an average of 50 minutes per day across Facebook, Instagram, and Messenger. It also noted this summer that younger (under 25) Instagram users spend 32 minutes per day on the app, while older users spend an average of 24 minutes.
Despite fears that younger users are spending less time on Facebook in favor of platforms like Snap's (NYSE:SNAP) Snapchat, Facebook is seeing improved engagement. Instagram is helping retain young people, and engagement is growing on that platform. Still, Facebook's flagship app continues to see increased time spent per user, according to Wehner.
But Facebook's growing engagement isn't as easily monetized
Facebook has made a lot of efforts to increase video viewing on its platform. It started promoting videos in its News Feed several years ago, and it launched its new Watch platform earlier this year. CEO Mark Zuckerberg told analysts, "Video is growing incredibly quickly on Facebook," but he also noted "most of that is in News Feed."
As users spend more time watching videos in News Feed, it means they're potentially spending less time scrolling through other posts. That means even though they're spending more time on Facebook, the time spent doesn't present as many advertising opportunities. "I do think that there are less impressions when people are consuming video," Wehner told analysts.
Fixing the problem
Facebook only recently started monetizing organic video in News Feed with an ad format called ad breaks. Ad breaks run in the middle of videos, similar to commercial breaks in television programming. COO Sheryl Sandberg told analysts, "We're seeing good early results, with great than 70% of ad breaks up to 15 seconds in length on Facebook and Audience Network viewed to completion, most with the sound on."
Perhaps as ad breaks become more common, Facebook's ad impression growth will move more in line with its daily active user growth. In the meantime, the ad impression squeeze is causing average ad prices to climb as demand continues to rise.
Facebook has been able to deliver better returns on investment for marketers even with rising ad prices. Snap, by comparison, offers some of the worst returns, according to a recent survey of marketers. Snap's advertising auction actually caused its average ad price to decline due to relatively low demand for Snap ads.
While the gap between Facebook and competitors like Snap is pretty big, it will slowly shrink if Facebook's ad prices climb too quickly. Facebook needs to find a way to mitigate that impact by at least maintaining ad impressions per user. It failed in that respect last quarter, and investors should pay close attention to see if impression growth and user growth become more in line with another.