Facebook in Flux?

Facebook (META 2.98%) had a bumpy ride this week after reporting some good and bad news in its quarterly report, including the announcement that changes to the News Feed led to a whopping 50 million fewer hours spent on the platform per day.

On this week's episode of Industry Focus: Tech, host Dylan Lewis and Motley Fool contributor Evan Niu take a close look at Facebook's quarterly report. Find out how Facebook did in terms of revenue, earnings per share, user count, and other key metrics; what changes the social media giant has made to its News Feed; and how this will shake things up for the company in the short and long term. Then, the hosts dive into Apple's (AAPL 0.64%) earnings report -- the biggest headline numbers, how the tax plan is affecting its numbers this quarter, why iPhone X demand trends are a little bit worrying for investors, and more.

A full transcript follows the video.

This video was recorded on Feb. 2, 2018.

Dylan Lewis: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It's Friday, February 2nd, and we're talking big tech earnings: Facebook and Apple. I'm your host, Dylan Lewis, and I'm joined on Google Hangouts by senior tech specialist, Evan Niu. Evan, what's going on?

Evan Niu: I'm ready for the weekend! It's been a busy couple of days with these earnings releases.

Lewis: Yeah. It's a good thing that you're out on the West Coast, because you have a little coverage benefit with these after hour earnings releases.

Niu: Yeah, I'm usually still working when they come out, unlike you guys. You're home at 05:00, for tech companies.

Lewis: Yeah, we have to put an overtime over here if we want to stay up-to-date on what's going on with the tech earnings news. Meanwhile, this is just a standard workday for you.

Niu: Yeah, more or less.

Lewis: Why don't we talk about what happened with Facebook first? It seemed like a pretty good quarter for the top line, at a quick glance, the stock seemed to disappoint. But there's a lot to unpack with what happened with their income this year.

Niu: The top line looks great. Total revenue is up 47%, which is crazy, that a company of this size is still putting up growth rates approaching 50%. But, yeah, the numbers that Facebook continues to put up are incredibly strong. There's been all sorts of controversy over Facebook's role and impact on society, politics, democracy, etc. But that's not really manifesting in the financials.

Lewis: But don't you worry, listeners, we will touch on it on today's show. I mentioned that things are a little surprising. They posted $1.44 per share in net income. Analysts had been modeling for $1.94 per share. And you think that's a massive miss, and then you look at what actually happened on the tax side, and those numbers start to make a little bit more sense.

Niu: Right. They took a pretty big hit on taxes, a $2.3 billion hit for deemed repatriation, which is when the government, part of the new tax code is, any foreign earnings that you've been deferring paying taxes on because you don't want to repatriate and pay that old rate of 35%, you basically have to pay all of it right now. So, they took a $2.3 billion hit, or about $0.77 per share. So, if you back that out, which is a one-time item, it's tax reform, then they actually would have beat. And with tax reform happening right at the end of the quarter, I don't think analysts had enough time to change their estimates to compensate, because it's obviously a very complex issue with a lot of moving parts. But, there's a lot going on there, but they would have beat on the bottom line if it weren't for this.

Lewis: Yeah, I think, looking at their conference call, they cited that their effective tax rate was 43% or something like that this past year just because of that charge being taken. Moving forward, it's going to be far more favorable. So, the long-term effects for Facebook and a lot of these big-time multi-nationals, definitely positive with the tax bill. We're not 100% sure what's going to be going on with foreign cash exactly because they have yet to file their 10-K, right?

Niu: Right. As of the end of the third quarter, they had about $12.9 billion in foreign cash. That's the foreign earnings were talking about. It's interesting, because they basically weren't really planning for this, which is why this charge comes up, in contrast to Apple, which we'll discuss later in the show. Apple has been deferring tax liability on foreign earnings for over 30 years. I was looking at their 10-Q they filed, they've been accruing this liability for literally 30 years, all this time. So, in contrast, they didn't get surprised by some big one-time charge, because they had more or less than planning for this eventuality for quite some time.

Lewis: And I think it's important to look at scale there. We talked about how Facebook has $12.9 billion in cash by foreign subsidiaries. Apple, I think that number is a little bit closer to $230-240 billion.

Niu: It's up to $269 billion now. We'll hit more on that later.

Lewis: So, you have to be a little bit more deliberate about what you're doing with your cash and your tax liability when you're operating at that scale abroad. Evan, the story of mobile continues for Facebook. Mobile ads comprised 89% of ad revenue, which is pretty incredible. This is just the ongoing shift to mobile, and something that they have just killed.

Niu: Right, and on a trailing 12-month basis, this mobile ad business is something around $35 billion. This is really where all growth comes from. If you look at their other two main segments of Facebook, which would be desktop ads and this stagnant payment business where they get a cut of fees and stuff like that, those two businesses are basically flat, and have been flat for many, many years in absolute dollars, whereas ad sales, mobile ad sales specifically, have been skyrocketing. And I think a lot of it, particularly this quarter, has been driven by ad prices, increases in ad prices are really helping drive growth, as opposed to ad load or impressions in volume.

Lewis: For a company that has been as on fire as Facebook has over the last couple of years, we talked about that crazy growth that they've been posting even on the base that they currently have, this might be the first quarter that we're really seeing some uncertainty with this stock. And I think, for me at least, it started in the conference call when they started talking about the users.

Niu: Yeah. There's been a lot of discussion about, and also justifiable concern from investors. Facebook has been talking about, announcing this month, that they're going to really make some major changes to the News Feed to prioritize social content from your friends and family, meaningful interactions, as opposed to publisher content. And there's a big uncertainty risk associated with, what's this going to do to the business. And I think one thing that COO Sheryl Sandberg said on the call that really help to reassure investors, and you saw it immediately affect the share price after hours when they reported, she basically was saying, we're not doing this because it's positive or negative for revenue, we're just doing it because we think it's the right thing, the impact on monetization is "certainly not clearly negative." [laughs] 

Lewis: Kind of have to unpack that a little bit.

Niu: Which is a roundabout way of saying, don't worry too much about it. But, I think that did a lot to reassure investors, because any change to the News Feed -- I mean, the News Feed is Facebook's core product. That's by far the most important product. So, any change you talk about there is going to have potentially big implications on the business.

Lewis: The thing that I really homed in on with what was going on on the user side, overall, they have 2.1 billion monthly actives. They're absolutely crushing it there. Daily actives at 1.4 billion. But within that U.S. and Canada, that North America segment, which is the most lucrative ad market for digital ads, daily actives actually declined by 700,000 sequentially. And I think it's the first time that happened. Even anecdotally thinking about what I see with my friends and their Facebook usage, I notice that people are less and less active on Facebook. And I think that a lot of the News Feed changes that we're seeing are in response to that. They're trying to revive it and make it more a staple of people's day-to-day lives. Most of that activity seems to be on Instagram now. It's lucky for the business that they also own that property. But I do seem to notice people using their namesake platform a little bit less.

Niu: It's definitely changing. In terms of the DAU decline, they mentioned this is mostly a function of the fact that the U.S. and Canada and North America in general has really high penetration of users. So, it's becoming a saturated market, so it's going to fluctuate a little bit, but I don't think it's necessarily something to worry about. It's absolutely their most important market, but they've continued to make incredible gains in terms of monetization. Even if the users are kind of plateauing and hitting this ceiling, they still have several levers they can pull on the monetization front where they can still actually milk more money out of that user base.

Lewis: The comment that got the most people's attention during the conference call came from Mark Zuckerberg, at least in my opinion. He said, we made changes that reduced time spent on Facebook by an estimated 50 million hours every day to make sure that people's time is well spent. And you look at the after-hours chart of Facebook's stock, and they were down about 4% immediately after reporting as the call went on, because people really freaked out about some of the News Feed changes that they're making, and the idea that we're going to push user experience over profitability because the long-term bet is that that's better for the platform, and the business results will follow. But, when you see a number like 50 million hours, that's a big one.

Niu: Yeah. I think it ties into this broader topic that's been coming up recently in social media, which is the subjective distinction between time spent and time well spent. What constitutes time well spent is going to vary by user. It's extremely subjective and personal. The examples he was mentioning with this 50 million number was, they reduced how much people were seeing these viral videos. But I'm sure there are lots of people out there that just absolutely love passively watching viral videos. And maybe they consider that time well spent, but Facebook doesn't. So, it's almost arbitrary, like, what's the difference. But, that's what Facebook is pushing now, this idea that, we want you to be having more meaningful time. And they believe that passively consuming content, whether it's video, articles, whatever it is, is not good for you.

Lewis: And we actually got a listener question on this that was incredibly well timed, I guess inspired by Facebook's earnings. Joseph, who is someone who frequently writes into the show and one of my personal favorite listeners, wrote in and said, "On the call, Facebook mentioned their "measures of wellbeing" associated with the newest initiative of focusing on healthy engagement. Can you folks sleuth out what their list consists of?" I think it's a great question. I have a couple of ideas, but they weren't all that elucidative on the call, frankly, they didn't give a lot of details about what they're specifically looking at. Evan, do you have any thoughts on maybe what might go into that calculation for them?

Niu: I was just saying, it's a very subjective thing. I don't think there's any quantitative metrics that they're looking at. For many years, this has been a topic of debate, but more so very specifically in the past few months and years. But, this idea that Facebook is bad for mental health, does it make you more socially connected with people or does it make you more socially isolated, and all these things. On the call, he mentioned things like long-term happiness and health. Those are obviously not metrics you can measure. And Zuckerberg had an interview with The New York Times earlier this month talking about these changes, and he was like, we need to make sure that our products are not just fun, but they're good for people. He said that it's important to him that his kids grow up and think that their father made something good for the world. So, I don't think there's going to be any kind of way for us as investors to track what Facebook is looking for, because I don't think there's a way to measure this type of stuff quantitatively. I think it ties into things like mental health, human psychology and just making sure it's good for people in that way.

Lewis: Something that I was kind of surprised that management talked about was the supposed science of the Facebook News Feed. This is Zuckerberg, again, talking. He described this idea that the News Feed is driven by likes and comments, and it's this algorithm that's geared specifically toward time spent on site and things like that. He said the reality is, the company has this panel and surveys thousands of people to get a sense of the content that's meaningful to them, and then calibrates their feeds to that. So, I think we were, for the longest time, assuming that the company was running on this purely calculated, very metric-driven decision tree for what should go into News Feeds and what the weighting should be, and the reality is, it's been this combination of art and science for a very long time.

Niu: Right, exactly. It's so important to their business. Of course, they're going to keep all the really technical details a very closely guarded secret, it's a trade secret, just like Google's algorithm is incredibly important to its competitive advantages. Facebook's News Feed algorithms are basically the same thing.

Lewis: My best bet to try to answer Joseph's question here is, we talked about how these are soft science things that are a little tougher to wrap your head around. I'm sure the company has proxies for them. My best bet on what that might look like, you think about in the past, if someone spent an hour on Facebook scrolling through their Feed just looking at pictures and watching video with no interaction with those posts, that might have been considered a good session because of the amount of time they spent on the site. Now, I think they're viewing that as a failure. They want to see people commenting on each other's posts. They want to see people sharing content with their friends, maybe messaging people about content that they saw. I'm sure there's going to be stuff with text mining to see, if people saw something in a post, did that wind up becoming something they posted later on. I think Wall posts, going back to that. Evan, do you remember a period where Facebook was a lot more prominent in people's lives and you would write on people's Walls? When was the last time you wrote on someone's Wall on Facebook?

Niu: I mean, I'll share links or interesting things on friends' Walls sometimes. But as far as just a text-based message, that's what you text message people for. [laughs] Or iMessage or Messenger. Nowadays, yeah, I think the use case has evolved, where a lot of times, now you're sharing other stuff on the internet on Facebook, which, who knows, does Facebook consider that time well spent or not? I don't know. Is that a meaningful interaction? These are all such mushy concepts.

Lewis: But if it connects people, Evan, I think that's what the company wants. It can still be content-based, I don't think that's the problem. I think it's that they want to use content to inspire community. That's my best guess. So, all the metrics they use as proxies for wellbeing and things like that are going to be centered around that.

Niu: Right.

Lewis: If you are a Facebook investor and you are maybe a little worried about the crossroad that the company is currently at, I have a quote from Mark Zuckerberg that personally put me at ease, and I think is important to keep in mind. He said, "I always believe that if we do the right thing and deliver deeper value, our community and our business will be stronger over the long term." To me, Evan, that sounds pretty Foolish. That's exactly what I'd like to hear from a CEO. That's long-term thinking. He's been someone that has a three, five, 10-year plan for the longest time, and he's continued to execute on it. I'm not too worried.

Niu: Yeah. If you go back to Facebook's very first S-1 registration statement before they went public, there was a founder's letter from Zuckerberg, it was pretty long, but at the end of it, he sums it up, he's like -- I can't remember the exact quote, so if you're curious, go look it up, but something about, "We make money to build better services. We don't build services to make more money." Which kind of goes to what you're speaking about. Their goal is not to make money, their goal is to create a social platform to connect the world together, and hopefully have a positive impact on social, meaningful interactions, or whatever. But the money will follow. That's incidentally Apple's approach too, which is to say, "We just need to make great products and the money takes care of itself later."

Lewis: Way to queue me up for that transition there, Evan. That was perfect. We're going to hit Apple earnings on the back half of the show. OK, Evan, we're talking about Apple. I know that you and I have a reputation, when we talk about Apple, to get a little bit long-winded. We spent a decent amount of time talking about Facebook earnings, we're going to try to keep it relatively short here. This is a company we cover a lot. We can get very excited. Looking at the earnings and trying to keep it succinct, what popped out to you with the company's report this quarter?

Niu: I'm just going to cover the headline metrics. Revenue was $88.3 billion, which is insane. It topped the high end of guidance. The high end of guidance would have been $87 billion. Gross margin came at 38.4%, close to the high end. They sold 77.3 million iPhones, which is actually a 1% year-over-year unit decline. But revenue jumped 13% just because these phones are so expensive. The iPhone X starts at $1,000, the iPhone 8 and 8 Plus got $30 and $50 bumps. We knew that average selling prices were going to go up. They spiked to almost $800, which is kind of insane, came in at $796. Apple also pointed out that their active installed base has now reached 1.3 billion, and that's devices, not users. That's up 30% over the past two years. Two years ago, almost to the day, they announced that they had 1 billion active installed base. So, making a lot of progress there. And that, of course, feeds into every other part of the business. But, overall, it was a pretty strong report.

Lewis: Yeah, you cited that installed base number, and I think one of the places where it really plays in is with their services business. This is something that people have been paying a lot more attention to over the past couple of years, and the reason being is, it's high-margin and it's a great business, because you already have these people with devices in hand. What does that look like for them as of this most recent quarter?

Niu: A year ago, they publicly stated this goal of doubling their Services business over the next four years. Here we are, a year later, so we get to check in. For context, a year ago, the Services business was at about $25 billion in trailing 12-month revenue. Last quarter, Services grew 18% to $8.5 billion on a TTM basis, it's up to $31 billion. So, they are making progress. The App Store continues to grow. The number of people actually transacting and buying stuff and the amounts that they're buying, all these numbers are all heading in the right direction. So, that's really helping drive this business. But, also, they've been highlighting paid subscriptions as well. There are now 240 million paid subscriptions running through the App Store. That's recurring revenue, it's high margin revenue, so that's a great number. That's why they're really proud of this number. And they do almost nothing for that money, they just get a cut out of it, and all they do is operate the App Store. It's a very profitable little part of that business. Overall, they're making pretty good progress. But they did not give us any updates on how many Apple Music subscribers there are, which I was hoping they were going to, because the last number they gave us was back in September, they said they had 30 million. This month, Spotify said they're up to 70 million. And Spotify is the market leader, so, you want to keep an eye on these two companies. But, again, Apple didn't give us any updates here.

Lewis: I wonder if, as we get further into 2018 and the rumors of a Spotify direct public offering come to fruition and we ultimately start seeing some financials for this company as they begin to list, we might get an update at a very inopportune time for Spotify about what's going on with Apple Music. I could see a lot of people reading the tea leaves with one and trying to make some inferences about the other.

Niu: Maybe that's what they're waiting for, so they can steal the spotlight.

Lewis: I wouldn't be surprised. It's well within the possibilities for Apple. We talked about tax repatriation and what a several-decade plan this has been for Apple at this point in the first half of the show. Why don't we briefly touch on that?

Niu: Apple is about to cut a check to the U.S. government for $38 billion. Probably not an actual check. [laughs] 

Lewis: That has to be one of those huge novelty checks. [laughs] 

Niu: So, they've been accruing this expected tax liability for quite some time, so they're not getting caught off guard with any one-time charges. But, they are going to have greater access to, they have $269 billion in foreign cash, and $285 billion total gross cash. If you back out $110 billion of term debt, and another $12 billion in commercial paper, net cash was at about $163 billion. And CFO Luca Maestri actually said that Apple, over time, wants to bring this net cash position to zero, which is a really interesting idea. Of course, he means cash roughly equals debt. The implication there is, are they going to have some massive capital return? How are you going to get that number down to zero over time, and what time frame are you talking about? Those are obvious questions, but he didn't really elaborate beyond that. He said they'll give more detail when they report their March quarter earnings, which will be in April or May. So, about three months in the future, we'll get some more detail here. But, they have access to all that cash now. And that's going to be a pretty interesting thing, to see what they do with all that money. 

Lewis: What for them is the motivation with going to that cash-neutral position? Is it really for them that they've been sitting on it for such a long time and maybe caught so much flack for it, now that they have it repatriated, and can actually make acquisitions, buy back shares without taking on more debt, they're going to do that? Or is it that there's a capital allocation strategy here that I'm missing, Evan?

Niu: I think it's honestly just the simple fact that they have way more than you would ever conceivably need. They generate so much cash -- they've given back hundreds of billions of dollars to shareholders over the past five years. And as of right now, they have more cash than they started with in that timeframe. They're generating so much cash that they've returned a ridiculous amount and they still keep growing. They just make so much money that they literally have nothing to do with it, it's just sitting around. It's also even a drag on certain financial metrics. If you think about certain performance metrics that investors look at like return on assets, return on equity, the cash basically inflates the bottom figure there and makes these metrics look worse. And it's not really doing a lot, it's just sitting around. So, I think it's just an efficient use of capital, having it sit there. Of course, they've been doing these aggressive capital returns, but if they ramp them up even more, then you have some really meaningful earnings accretion to bottom line if they can retire a bunch of shares, and then earnings per share will just continue to skyrocket, which is a very good thing for existing shareholders, remaining shareholders, because they're going to get a greater claim to those profits.

Lewis: And I think that's probably where this has to be going. You think about Apple and their reputation when it comes to capital allocation, they're really not a company that goes out there and makes a huge splashy acquisition. They're a company that very diligently manages their capital return program, buys back shares, pays a dividend. They haven't really made too many big acquisitions in the past 10 years.

Niu: Right, the biggest acquisition historically, still, is Beats, and that was only about $3 billion. In the past several years, they've talked about this idea that, we look at companies of all sizes, but they don't actually make these gigantic blockbuster acquisitions, even though they could easily afford to. But those types of deals have huge risks associated with them. Apple likes to play conservatively. They reiterated on the call that M&A strategy hasn't really changed much. It's always been the same, they look for stuff that either, new technologies to integrate into products, accelerate the roadmap, or fill a gap in the portfolio, or somehow benefit the customer experience. And most of the time, these are pretty small deals, and even though they've said that they consider big deals, we haven't seen any real meaningful moves to actually suggest that they're seriously considering a giant deal. I'd would rather them keep it that way, because I don't want them to blow a bunch of money just for the sake of blowing a bunch of money.

Lewis: Yeah. If you look at the tech space, in mergers and acquisitions specifically, it's just rife in history with all of these instances of companies making really big acquisitions and then subsequently, in the years following, making really big writedowns. So, I'm certainly a fan of them sticking to the capital return program as a way to funnel that cash somewhere. But we'll see. Evan, I love the headline for your Apple earnings take. It was, Apple Earnings: A Record Quarter with Mediocre Guidance. Do you want to touch on what people can expect for the next quarter?

Niu: Guidance was a little softer. They're expecting guidance of $60-62 billion. But the Street was looking for closer to over $65 billion. But, I think the bigger issue here is what's going on with iPhone X demand. There's been a lot of investor concern about this lately. There are some data points that they mentioned that suggest that demand isn't as good we'd hope. The most important in my mind was, they confirmed that they achieved supply demand balance for iPhone X in December, which, to me, is way too fast. They shipped iPhone X in November. They caught up with demand in about a month? Something doesn't add up there.

Lewis: That's dramatically faster than it has been historically, right?

Niu: Right. For context, iPhone 7 Plus, the year prior, it took about two quarters to achieve supply demand balance. And on the one hand, Apple has been ramping production much faster than expected, they've been able to resolve some of the manufacturing bottlenecks around the TrueDepth camera and other things that they've been constrained on. But even if they're able to really get the supply up to where it needs to be, shouldn't they have sold more units? At the same time, you have this guidance that's worse than expected, you have catching up with demand almost within a month. It really does suggest that iPhone X demand isn't going to be this blockbuster supercycle incredible thing like all these people have been talking about. It probably relates back to the fact that this phone starts at $1,000 and goes up to $1,150. You add in taxes, you add in your cellphone plan, you add in AppleCare, because this thing is crazy expensive to repair, you could easily push $1,500 for the phone, and not a lot of people are willing to pay that.

Lewis: Especially in a world where most people don't have any wireless subsidies. I think in the last four years or so, people have had this sticker shock of realizing exactly how expensive their phones are. In the past, they were maybe paying $200 or $250 for the next iPhone, and now they're being forced to pay $700 or in some cases $1,150 for a new iPhone, that will definitely slow down the upgrade cycle quite a bit.

Niu: Right. I do think there are some clues that demand is not as great as people had hoped. But, that being said, this is still a very healthy business. Coming back to guidance, there's a good part about guidance, which is that gross margin for the next quarter is forecast to be about a flat at 38-38.5%, and that's despite the loss of seasonal operating leverage. So, the fact that they're able to maintain that level of profitability despite coming off this really high revenue base is pretty encouraging. I think the big things that are driving that are cost improvements as well as product mix. The comment on product mix is encouraging because that suggests that they're expecting a lot of people to be buying higher-end phones, which are more profitable, like iPhone X. That's not to say that iPhone X demand is terrible, per say. But I just think that the expectations for iPhone X demand were really, really high, and maybe they're not going to be as high as people had hoped, but it's still going to be a very healthy and solid business. It's nothing to be scared about.

Lewis: Evan, I think that might be the fastest Apple earnings rundown we have ever done.

Niu: Maybe. [laughs] 

Lewis: It looks like Austin Morgan, our producer, is still awake in the studio, which is always a good sign. I think we might decide to wrap the show there. Anything else before I let you go there, Evan?

Niu: No, I think we hit it quickly.

Lewis: Alright. That does it for this episode of Industry Focus. If you have any questions, or if you just want to reach out and say hey, you can shoot us an email over at [email protected], like our favorite listener, Joseph. Or you can tweet us @MFIndustryFocus. If you're looking for more of our stuff, you can subscribe on iTunes, or check out The Fool's family of shows over at fool.com/podcasts. As always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against stocks mentioned, so don't buy or sell anything based solely on what you hear. Shout-out to Austin Morgan for all his work behind the glass. For Evan Niu, I'm Dylan Lewis. Thanks for listening and Fool on!