A Turn of Tides for Facebook

Facebook's (META 0.43%) eagerly anticipated quarterly report finally dropped, and given the copious negative media attention it's received lately, the company did shockingly well.

In this week's episode of Industry Focus: Tech, host Dylan Lewis and Motley Fool contributor Evan Niu dive into Facebook's report -- how monthly and daily active user counts were affected by scandal, what big regulatory headwinds the company is still yet to face, how currency exchange rates influenced its numbers this quarter, and more. Also, the hosts talk about Twitter's (TWTR) earnings release -- where the company did well and where it didn't, what huge concerns still loom on Twitter's horizon, and how the stock looks for the long term.

A full transcript follows the video.

This video was recorded on April 27, 2018.

Dylan Lewis: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It's Friday, April 27th, and we're talking Facebook and Twitter earnings. I'm your host, Dylan Lewis, and I'm joined on Skype by senior tech specialist Evan Niu. Evan, we were going back and forth on Twitter last night about Facebook earnings. It only seems appropriate that we're talking about these two companies on the show today.

Evan Niu: Yeah, it's been a big week. Earnings season has begun.

Lewis: Yeah, it's our favorite time of the quarter. Why don't we kick things off talking about Facebook? This was a pretty hotly anticipated earnings release, given all of the scandals and issues surrounding the company in March. What did the numbers look like?

Niu: Revenue came in at about $12 billion, which is up almost 50% year over year. Net income jumped over 60% to $5 billion. Facebook enjoys quite a bit of operating leverage, so they're able to really squeeze out more profit as their top line grows. And these are insane growth rates. This is a huge company, and they're still putting up these massive growth rates.

Lewis: And the market seemed to love all this news. I think shares were up about 10% since the company reported results. Some of that, I think, was due to these financial numbers you just mentioned. I think a lot of it had to do with what we saw on the user metrics side as well. I think there were a lot of concerns that the #DeleteFacebook movement, after the Cambridge Analytica data issues came out, might cause this meaningful dent in users going forward. The short answer to that is, it doesn't seem like it has.

Niu: Right. Monthly active users were up. They're now at 2.2 billion worldwide. Daily active users is now about 1.45 billion, also up sequentially. So, a lot of really strong numbers here. I think all these scandals that have been breaking the past couple of months have certainly rattled investors to the point where the stock was down quite a bit over in the past several weeks, after all these revelations about Cambridge Analytica, what have you. I think that sets you up for, when they put up a strong quarter like this, for the shares to rebound a little bit.

Lewis: And looking at the specific geographies here on users, a lot of the growth that we saw with those numbers came from Asia, but Facebook did post sequential user growth in every geography. So, it's not like there was a big impact in the U.S. that was masked by other geographies making up for it. We saw growth across the board.

Niu: Correct. DAUs in the U.S. and Canada were basically up a little bit sequentially, but the important thing is, they were not down a lot after these stated issues. And the way that they calculate daily active users is, that number, you have to be logging in every day. Even though the Cambridge Analytica stuff broke in mid-March at the end of the quarter, if that was causing a big drop-off in daily active users, you would actually see that start to manifest in the numbers from this quarter. In the previous quarter, they kind of hit the ceiling in the U.S. and Canada because it's a very mature, saturated market. Kind of holding steady there, which I think reassured investors a lot.

Lewis: It's possible that that MAU number might be influenced a little bit by the timing of the Cambridge Analytica stuff. That's something where, if you were active in the last 30 days as of the date of measurement, it's possible that you could have deleted your Facebook account but have logged in in early March and still been counted as an MAU. The fact that MAUs and DAUs trended in the same direction says to me that we're not going to have this massive shock come next quarter when we see more fully baked results of the post-Cambridge Analytica world for Facebook.

Niu: Right. I definitely think there's a possibility that the fallout could continue, but so far, it really doesn't seem like it's impacting them. There's been a lot of third-party evidence, too. Street analysts have been conducting surveys around users, and Mark Zuckerberg has made some public comments that this really isn't affecting the user base very much. This really confirms those data points.

Lewis: If you were worried at all about advertisers leaving the platform, average price per ad increased 39%, and the number of ad impressions served increased 8%, so, solid growth there. Both numbers moving in the right direction. We're not going to see as much growth with ad impressions as we have in the past couple of years simply because ad load is reaching saturation for Facebook, and starting to get there for Instagram, as well.

Niu: Right.

Lewis: Beyond Cambridge Analytica, though, something that management spent a decent amount of time talking about on the conference call was this GDPR. This is the other medium-term risk for Facebook, and I think it's something investors, if they're unfamiliar with, should definitely keep an eye on. This is the General Data Protection Regulation, and this is kind of specific to what's going on in Europe.

Niu: Right. This regulation has been a long time coming. The E.U. Parliament spent about four years debating this thing, and then it was finally approved about two years ago -- so, that's six years right there. And now, it finally goes into enforcement next month. So, there's been a lot of runway up to this point. 

But, it does have a lot of implications for companies that leverage user data, which obviously speaks to advertising companies. The basic rundown is, it gives users a lot more control and basic awareness of their data. Mandatory notifications of data breaches, you have to be notified within 72 hours. Users have a right to confirm if companies are collecting their data, how it's being used, how it's being processed. They also have a right to a free copy of that data, so companies can't charge users to give their data back to them, which would be kind of messed up. Users have a right to have their data erased, so, they can make companies stop disseminating their data. They can have third parties stop processing. A lot of different controls. There's also data portability, so, users can have their data transmitted between companies. It's really built up fundamentally for privacy.

The penalties can be substantial if companies fail to follow these regulations, up to 4% of revenue for the most serious infringements. Lesser infringements could be maybe 2%. Worth pointing out, like we have before, oftentimes, even if you do face a fine, you can usually settle it for a lot less. So, it's not like they would ever really realistically face the maximum of 4%. 

Specifically for Facebook, another thing they mentioned is, another piece of it is that the conditions for consent have also been strengthened. Companies can't obfuscate what they're doing with these terms and conditions in dense legalese that no one can read. It has to be presented in an intelligible way. And on the conference call, Facebook management was saying that these consent flows, which is what they call them, there's a lot more of those that users have to go through. That's why they're expecting that, in the second quarter, user growth could be flat to slightly down.

Lewis: And that's speaking specifically to the European market. That's not something they're expecting will broadly impact all of the geographies that Facebook is in.

Niu: Correct. There's been a lot of talk about, people have been saying, "You should roll this out to everyone, even if you don't have to," because it's clearly a very pro-consumer thing with privacy, but Facebook hasn't really committed to it. There are people that are saying, "You should just make this universal across the board, as opposed to only applying it in Europe, where you have to." But we'll just have to see how that plays out.

Lewis: Yeah. And looking forward, looking at the numbers here, Facebook continues to sing this song of, "Revenue growth is going to decelerate throughout the year." And this is something they have been saying for quarters and quarters and quarters. It hasn't really happened. It's tough to sustain the blistering pace they've been on, but I think a lot of people expected the drop-off to be a lot more severe than it has been. Even if that growth holds, though, we might see some pinching on the bottom line. The company is doing quite a bit to roll out what they're doing with headcounts and investments in safety and security. So, I think expenses are going to be coming in a little bit higher, in the higher end of the range, from what they had originally guided for 2018.

Niu: Also, capital expenditures, they're now forecasting to be at the high end of the previous range. Last quarter, they guided to about $14-15 billion in capex, and now they're saying that's probably going to be closer to $15 billion. Most of that is data centers, infrastructure, stuff like that. But, yeah, another piece of the cost side of it.

Lewis: One tidbit that I really appreciated from this call, you look at the revenue growth they posted, 49% year-over-year, foreign exchange tailwinds contributed $530 million to revenue in Q1, which accounts for 7% of growth. That's absolutely incredible. Most of the time, when you talk about these multinational companies bringing money back, they're almost always eating some adjustment related to forex. They're almost never benefiting from it. Is this a changing tide that we're going to be seeing here, Evan?

Niu: In 2017, the U.S. dollar actually had its worst year in 14 years. So, it's been weakening quite a bit over the past year or so. I think we're just seeing a continuation of that trend. Specifically in Q1, the U.S. dollar weakened quite a bit against the euro and the yen. So, when you talk about geographies like Europe and Asia Pacific, those two geographies are 40% of revenue in the first quarter. So, that's where you're seeing these forex tailwinds come into play.

Lewis: And a lot of the user growth was coming from Asia, so it stands to reason that they would benefit if there's a rising tide there against the currency of the United States. Evan, looking at everything, the whole picture here, I'd say I'm glad that we held onto our Facebook shares. We talked about the Cambridge Analytica data breach a little ways back and how we were handling it as investors. I look at this company and I say, this is a business that's going to continue to chug along over the next couple of years. They may not post incredible share price appreciation. At $450 billion, it's going to take a lot for them to put up monster gains in a short period of time. But, short of some huge regulatory hit, I think this stock is going to continue to ride and probably put up pretty solid market-beating returns over the next couple of years.

Niu: Yeah. I think there was a lot of people saying that the sell-off from all these scandals was an overreaction, because the financials are super strong, the fundamentals are amazing still. And, like we talked about before, it reinforces how good the ads are. So, even though they do have quite a bit of work to do on the user trust side, I think that's manageable and I think they can do it. It'll be a challenge, but Facebook has shown that it can execute really well. These scandals are huge negative publicity, but they're still putting up amazing numbers.

Lewis: And what's been lost in a lot of this Cambridge Analytica and data-related issues is the fact that they still have two massive properties that haven't really been monetized. So, you got some hints of this on the conference call, some discussion about what things might look like for Messenger, what things might look like for WhatsApp, and this idea that there might be Feed ads on Facebook or Instagram that would push people to Messenger and create these organic communications between businesses and consumers. Those are huge, huge growth runways for this business, and they're largely untapped at this point. I think there's still a lot in front of this company, even in the face of, maybe, some heightened regulatory risk and some skepticism from consumers.

Niu: I definitely agree. I think Instagram in particular has a ton of upside potential.

Lewis: Alright, we're going to switch gears and talk Twitter earnings on part two of the podcast. Evan, turning our attention to Twitter. This is a battleground stock, I think, is probably the easiest way to put it. We have been kind of bearish on this company for quite some time. It's been a company that's performed pretty well, though, over the past year, and a lot of that has come from this idea that we're seeing it turn the tides and become profitable. We saw more of that this quarter.

Niu: Right. Their fourth quarter was their first ever GAAP-profitable quarter. This first quarter that they just reported is now the second consecutive one. They're definitely showing that they are able to be profitable, which is certainly something investors should be concerned with, because if they just constantly lose money, then it's not good. [laughs] 

Lewis: [laughs] And while this was the second consecutive quarterly profit for them, it was a story of different profitability. Last quarter, it was really due to cost-cutting, and things changed this quarter.

Niu: Right. In the fourth quarter, it was basically all cost-cutting, no revenue growth. Revenue growth was up 2% or something, and costs were down like 30%. So, in the fourth quarter, it was all cost-cutting. But, this quarter, it seems like the opposite. Costs were about flat in the first quarter, but revenue growth was up some odd 20%. So, it's the exact opposite story this time, where that profitability is really being driven by top-line growth as opposed to cost-cutting.

Lewis: What concerns me a little bit, though, is, based on management's expectations for the rest of the year, we are not going to see particularly blistering growth going forward.

Niu: Right. And I think the way they put this was kind of annoying. [laughs] In the letter, they basically said, "We expect our sequential growth rates to be similar to 2016 for the rest of the year," which is like, why can't you just tell us what that is? Why do you have to make us look it up? It's just a weird, roundabout way to say, "We don't have great expectations for the rest of the year." I just found that kind of annoying. [laughs] 

Lewis: What I appreciate, Evan, is that you went and grabbed the 2016 growth rates for readers on fool.com so that they don't have to weed through all this and figure out exactly what those growth rates are. For listeners, Q2 2016 growth sequentially for Twitter was 1%. Q3 was 2%, and Q4 was 16%. So, going from pretty strong revenue growth to pretty muted revenue growth is obviously something that's disappointing, and that's why we saw the stock sell-off after they reported earnings.

Niu: And on top of that, I do think that costs are going to be going up, too. They still need to be investing in user safety. Harassment and trolling has long been a problem, far too long been a problem, on Twitter, and they've always been really bad at it. There are still way too many Nazis on Twitter. They really only started banning these hate groups in December, which was just a few months ago, after they had this new policy that basically forbids any type of association with any hate groups of any kind. That went into effect in December. So, they're starting to make some progress there. But, they are going to be hiring a lot more for those teams. Meanwhile, while we're talking about it, revenue is probably not growing too much, costs are also going to be coming up quite a bit, too. I think they could get a little bit pinched there, which I think is also part of why the stock was down. Investors were a little cautious.

Lewis: We always talk about users when we're talking about Twitter. The company now has 336 million monthly actives. That's up 3% year over year. Not crazy growth, kind of what we've been expecting from this business over the last couple of quarters. Nothing too surprising there. The U.S. user base in particular was flat, more or less, year over year. Daily actives grew 10%. As a point that we've talked about several times in the past when we've talked about Twitter earnings, we don't know what daily actives are as an actual metric, we rely on this percentage growth metric that they continue to provide us.

Niu: Right. We don't know the number, but directionally, it's still good. Engagement is still certainly on the rise. That's a good thing for the company, sure.

Lewis: The figures I always tend to fixate on with Twitter is ad prices and impressions. For me, that's the best indicator of the dynamics of the ad market and how interested marketers are in being on Twitter. You look at engagements for this quarter, and that's essentially the number of ads that were served up, those were up 69% year over year. And I think that's pretty good growth. It has slowly trended down over the past five quarters. It was up over 100% year over year about a year ago, so that's slowly coming down. 

And cost per engagement, which is effectively ad prices, was down 28% year over year. That doesn't sound great, but that's actually an improvement on the declines that they've seen in the past. This has been a number that's been in free-fall for the last several quarters, recently posting 60% year over year declines on top of something like 40% or 50% year over year declines. So, that doesn't sound super encouraging. For both of these metrics, though, it's a continuation of a trend that we've seen for a long time -- making up for falling ad prices by selling more ads.

Niu: Right. I think video is also helping play a more important role. They said that now, videos are over half of all ad revenue, and that's the fastest-growing ad format in the first quarter. And video ad prices certainly fetch higher prices than other formats, so I think that's also contributing to the trends you were talking about.

Lewis: Something that's interesting that came up on the conference call was, they were like, "Can you unpack the CPE number that we're seeing here in this decline?" And they said, "Some of that's attributable to video ads," which, to me, says that video ads are fetching a lower rate on Twitter. And, they said some of it is attributable to like-for-like, meaning the ads that have been available for a very long time are also fetching lower rates. 

So, this numbers continue to fall, like I've talked about. I think we're getting, perhaps, closer to them hitting a bottom here, and maybe not posting as severe year over year declines going forward, which is something that would be very good for their ad business, because even if they're able to grow impressions slightly, if they find a floor, it's going to be a lot easier for them to post year over year revenue growth.

Niu: Right. I think they are starting to get better at targeting. They're saying they're having a lot better ad relevance and click-through rates. Which is probably one of the challenges they've always had. If you think about it, fundamentally, the amount of data that you put on Twitter vs. the amount of data that you put on Facebook, it's just nowhere near the amount of information that those companies can use to target these ads to you. Facebook, you put so much stuff on there, which is why they're so good at targeting. But, for Twitter, you don't really put as much on there, so the fact that they're able to start squeezing more relevance out of the limited amount of data that you do give them, relatively speaking, I do think that's a pretty nice progress and improvement on their part.

Lewis: Something that was interesting to me in the conference call, Evan, was this quote from Dorsey. He's talking about how Twitter is not a social media platform, it's not a connection platform, in the same way that Facebook is. It's about news and it's about recency and information. And it was nice to see management acknowledge that. I think, if you're a Twitter bull, you have to be excited by the fact that that's what management is focusing on, because that's what the platform does really well. 

Niu: Right, exactly. I think they've been trying to distance themselves from this idea of being a social media company in some ways, because what they inevitably run into is these comparisons against Facebook, which, again, you can't really get away from that. But, I think they've been trying to, because any time you're comparing yourself against Facebook, you're going to look bad. [laughs] So, I think that's what they're trying to do, trying to be a little bit more nuanced with how they define themselves. 

And I don't think he's wrong in any sense. I do think Twitter is much more useful for real-time information, getting information from public figures, not these personal connections as much, but more just what's going on. So, I do think they're accurate in that sense, but I think it's kind of a funny thing. I think that's what they're doing, trying to avoid these comparisons to Facebook, which will never go away, frankly. [laughs] 

Lewis: Yeah. Evan, you are a frequent Twitter user, not a shareholder. You are a Facebook shareholder, not a user. Is there anything in the Twitter report that really changes your tune on this company?

Niu: No. I've started using it more as a user, because I do think it provides quite a bit of value in terms of being able to know what's going on and stuff like that, which is what their pitch is. But, as far as the financials go, I'm not really sold on them. I mean, yeah, they squeezed out $60 million in net income this quarter. Facebook just did $5 billion. [laughs] I mean, those numbers are just so far apart. 

I'm still not really interested in owning Twitter as an investment because I don't think they're going to specifically beat the market. Maybe they'll be OK, maybe they'll have gains here or there, but I don't see them consistently beating the market, whereas I do see Facebook doing that.

Lewis: I'm kind of in the same camp as you on this one. And it's worth noting -- the stock is up about 80% in the past year, this is a period where we have dogged it quite some time. So, we haven't always been right on it. I continue to feel the same way, though. If you're an ad business and marketers aren't flocking to you to put ads out there and reach consumers, you're going to struggle, especially if ad prices are continuing to fall. You look at Facebook, and for as much growth as they've gone through, they still see these huge hikes in ad prices. That's just a testament to how strong it is as a platform for marketers. I don't see that with Twitter, and the audience isn't growing enough for me to really be interested in it. 

All that said, the people that have bought the stock more recently have done quite well. If any listeners want to hear more of a bull take on Twitter's earnings, check out this week's episode of Motley Fool Money. Jason Moser is on there and he lays out why he loves this quarter's release. He is a perma-bull for Twitter and has been behind the platform for quite some time. 

Niu: [laughs] Yeah, he is.

Lewis: [laughs] So, if you want the alternate take, go there. 

Niu: He's definitely a perma-bull.

Lewis: Evan, anything else before we wrap up and I let you go?

Niu: No. I'm excited to see Infinity War this weekend. I don't know if you follow the superhero movie stuff, but I'm ready for the weekend.

Lewis: You know, I'm not a superhero movie person. I'm just not. It just doesn't work for me as a genre.

Niu: I grew up as a comic nerd, so that's why it still hits home for me.

Lewis: I can't do anything that has predictable plot lines, that's really what it comes down to. I appreciate the journey of the story too much, and if I know where it's going, I just can't enjoy it. So, you'll be watching a movie. Our producer, Austin Morgan, what will you be up to this weekend?

Austin Morgan: I'm actually going to see Super Troopers 2 tonight.

Lewis: Wow, so it's a movie-filled weekend for Industry Focus.

Morgan: A movie-filled weekend. It's crappy weather.

Lewis: It's supposed to be nice, though.

Morgan: Well, today's weather. This weekend, different story.

Lewis: Yeah. You'll be enjoying some nice sunny weather while you play baseball.

Morgan: Oh, yes!

Lewis: Sounds pretty good. I will be in a basement watching my friend's band play.

Morgan: That sounds like fun!

Lewis: It's fun. Not the best way to spend a beautiful Saturday, I would say.

Morgan: It's probably a Saturday night.

Lewis: It is. This is true.

Morgan: There you go.

Lewis: So, you can picture us doing all of those things. If you have some takes on Twitter or Facebook, I would love to hear about them, listeners. Shoot them in to [email protected], or you can tweet us @MFIndustryFocus. If you want 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. Thanks to Austin Morgan for all his work behind the glass. For Evan Niu, I'm Dylan Lewis. Thanks for listening and Fool on!