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The 3 Biggest Challenges Facing Facebook

By Adam Levy – Updated Jun 2, 2018 at 4:55PM

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Is management up to the task of overcoming these obstacles?

It seems like nothing can throw Facebook (META 7.89%) off track. After getting into hot water with the Cambridge Analytica scandal, Facebook posted much better-than-expected results for the first quarter, and it doesn't appear the situation will have a devastating impact on the business.

Facebook saw ad revenue climb 50% year over year in the first quarter. Nonetheless, the company certainly faces numerous hurdles to keep its revenue growing anywhere near that pace in the future. Here are the three biggest challenges facing Facebook.

Facebook CEO Mark Zuckerberg holding a microphone.

CEO Mark Zuckerberg. Image source: Facebook.

General Data Protection Regulation and other potential regulations

One of the biggest challenges facing Facebook is the recently enacted General Data Protection Regulation (GDPR) in the EU. The new rules went into effect on May 25, and Facebook along with pretty much anyone with a digital presence in Europe had to issue new privacy policies to its users and make some significant changes to its operations.

Facebook (and others) had to go back to their European users and ask for consent to use their data for things like targeting advertisements. They had to outline specifically what data they collect and why. The regulations also put limits on what data companies can collect and how they can use it, which could negatively impact Facebook's ability to target ads effectively, potentially reducing its pricing power.

That said, Facebook CFO Dave Wehner doesn't see GDPR having a major impact on European ad revenue. He did say, however, its European user count may be down or flat in the second quarter. He pointed out that Facebook isn't the only company that faces the challenge of GDPR, and believes Facebook's ability to create better ad products than the competition positions it well to keep winning market share despite the setback.

There's also a strong potential for other countries and regions to establish regulations for companies like Facebook. To that end, Facebook is pre-emptively enabling some of the same user protections as it's done in Europe.

Additionally, it's worth noting companies the size of Facebook and Google are much better equipped at handling regulations than small start-ups. In fact, regulations like GDPR may benefit Facebook in the long run by reducing competition from smaller companies.

Ad load saturation

Facebook has been facing ad load saturation in News Feed for nearly a couple years now. Wehner originally warned investors of an expected slowdown in ad revenue growth way back when it reported second-quarter results in 2016. That slowdown, which was originally anticipated for the second half of 2017, has yet to show up in Facebook's results.

Facebook has managed to stave off lower ad impression growth with higher average ad prices. Ad price is driven by increased demand for Facebook's ad inventory, since Facebook sells its ads in an auction.

But Facebook can only rely on increasing demand for a limited amount of time. The market is taking its time finding an equilibrium between the value Facebook ads provide and marketers' willingness to pay, and Facebook continues to improve the value through product improvements. Still, Facebook needs to find other ways to increase ad inventory if it plans to continue growing ad revenue at such a high rate.

To that end, Facebook is opening more and more ad inventory on Instagram, which is also growing users quickly. It's experimenting with advertisements in its Stories products in both Instagram and WhatsApp, which have 300 million and 450 million daily active users, respectively. It's also working to establish a video portal (Facebook Watch) within its flagship app, which could provide valuable digital video ad inventory. There are lots of other avenues for Facebook to increase its ad supply, but ad load saturation within News Feed -- its main revenue source -- will remain a challenge for Facebook.

User engagement and growth

When you reach 2.2 billion monthly active users, it can get difficult to keep growing the user base. Nonetheless, Facebook has managed to consistently grow its users around 13% for several years now. But the challenge to grow that much while maintaining such a large user base only gets more and more difficult as the company grows. It's the law of large numbers.

Just as importantly, if not moreso, Facebook must work to keep its users engaged. The company revealed that changes to its News Feed in the fourth quarter last year resulted in a 5% drop in time spent on Facebook. Less time spent on Facebook equates to fewer opportunities for Facebook to show users ads.

In fact, Facebook has made several changes recently in an effort to increase the value of the time spent on Facebook. At the same time, management believes the changes will negatively impact total time spent on the platform. That's not necessarily bad, though, as the move could give users a better feeling when they use Facebook, which could benefit the company long term and increase the value of advertisements in news feed.

Meanwhile, the company continues to see engagement improvements in its other products: Instagram, WhatsApp, and Messenger. As the company increases its advertising and other monetization efforts in those products, that engagement will be crucial to the company's continued growth.

Overall, Facebook faces some serious headwinds. But management has led the company through big challenges in the past, and it's navigating through its current set of issues right now. Investors just need to be aware of these issues and pay attention to how the company, its users, and its customers (i.e., advertisers) respond to them.

Adam Levy owns shares of Facebook. The Motley Fool owns shares of and recommends Facebook. The Motley Fool has a disclosure policy.

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