What the Heck Happened to Facebook?!

Good news: Facebook (META -2.28%) broke a record! Bad news: It was the record for largest market cap loss in a single day. In this episode of Industry Focus: Tech, host Dylan Lewis and Fool.com contributor Evan Niu explain what caused the gargantuan drop, and how worried long-term investors should be. Tune in and find out which trends led up to this, what probably freaked out the Street the most, and how long-lasting these problems could be for the social media giant.

Also, the pair dive into significantly brighter news from Spotify Technology (SPOT -3.31%). This quarter looked pretty nice, and rumor has it the company wants sign musicians directly. Could that be the edge Spotify needs to maintain its position in such a cutthroat industry?

A full transcript follows the video.

This video was recorded on July 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, July 27th, and we're talking tech earnings. I'm your host, Dylan Lewis, and I'm joined on Skype by senior tech specialist, Evan Niu. Evan, I appreciate you hopping on even with all of the house troubles you're currently dealing with over in Colorado.

Evan Niu: Yeah, some thunderstorms flooded my basement, but always make time for the podcast.

Lewis: I think our listeners appreciate it plenty, for us to be covering, this week, Facebook earnings. Probably one of the biggest stories in the market. We're going to touch on that first, and then we're going to get over to Spotify's earnings, as well. That's a company we've been covering over the last couple months.

Looking at Facebook, this company posted the largest single-day market cap loss in stock market history. Investors erased roughly $120 billion in market cap from Facebook this week post-earnings. Evan, do you have any idea what the next closest single-day loss was?

Niu: I don't. I'm going to take a complete guess and say Microsoft, maybe in the 90s or early 2000s or something.

Lewis: You are not far off. Based on my research, Intel lost $90 billion in a single day in September of 2000, right around when the tech bubble popped. I believe Microsoft might have been in the top five for that conversation.

Niu: It had to be a tech company when the bubble popped. 

Lewis: You were in the right wheelhouse. That's all to say that the types of losses that we saw with Facebook earlier this week have not been seen in quite some time, and I think it was surprising for a lot of people. You look at the numbers, and it's pretty apparent why investors sold off the stock. The company beat expectations for their bottom line, but that's pretty much it.

Niu: Also, one thing to put that drop into context, the stock was trading at these levels in May. That number sounds really scary and huge, and it is huge, but the stock has been going up for the past couple months. We're just back to where we were in May. It's not as if Facebook is back down to some crazy low level. They're still a very large and profitable company.

Lewis: In the wake of Cambridge Analytica news and the immediate aftermath to present, or just before earnings, the company was at 40%. That gives you a little bit of an idea of what the stock went on, in terms of a run, prior to these results. Of course, a lot of expectations baked in, maybe a lot of people thinking they were out of the rough part of some of the scandals facing the company. It turns out, they still have to report good earnings to keep investors happy, and that's not quite what happened here.

Niu: I thought the numbers were pretty good for the second quarter, at least. Revenue was up 42% to $13.2 billion. Mobile ads, 91% of ad revenue, roughly consistent, where it's been trending, also the same as where it was the quarter before. 

But costs are rising faster than revenue. Costs were up 50%. The result there is, your operating income and net income and everything gets squeezed. The company, because of these scandals, has been very upfront, like, "Hey, we're going to be investing a lot more in safety and security." That includes hiring tons and tons of people to invest in the AI and algorithms to be proactively fighting some of this bad content. That's actually going to put a cramp on profitability, and that's what we're seeing play out.

Lewis: And you're seeing that play out a little bit this quarter, but really, looking forward, that's where things start to change pretty dramatically for this business. Why don't we talk a little bit about what the company was expecting going forward? I think that's what caused this massive sell-off. We have some revenue guidance that is a pretty big departure from where the company has historically been. 

The past quarter, you said 42% growth year for year. That was down 7% from Q1. On the conference call, CFO Dave Wehner told analysts, "Our total revenue growth rates will continue to decelerate in the second half of 2018, and we expect our revenue growth rates to decline by high single-digit percentages from prior quarters sequentially in both Q3 and Q4."

There's a lot to unpack in that statement there, but basically, the year over year growth from Q3 is going to be somewhere in the mid-to-low 30s, and the growth for Q4 is going to be somewhere in the mid-20s as a percentage. That's huge slowdown from the 40-50% we've been seeing.

Niu: Right, and that's what's getting investors upset. In the meantime, their guidance, same thing, predicting costs to continue rising going forward, as well. It's to the point where the net result is, Wehner was like, "Operating margins are probably going to trend toward this mid-30s range over the next couple years." In comparison, operating margin last quarter was 44%. If we're talking about a roughly 10% drop in operating margin, that's a pretty huge dip in profitability. That's a lot of what's scaring investors right now. This company has been in heavy growth mode, pumping out profits like crazy. Now, all the sudden, growth is going to slow down a bit, and profitability is taking a big hit.

Lewis: And you have some of that scariness looking forward. I think some people were a little concerned about what was going on on the user side, as well, for the current quarter, and what that foretells about coming quarters. For Facebook, the North American market and the European market are the big ad markets. That's where their most lucrative users are. North America DAUs were flat at 185 million, and they've been relatively flat for the past couple quarters. The market is pretty saturated here in North America. This is where Facebook was introduced, and this is where most people first came onto Facebook. That's not a huge surprise. 

But what we saw in Europe was DAUs and MAUs decline for the first time ever. This is something that we probably could have expected a little bit because Europe rolled out the Global Data Protection Regulation during the period. But, at the same time, you don't ever want to see a dip from your most lucrative ad markets.

Niu: Right. On the last call, on the first quarter report, they were very clear, "We're expecting user slowdown." GDPR basically introduces a bunch of different hurdles that you need to agree to, with acknowledging your privacy rights and all these things. They're small hurdles, but when you're talking about a user base this big, those things do impact the numbers. 

That's what we're seeing manifest here, with user numbers going down. To put this in perspective, how important these markets are, Europe and North America combined are about 30% of the global user base, but they represent over 70% of all revenue. These markets are so important to the business, so it's warranted to freak out when you have any concerns here.

Lewis: Yeah, and the company is going to look a little bit different on its financial statements than people have gotten used to. I think a lot of the moves that they're making totally make sense. The big spends, the big ramp up in expenses that we're seeing, some of that is tied to infrastructure, some of that is tied to the safety, security, privacy measures that they want to make sure are in place.

Actually, one thing that doesn't quite work into the conversation as much as you might expect is the impact of currency. Facebook has been very lucky in the past year or so. Currency has been a pretty good tailwind for them. In this most recent quarter, currency exchanges contributed over $300 million to revenue. In past quarters, it was even $500 million in revenue. They have projected that, moving forward, they aren't going to benefit as much from that, and it might become a headwind. You have all these things that, for a very long time, have benefited the company, slowly coming around, and they just have to address them.

Niu: Right. I don't know why they don't hedge their currency more anyways, but that's a topic for another day. [laughs] 

Lewis: Taking all of this into consideration, and looking at Facebook -- you own shares of Facebook, right, Evan?

Niu: Yes, I do.

Lewis: As do I. We're happy to talk about it because it's a stock we own, we're interested in it, and we're investors. How are you thinking about this business right now?

Niu: I'm still fine with it. I think this could end up being a buying opportunity. We've seen this play out in the past. Facebook has literally been talking about ad revenue slowing down for the better part of two years. I don't understand why, all of the sudden, this is catching everyone by surprise. They talked a little bit about how, they've been really pushing the Stories format that they copied from Snap. It's very popular among users to put these Stories, sequential videos and photos and captions, and all this stuff. For Facebook, they can't monetize them as well, they're still trying to figure that out. 

The bigger picture is, they've been warning about all of these different ways that the business could slow down for over a year, maybe two years. So, why is this so surprising now? And they just put up 40% growth. That's hardly a bad growth rate. Yeah, you don't want to see them slow down, but I'm not surprised by this. They've been trying to provide visibility. Maybe they could have done a better job. But I'm not too worried about it. 

In the long-term, in the grand scheme of things, Facebook is still so massive, so influential and necessary to large swaths of the global population -- this isn't to say they don't have problems. They obviously have many problems with execution they need to be fixing. But that's what they're doing. In my opinion, it's the right thing to do in the long run.

Lewis: Yeah, I'm with you. I think, maybe, Facebook had this problem that Apple had for a little while. Management was doing the right thing in sounding the alarm and saying, "Growth is going to slow down." I remember there was a period where Apple was extremely conservative in the guidance they were providing, and then would just blow it out of the water every single time. If you do that enough, the analysts on the Street are going to stop listening to your warnings about revenue slowing down. I think this is what happened -- when it finally happened, it caught a lot of people by surprise, even though it's something management had been talking about for quite some time.

There's also some element of Facebook, it's interesting now, where, you look at their valuation. This is a company that, if you look simply on a P/E basis, seems pretty cheap. They trade right around market multiple, I think it's about 25-26X on a P/E basis. You look at them on a price-to-sales basis, and they trade at roughly 10X sales. That's actually quite above fellow megatech company, Alphabet. 

You think about the dynamics for this business going forward, they're going to get pinched a little bit more with their costs. Not as much money is going to be going down to their bottom line. For them to be cheap on a P/E basis isn't quite the quill in its ... I don't remember what the expression I was going to say was. It isn't quite the benefit that has been in the past, so I can see why people are a little bit worried about that. 

There was a journalist at Bloomberg, Sarah Frier, she wrote a piece and it went on a Twitter thread. She said, "The easy days of growth for Facebook are over." I think she nails it with that. What we've seen over the past five years is them monetize the North American market, the European market, and enjoy a lot of growth in developing markets. But really, all the financial performance has been from increasing impressions and benefiting from really great ad rate increases on their platform. It's going to get a little tougher for them in the next couple quarters. That doesn't necessarily mean it's a bad business, though.

Niu: Right. They've already picked the low-hanging fruit, but they have so many levers to pull, particularly on the Instagram side. There's a million things they could do, and are doing, on Instagram, that are really promising as a business. I agree with you, it won't be as easy going forward, but that's not to say they've run out of options.

Lewis: And they do have those other 1 billion user properties that are just beginning to get monetized. We have Messenger and WhatsApp. As a user, anecdotally, I have seen ads beginning to come onto Messenger. You can see them starting to tinker there. Those are levers that have largely gone unpulled for them and could be pretty good growth ramps for them down the road.

Niu: Exactly. They have so many things they can explore. I think one challenge will be picking the right ones and focusing on them, as opposed to getting distracted and chasing too many. Overall, I'm not worried about it. I'm honestly considering buying more shares. We'll see.

Lewis: Yeah, the conversation and the attitude is similar to the way we felt when we talked about them back in April. I still like the core business. Ad rates are still going up on the platform. They're showing advertisers that their money is well spent there, and more people are going to want to put money there. Ultimately, that's what matters if you're an ad-based platform. There are some other things they need to figure out along the way, but if they're going to be growing at 20%, that's pretty good for business this size.

We're switching gears from a company that we both own to a company that you own and I'm a user of, and that's Spotify. You've been following this company for quite some time. They've been in the news recently. There's a lot going on in the past quarter. What really stood out to you with this report? What were you interested in?

Niu: It was interesting, their losses are really widening for a couple reasons. Investors were pretty much OK with it because their user numbers continue to be really strong. This is one of the biggest music streaming platforms on Earth, I believe second only to Tencent Music, which we can touch on later, but much larger than Apple Music, about twice as large, now. There's a lot of interesting stuff going on here. 

Total revenue jumped 26% to €1.3 billion, which is about $1.5 billion. Gross margin expanded a little bit on a sequential basis. Costs continue to rise. They had a couple of one-time items this quarter, because this was the quarter when they went public. Anytime you go public, you have all these different triggers, all these recognition things with your stock-based compensation. Those are one-time things, so I'm not too worried about them. 

They also had some fees associated with their direct listing -- again, just a one-time event, par for the course when you go public. Nothing too surprising there. Overall, they had a net loss of about €394 million, about $459 million, which is more than double from a year ago. The bottom line didn't look too great.

Lewis: The financial story here is, revenue growth but widening losses. Much like Facebook, this is a business where the user counts matter. What's going on there?

Niu: The good news is, the user numbers continue to look very strong. They have 83 million premium subscribers, 101 million free ad-supported monthly active users. Total monthly active users is 180 million. Those numbers don't actually add up. I asked Spotify's investor relations department to clarify. My suspicion was there are premium subscribers who are inactive. They confirmed that is what that difference is. Over time, that'll be interesting to track. If you have premium subscribers that are inactive, that's not a good thing, because there's a good chance those people will cancel. 

I went back and looked at the historical numbers, and it's not too big. They actually restated some of the numbers, but it's 1%, it's only a few million people, so it's not a huge concern. But if that number started to rise, that would be something to keep an out for, because obviously, you want people to be engaged in the platform. 

But overall, very healthy. In comparison, Apple Music has about 40 million paid subscribers. They're roughly twice as big as Apple, in terms of paid subscribers. Pretty strong there.

Lewis: Something that's gotten quite a bit of press recently with Spotify is its direct licensing efforts. This is them exercising some of the optionality that we noticed they had as a business when we did our prospectus show, when we looked through their S-1. We talked about how they are establishing themselves in the music space, and that might give them the flexibility to do some interesting things.

Niu: There have been some reports we have that they're approaching small, independent artists, inking direct licensing deals, essentially cutting out the record labels for those artists. They're basically paying these artists direct royalties. What that does is reduce their royalty cost. Their royalty burden is really huge, it's their biggest cost by far. To the extent that you can cut out these record labels and get the artists directly on Spotify, that has the potential to save you quite a bit of money. Not a ton, because in the grand scheme of things, a lot of the usage of Spotify will still likely be concentrated on these mainstream artists that will always want to go to the labels. But every little bit helps. 

It's an interesting strategy more long-term. When they went public, they laid out this vision of, they're building a two-sided marketplace. They're helping fans connect with artists, and they're helping artists connect with fans, and they're in the middle providing creative tools, analytics, all sorts of stuff to the artists. On the user side, they're providing content discovery, and allowing people to connect more directly. So, there's a lot of really interesting stuff going on there. Nothing like this is really out there right now, particularly at this scale.

Lewis: You mentioned Tencent Music earlier. What did you want to bring into that for this conversation?

Niu: The interesting thing is, Spotify and Tencent Music did an equity swap back in December. Spotify actually owns 9% of Tencent Music, which is Tencent's music subsidiary. They're planning on going public pretty soon. Tencent Music is humongous. I forget the numbers, but they're actually much larger than Spotify. The fact that they have this partnership, this investment with them, they can also learn from them, for one. But, if Tencent goes public, Spotify will probably get a big boost. They actually said this directly in their report, that they would have a "significant gain on their investment if and when Tencent Music goes public." That would actually push them into profitability during the quarter, if and when that occurs. But they're very clear, like, "Don't expect that to be a regular thing, because we'll probably go back to losing money."

Lewis: So, just a short-term blip in profitability.

Niu: Right. It would be interesting in general if Tencent Music went public. That gives investors more public data points on this business. There's not a whole lot of pure play music streaming companies out there that are public sharing this type of data, other than Spotify. Apple doesn't share this kind of data. Streaming is really where the music industry is heading. The more information you get on this industry as it evolves, the better, and the more informed investment decisions you can make, too.

Lewis: So, Spotify investors should be rooting for a healthy Tencent Music IPO, huh?

Niu: Right.

Lewis: Anything else before I let you go, Evan?

Niu: They're really executing well, in terms of their ARPU and churn. Average revenue per user continues to go down, but at the same time, that's because they're having more family plans, more student plans. Those plans have much higher retention rates. So, churn continues to go down a lot, as well. 

In the long-term, I think that's still the right call to make. You're giving up a little bit of money upfront, but you're keeping these users in the long-term, which provides your business, which is a subscription business, you got a lot more visibility, you get more recurring revenue, it's much more stable that way. They're continuing executing on that front. The trends are all in line with what we've seen over the past two years. I just think they're doing a really good job there, too.

Lewis: Any music recommendations for folks after they finish this show and want something to bring them into the weekend?

Niu: [laughs] I can't think of anything.

Lewis: Austin Morgan, man behind the glass, what have you been listening to lately?

Austin Morgan: I think my most played Pandora station right now is Run The Jewels radio.

Lewis: Alright! Not the most family friendly.

Morgan: Not family friendly, no. But good for the gym.

Lewis: If you're listening with kids, do not listen to Run The Jewels.

Morgan: Do not listen to that.

Lewis: Same goes, I've been listening to new music from Chance the Rapper and the new collab that Kid Cudi and Kanye put out. It's excellent.

Morgan: Not a big Kanye fan, but I like the rest of them.

Lewis: To each their own. I don't love the guy, but he makes amazing music. But, like Run The Jewels, you should not listen to it with children in the room. It's good gym music, though. On that note, I'm going to wrap this show. Evan, thanks for hopping on!

Niu: Thanks for having me!

Lewis: Listeners, that does it for this episode of Industry Focus. If you have any questions, or if you want to reach out and say hey, you can shoot us an email at [email protected], or you can tweet us at @MFIndustryFocus. If you want more of our stuff, 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!