In this week's episode of Industry Focus: Tech, host Dylan Lewis and Motley Fool contributor Evan Niu check in on earnings from two social media giants. Snap (NYSE:SNAP) popped 20% after reporting, and a lot of its numbers are trending in the right direction. The unprofitable company still isn't without some big risks, though. Meanwhile, Facebook (NASDAQ:FB) continues to step in it with privacy concerns -- every week seems to bring us news of another screw up. But at the same time, its user numbers just keep rising, and it's raking in money hand over fist. What needs to change to get Facebook to actually value user privacy? Can Snap maintain this winning streak? Tune in to learn more.

To catch full episodes of all The Motley Fool's free podcasts, check out our podcast center. A full transcript follows the video.

This video was recorded on July 26, 2019.

Dylan Lewis: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It's Friday, July 26, and we're running through earnings reports from Snap and Facebook. I'm your host, Dylan Lewis, and I've got fool.com's Evan Niu on Skype. Evan, what's going on? It's been a little while. I've been on vacation.

Evan Niu: Yeah, it's been a while. My brother just had a baby. That's fun! We're going to go visit Boston in a couple of weeks. 

Lewis: What's the plan while you're there? I was there for five years. I know the city pretty well.

Niu: I don't know. He just moved there, actually; his wife got a new job. They just moved from Brooklyn to Boston. We have some other family there, so we're kind of familiar with the area. Probably not as experienced as you are. But yeah, it's always a fun place to visit.

Lewis: Yeah, check out the public gardens, maybe walk along the Charles. Do some outdoorsy stuff.

Niu: We're going to go down to Cape Cod. Part of my family has this house right on the beach, on the Cape, which is amazing. So, probably go hang out there for a little bit too.

Lewis: I have never gotten to the point in my life where I've had a friend who has a beach house. One day I will get there. Until then, I will use the public pools in Washington, D.C. 

Evan, when I come back from vacation, I'm often scrambling to come up with a topic to talk about, especially on a short week like this. I got back on Wednesday, need to do an episode on Friday. The beauty of earnings season is that there's always a story when companies are reporting earnings.

Niu: Yeah, always stuff to do. How was The Philippines, though?

Lewis: The Philippines was great! I think I ate some of the best pork I've ever had in my life. The lechon game in The Philippines is absolutely incredible. Danced some zumba with my girlfriend's aunts and parents, which was definitely a first for me, but seemed to endear me to her family. I was putting the charm on, trying to do what I could, and I think I managed to survive the trip.

Niu: That's what counts!

Lewis: [laughs] Alright, we are talking some earnings releases from some big tech companies today. Why don't we kick things off with Snap, the ephemeral messaging company. I always love using that little descriptor, so popular. The stock is up over 20% since the company reported earnings after the bell on Tuesday. Revenue was up 48% year over year, which is actually an acceleration and its best growth rate since Q1 2018. Of course, the company is still losing money, but losses narrowed to $250 million from $350 million a year ago. I think the real story, and the reason that people were so excited with this earnings report, was the user numbers that Snap posted.

Niu: Yeah. There was really a lot to like, and I've been pretty hard on Snap historically, as you know. But if you look at their results relative to guidance, they really blew it out of the water. Putting up almost $390 million in revenue. Adjusted EBITDA was negative $79 million, but their guidance had predicted sales of upwards of $360 million. That was the high end of their guidance. And they expected adjusted EBITDA to be negative $125 million to negative $150 million. So they were really able to outperform the guidance by a pretty substantial margin there.

Lewis: What really drew those numbers up was some additions on the daily active user side, and increases in revenue per user. DAUs were up 13 million sequentially, which is the most they've added in a quarter over the past three years. And it also pushed them over the 200 million DAU mark. What's the driver there, Evan?

Niu: First of all, that is really impressive, in terms of how many they were able to add this quarter. It's been a really long time since they've been able to put up such a strong user number. But that was really being driven by this revamped version of the Android Snapchat app, which has always been really bad -- bad performance, buggy, not a good experience. And they've been focusing on really improving that on the Android side over the past year or so. And you can tell that's really paying off. But on top of that, they're putting out more of these augmented reality filters. For example, this gender swap, one that's been going viral all over the internet, people being able to switch genders based on this augmented reality filter. A lot of these things are bringing people back into the platform, keeping them engaged. And it's showing in these user numbers.

Lewis: I think it's easy for us to underestimate how important Android is on a global scale in the United States. You look at smartphone market share in the U.S., it's about 50-50 between iOS and Android. But if you take a step back, and you look at the global market share, iOS only has like 15% to 20% of the smartphone operating system market share. So really, if you want something that is truly global, if you want hundreds of millions of users, you need to nail Android.

Niu: Right. If you look particularly more specifically at emerging markets, their share is even higher. Like you said, globally, Android is around this 85% figure. But if you're looking specifically at emerging markets, like India, Latin America, regions like that, it's upwards of 90%, 95% Android. It's really critical for anyone that wants exposure to those markets.

Lewis: Typically in the past, Snap has focused on what they consider the most important ad markets. That's North America and Europe, to some extent, because there's more purchasing power there, and advertisers are willing to pay more for access to those markets. And of course, Snap is a very data-heavy app because it's sharing images and sharing video. What I think is really interesting now is, you look at where the growth is coming from, it's the "rest of world" segment, and they are actually able to monetize this segment better than most social media companies out there.

Niu: Right. And that's something you mentioned earlier, which was definitely a really good point. Their rest of the world segment is now larger than Europe, both in terms of sheer revenue in absolute dollars, but also in terms of average revenue per user (ARPU), which is really interesting, because most other companies can monetize Europe much stronger than the rest of world or Asia Pacific. It's worth noting, there is a mild difference in terms of the reporting. For example, Twitter only reports U.S. and international. Facebook and Snapchat both have North America, Europe, and the rest of the world. But Facebook also has this Asia Pacific segment. So for Snapchat, Asia Pacific and the rest of the world are bundled together. But when you're looking at the ARPU numbers, it's a pretty big difference.

Lewis: Yeah, I'm trying to work through exactly what's driving that. My hunch here, and I really am just grasping at straws because it is so anomalous with what we normally see with social media companies, is that most of the people in the rest of the world segment are people that are iPhone owners in fairly affluent parts of what would be the rest of the world. Maybe that's some of the wealthier Middle Eastern countries, some of the wealthier Asian countries. So, because they have a very low percentage of Android users currently in that segment, it is almost overstating the value there, and over time, that will come down. You see that a little bit when you look at the ARPU trends here. ARPU in North America and Europe were both over 40% year-over-year growth, and it was only up 25% in the rest of world segment. So it's possible that the rest of world segment might moderate a little bit over time, and Europe might start to take over and become the second-most-valuable segment for them.

Niu: I think part of it is also that Snap is such a young company that they hadn't really gotten the Europe monetization up. And, at the same time, they've been working on this rest of the world segment. Whereas in comparison, Facebook is obviously much larger, more mature, been around a lot longer. They've had a lot more time to nail down Europe monetization. For example, Facebook, in Europe, their ARPU is almost $11. Whereas in Asia Pacific and rest of the world, it's like $2 to $3. It's a huge discrepancy there. But I think it's more of, Facebook's more mature, it has been working on that market for a lot longer than Snap, whereas Snap is working on both at the same time right now.

Lewis: A couple of other interesting tidbits from the report. Gross margins were at 46%, which is the second-best margin figure they've ever posted. Of course, Snap is still losing money and posting operating losses -- this time, almost $300 million. Looking at all this, the market is very excited, particularly because the user growth story came back and in pretty big numbers. To add 13 million is pretty impressive, given we were seeing flat sequential or single-digit sequential adds in some of the more recent quarters. With the spike that we've seen in shares since they reported, we are basically back to the valuation that Snap was at when it went public. If you go back to early 2018, they're up over 200%, which is pretty incredible. Evan, when you see the last year or so for this business, and you look at being back at IPO price, do you see more growth for this company? Or are you saying, we're back to where we started?

Niu: There's no doubt about it, they're definitely putting up some really strong numbers here. But at the same time, being back at the IPO price, it's almost like they're growing into the valuation that they had when they went public, which, in my opinion, they were dramatically overvalued when they went public. But now they're starting to catch up to that valuation. I'm not as bearish as I used to be on them. I'm still not interested. Their corporate governance is still terrible. Public investors still get no votes. They just had an annual meeting a few weeks ago. It was four minutes long. Last year's was three minutes. There's a lot of things I still don't like about this company. But I can't be as hard on them, because they're starting to put up some pretty respectable numbers.

Lewis: Evan, in fairness, that's 33% growth in the length of their annual meetings. That's pretty good.

Niu: [laughs] That's a metric all investors should care about, length of annual meetings.

Lewis: [laughs] I think I'm with you. I think there's a good lesson here in the valuations that a lot of these companies are going public at. Snap went public well before all of these other businesses that we're seeing in 2019, all these other unicorns that have gone public. But when so many of these companies have been propped up by private equity for such a long time, and the story has been, "build your total addressable market, don't really worry about building a sustainable business, we'll sort that out later," they're going to run into some issues when they actually have to start figuring out the business model and how to make money because they're publicly traded. We are seeing with Snap that it's taken several years for that to happen.

Niu: Right. I still think they have some challenges with scaling with costs, like we've talked about. But, at the same time, they're doing a lot of good work in terms of keeping those costs in check and under control, and not letting it destroy the economics of the business. At the same time, the ad business is starting to mature a little bit, they're getting more self-service tools, more automated selling of these ads, engagement is up on some of these premium shows that they're doing. I definitely think they're putting together a turnaround.

Lewis: I think they're showing that they can monetize their users better than maybe we'd estimated they could. They are still going to run into some issues with their financials because they're posting operating losses. And so much of that is tied to the infrastructure costs that we've talked about at length on past episodes. I think that that's a tough hurdle for them to get over. And that's something that I want to see with any business before I put any investing dollars behind it. At core, is this something that can, down the road, print money? The way that Snap is set up right now, I don't see it. 

Niu: Right. I'm with you there. 

Lewis: And we were talking about Facebook earnings. This is a company that I own. Evan, are you still a shareholder?

Niu: Yep. I've been very torn about being a shareholder still, because I have a lot of issues with everything Facebook's been doing over the last couple of years. But you know, we'd like to be long-term investors. That includes the ups and the downs.

Lewis: Yeah. I think unfortunately, Facebook feels like that guy in high school who you kind of liked but had a house and had parties. And it was a good connection to have, you knew that it was something that was worth maintaining, but you didn't necessarily love having that affiliation. That's how I feel as a Facebook shareholder. I know that at core, there's a very successful business here. I don't necessarily love what's going on in the company, though.

Niu: Right. They just keep putting up all these really good numbers. That's what's tricky for me. I have these moral qualms, but I like the numbers. [laughs] It's a moral compromise.

Lewis: [laughs] The numbers for the most recent quarter -- revenue up 28% to $16.9 billion. Net income cut in half to $2.6 billion. But that's due to a one-time adjustment there.

Niu: Right. There was this big FTC settlement, which we can get into in a minute. That really cut into their profits. They still put up net profits of $2.6 billion. User metrics, again, continuing to grow, just like every other quarter. On a sequential basis, they always add a little bit more, a little bit more. So right now, Facebook, daily active users are now almost 1.6 billion. Monthly actives are over 2.4 billion. And they've been really trying to highlight this family-wide audience metric. They've said that they're going to slowly transition to shift toward reporting toward this family number, which includes Facebook, WhatsApp, and Instagram. On that front, daily actives are 2.1 billion, and monthly actives are 2.7 billion. Again, the user bases for all these platforms continue to grow.

Lewis: Let's finally unpack that FTC story. It is no small thing to have $5 billion chunked off of your net income for a quarter.

Niu: Right. They've been in talks with the FTC for several months about all these allegations that they really abused consumer privacy and database use, all the stuff that we've come to know too well with Facebook over the past two years. In the first quarter, they basically said, "Hey, we think this is going to be between $3 billion and $5 billion." They took a $3 billion accrual in the first quarter in anticipation. And this week, it was officially announced that, yes, it's going to be $5 billion, which had also been widely leaked and reported on. So now they have to take another $2 billion. That's $3 billion the first quarter, $2 billion in the second quarter. It's a new record by far. $5 billion going to the FTC is a massive fine relative to historical records. The previous fine was $22.5 million for Google back in 2012. This Facebook penalty is over 200 times as large. But even still, there's some arguments that it's still not enough. In addition to the money, Facebook has to make a bunch of other changes operationally, which also apply to Instagram and WhatsApp. They have to establish a new privacy committee on the board of directors that will be independent. Zuckerberg will have influence on it, but it's not something he will have complete control over in the way that he has control over everything else. The company has to designate compliance officers to oversee this new privacy program. They'll have to submit quarterly certifications to the FTC. Stronger oversight over third-party apps. Can't use two-factor authentication phone numbers for ad targeting, which is a controversy that blew up last year. They have to put in this new, comprehensive, data-script program, encrypt passwords by default, a bunch of small things that ideally will help strengthen user privacy going forward.

Lewis: When people say that this doesn't go far enough, are they talking about the fine? Or are they talking about some of the restrictions that Facebook will have to operate under now?

Niu: There's a lot of really good criticism about this. I'm on the side that thinks that this wasn't nearly enough as well. For example, the FTC vote was on party line. There's five commissioners, three Republicans and two Democrats. All three Republicans voted in favor of it, the two Democrats opposed it, arguing that it didn't do it enough. And they issued dissenting statements that made a lot of really good points. For example, Commissioner Rohit Chopra argued that the penalty is not commensurate with how much Facebook has made in profits by violating user privacy. For example, the FTC often uses what they call "unjust gains" as a way to measure how much these penalties should be. For example, the fine that Google paid back in 2012 was roughly five times its "unjust gains." Whereas there wasn't really a good methodology for how they came up with this $5 billion number. At the same time, Facebook's entire business is built on vacuuming up as much data as they can about you and then exploiting that data for ad targeting. For example, Facebook can recover $5 billion with one quarter's worth of net income. So, it's a single quarter of profits, and then you just keep on doing what you're doing. He also notes that it doesn't change any of the Facebook's underlying financial incentives or their business model to keep on doing this. So they're just going to keep on doing this. And he argues, it's basically just, they're going to keep doing it, but they just now have to create a paper trail. So yeah, there's a little bit more accountability, but those incentives are still there. 

I think in terms of incentives, the strongest measures that Facebook could get would be user backlash. If users really cared about this privacy stuff, and really sent a message that it's not OK, and stopped using the platform, I think that would be a very strong message. But quite literally every single user metric that Facebook cares about has gone up vs. two years ago. So, in a way, it tells them, "We don't care. Keep doing it."

Lewis: Yeah. Unfortunately, that's what happens when something's free, right? You have an algorithm that is specifically geared toward making it precisely what people want. It does seem like there will have to be some operating changes to Facebook as we know it. Do you think that this puts some of the issues to bed for Facebook, and we can move past some of the controversy and the concerns with regulators? Or is there a point, maybe a couple of years down the line, where we find ourselves in exactly the same spot? This has been a company that has managed to step in it pretty much every other month, it seems. [laughs] 

Niu: [laughs] Speaking of that, while you were gone, I don't know if you saw the news, but remember, they put out this Messenger Kids app a while ago. And the idea was, they want to get young kids hooked on Facebook by having them message. But parents have the ability to approve who their kids are talking to. There was this bug in the app that basically let your kids talk to strangers. And it's just like, like you said, every week, there's just something. And Facebook keeps saying that they're going to get better, they're going to do better, we're doing all these things. But they just keep messing it up, they keep screwing up all these things. I think they've lost so much credibility in terms of reputation and whether or not people believe that they can actually be better with this privacy stuff. I don't believe them, first of all. [laughs] And I hardly use the platform because of all these concerns. And that's the thing -- I'm this minority. All these #DeleteFacebook movements come up every time these stories break, but it's clearly a very tiny minority, even if they're very vocal and say, "We're not OK with this." But in the aggregate, the user numbers just keep going up and up and up. Engagement numbers keep going up and up. So, again, most people clearly don't care. Like you mentioned, it's a free service, and people aren't willing to pay for it with money, they're willing to pay for with their privacy, and they seem to be OK with that.

Lewis: Some of the other stuff that came out during earnings was, of course, Facebook's guidance. Why don't we touch on that a little bit?

Niu: They increased their expense outlook again. That's mostly because of all this FTC stuff with the fines. Now, for example, 2019 total expenses are expected to grow 53% to 61%. That's up from the 47% to 55% growth outlook that they provided in April. But the CFO David Wehner mentioned that it's really all that FTC fine, because that represents 16% of growth. So if you back that out, since it's a one-time deal, the midpoint of their guidance suggests that their expenses this year will grow about 41%, which is actually at the low end of the guidance they initially provided in January of 40% to 50% growth. I think a lot of that is coming from their capital expenditure, which is now coming in a lot lower than previously expected. They initially said it'll be $18 billion to $20 billion, then they said $17 billion to $19 billion, and now it's $16 billion to $18 billion. This capex budget has really come down. I guess they're not expanding their data centers as much as they originally thought they would have to. So they'll save a little bit of money there.

Lewis: That's a little bit of a reversal from what we've seen from them in the past. There's been a discussion about how margins would be compressed a little bit as they were spending more. A lot of that spending was due to staffing and efforts to either up their privacy or increase user enjoyment on the platform. So, costs coming down a little bit. But, that right there is a perfect reason and explanation for why you need to read the conference call. It's so easy to lose track of those one-time things when they are masked in the larger buckets that you tend to see on the income statement.

Niu: Right. And to be fair, they did say that a lot of the FTC stuff with regards to the operational changes around these privacy programs will require significant investments. It's going to make their product development a little bit trickier because they have to jump through more hoops, be more careful, document more of the stuff. It'll be more costly, more time consuming. They didn't quantify that in any way. They didn't pin numbers to it. But qualitatively, they did say that it'll affect how they develop their products and stuff going forward.

Lewis: So, fine aside, it's business as usual for Facebook, Evan.

Niu: [laughs] Yeah, for better and for worse.

Lewis: [laughs] Alright, thanks for hopping on the show! And thanks for joining me! It was nice to talk to you now that I'm back from vacation. I missed you a little bit!

Niu: It was good to catch up! Thanks for having me!

Lewis: Of course! Alright, listeners, that does it for this episode of Industry Focus! If you have any questions or you want to reach out and say hey, shoot us an email at industryfocus@fool.com, or you can tweet us @MFIndustryFocus. If you want more of our stuff, subscribe on iTunes or check out the videos from this podcast on YouTube. 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 Dan Boyd for his work behind the glass today! For Evan Niu, I'm Dylan Lewis. Thanks for listening and Fool on!