Facebook Is Really, Really Good at Advertising

Facebook's (META 0.43%) second-quarter revenue growth was driven by its ability to charge more for ads. PayPal's (PYPL 2.90%) second-quarter payment volume grew 40%, but shares sold off due to concerns related to eBay. In this episode of MarketFoolery, John Rotonti analyzes those stories, iRobot's Q2 results, and which companies have (and don't have) the ability to raise prices.

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This video was recorded on July 29, 2021.

Chris Hill: It's Thursday, July 29th. Welcome to MarketFoolery. I'm Chris Hill. With me, for the first time in a while, it's John Rotonti. Thanks for being here.

John Rotonti: Thanks, Chris. Glad to be here.

Hill: We got more earnings. It's one of those weeks. We're going to talk PayPal, we're going to talk iRobot, we're going to start with the social network. Facebook's second-quarter revenue came in just north of $29 billion. It's interesting because Facebook, it's not like their ad inventory is getting dramatically larger but they've demonstrated their ability to charge more for ads, and you got to like that pricing power if you're a shareholder.

Rotonti: That's exactly right. Their revenue grew 50% constant currency in the quarter. Of that top-line growth, 6% came from growth in the number of ads or the number of impressions but 47% increase in the price per ad. Like you said, that's a lot of pricing power. On some level, it does show that businesses of all sizes, excuse me, are willing to pay Facebook more for better ad placement, higher ROI, higher return on their ad spend and then better, more effective measurement of the effectiveness of those ads, so they're willing to pay Facebook more.

Hill: I know Facebook gets a lot of attention for a lot of other things that have nothing to do with advertising. I think it's easy to lose sight of the fact that they are really, really good at this. In the same way that Google is really good at search, Facebook is really good at the business of advertising.

Rotonti: I think they are the best at the business of advertising. In my opinion, I think they are the best.

Hill: How big is the Oculus for them? For those unfamiliar, this is their virtual reality goggles headset. As someone who is watching a decent amount of the Summer Olympics, I'm seeing a lot of ads that Facebook is doing for the Oculus and it seems like this is something they are very serious about from a business standpoint. It's not just, "Oh, this is a fun thing to play with." It seems like the business aspirations around Oculus are pretty lofty or do I have that wrong?

Rotonti: No, I think you have that right, Chris. They break out their revenue by advertising and then other, most of the other is Oculus. I think that grew somewhere in the neighborhood of 30-35% this quarter if memory serves, which is great. The Oculus 2, their second version of the virtual reality headset has gotten rave reviews, and I've read probably 10 or more, a dozen reviews and it's gotten rave reviews. More important than the growth that it's seeing in Oculus is that VR and AR is a major investment area for Zuckerberg and Facebook. Not only are they investing in Oculus and the Quest, but they're coming out with smart glasses in partnership with Ray-Ban and Ray-Ban's parent company. But all of that Chris is a part of Mark Zuckerberg's vision for the next stage of Facebook. In a lot of ways, this was one of the most important calls I think in Facebook history, because Mark Zuckerberg talked about how he wants to transition the company over the next several years from being primarily a social media company into a metaverse company. He laid out in the call and in some interviews he's done recently with The Verge, for example. But he laid out on the call what the metaverse is, he defined it, and how Facebook may play a role in building out this metaverse, and VR and Oculus will play a role in that.

Hill: I'm trying to wrap my head around this because as someone who's had the chance to try virtual reality goggles and that thing, it's pretty compelling. But it's pretty compelling from the standpoint of this is a fun thing to do. From a business standpoint, there are a lot of investors who get a little nervous when they hear about CEOs saying, "We're shifting our business." If you're a longtime shareholder of Facebook, you're happy with how the business has been run. Is this a situation where you look at what Zuckerberg and his team, this pivot they're trying to do, is at the expense of the up until now, highly lucrative social network they have built or is this like, "No, we're going to keep that golden goose producing those eggs. But meanwhile, we're going to invest a lot of money into Oculus. We're not going to build the Oculus and the metaverse at the expense of the existing business."

Rotonti: Totally. Two things there. One is, Zuckerberg has trained his investor base, he's trained his shareholders from very early days and earnings calls to look at the long term. He has always laid out five-, seven-, and 10-year plans. That's one thing. Yes, the stock is selling off a bit today but Facebook investors I think are accustomed to this long-term shift. The other thing is, one of the key aspects of a metaverse is that there are going to be these economies in these virtual worlds. Facebook I believe if they're successful will be able to transition a lot of their advertising business, a lot of what their ability and e-commerce and payments over into the virtual worlds. It's not a shift so much from an economic point of view, I think it will be able to maintain good economics but I think Zuckerberg thinks that the next internet platform is going to be the metaverse. Facebook is clearly a major internet player now and so if they want Facebook to be a major internet player in the future, then it has to do so in this next paradigm shift which is the metaverse.

Hill: Shares of PayPal are down 6% this morning despite second-quarter profits coming in higher than expected. Earlier in the week, PayPal was close to an all-time high. I talked to Tim Byers yesterday about this with Starbucks. Just like with Starbucks, there was a lot to like in their quarter but there were enough things that weren't amazing that the stock sold off a little bit similar to PayPal. There's a lot to like here, total payment volume of 40%, but it seems like with PayPal there are enough short-term question marks that I get why you combine that with the stock close to an all-time high, I get why it's selling off a little bit today.

Rotonti: Yeah. Sometimes stocks sell off just because of what you said, just because they need to take a breather, sometimes they just had an all-time high. Could be a little of that. I think though that the investors are digesting what this drag from eBay, losing eBay business is going to be. What I mean by that is they're quantifying it, how much of a drag is it going to be going forward? I think PayPal suggested on the call that it's a little more of a drag than management originally expected, so there's that eBay drag. Also, the take rate is falling at PayPal, the amount that basically they charge to use their service. One question investors may be asking is, is this from increased competition? Are they having to lower prices? Because yes, PayPal's building is an amazing super app. It's got huge functionality across a lot of different use cases. I own PayPal, but also Square. Square is building a super app, so is SoFi. SoFi is building a super app. They guided a little light on revenue, we don't know if that guidance came in a little light because of eBay or because they're seeing increased competition from the likes of Square and PayPal or maybe a little bit of both.

Hill: It's a great point about the competition because for all the success that they've had, particularly with things like Venmo, it makes sense that Square is doing what they're doing, they're not just going to cede the ground to PayPal like, "Well, that's it. I guess they won."

Rotonti: Totally, Chris, I think that digital payments is such a massive addressable market, the size of the market, and then it's growing so rapidly. I don't think we have to pick just one. This is one of those ones when I think a basket is a fine approach. I own PayPal and Square as well as Visa and MasterCard. You can have a basket that includes PayPal, Square, SoFi, any of these players. I'm not worried about PayPal though, it's one of the largest digital platform companies in the world. It's riding these long-term trends toward the digitization of cash, and basically, electronic e-commerce and mobile commerce. It's got huge brands in Venmo, Xoom, Braintree, and Paydiant, all of which help make financial transactions easier and more secure for both merchants and consumers. I mentioned both because this is a two-sided network; it's got over 400 million combined users when you count merchants and users on the platform, and that network effect combined with a trusted brand drives really attractive growth. I see this as a high-teens grower. In some quarters, maybe they reach 20%-plus growth for a fairly long period of time. Intermediate-term, five to seven years, I think this is a high-teens grower and it's growing very profitably, Chris.

Hill: An important point there adding that they're not just growing, they're growing profitably. Last thing and then we will move on, is it safe to assume that three months from now, and I realize this might be annoying for some of the dozens of listeners, but every now and then, and this is one of those situations where when I really digest a company's earnings report, my main side is I can't wait to get to the next one, I can't wait for three months from now because I hear everything you're saying and I think to myself, "OK, so in three months, I'm assuming we're going to know more about the take rate and is that a speed bump or is that something that they are able to have bounced back?" We're going to know more about the eBay drag that you mentioned, like how long and how impactful is it?

Rotonti: Yeah. I think we'll know a little bit more in a quarter and I think we'll know a lot more in a year. Even if the take rate trends down slowly over time, it's not the end of the world, they can make that up with volume. Like I said, this is a super app, it offers peer-to-peer money transfer, it offers remittance across borders, it offers credit, it offers small loans to businesses, crypto by selling and holding crypto and now buy now, pay later, which grew something like 49% or 50% in the quarter. It is quickly becoming, and by it, I mean the PayPal app, the super app, it's quickly becoming a utility in our daily lives. I'm not terribly worried, but yes, next quarter we'll know a little more.

Hill: iRobot's second-quarter revenue grew 31%, demand is up for the Roomba and other cleaning robots. But there is a semiconductor chip shortage that you may have heard something about, and not surprisingly, that is having an impact on iRobot's business.

Rotonti: It's so funny going through this, not funny, but just enlightening going through this earning season and discovering all of the companies that are being affected by the global semiconductor shortage. I cover semiconductors shifts at The Motley Fool. It is really eye-opening how important these tiny chips are to our daily lives. Thirty percent growth is phenomenal. Some of that is pandemic-driven because during the pandemic the economy shut down, we were all forced to, or many of us were forced to work from home, learn from home, exercise from home, game from home, and so we're spending more time at home so people were buying robotic vacuums. That 30% growth makes sense.

Hill: You and I were chatting before we started recording about the five-year chart on iRobot. This is a stock, you go back to the summer of 2016, the stock has a little bit more than doubled since that. You get a double over a five-year period, that's great. Historically, that's a market-beating return. But the roller coaster that investors have been on over the past five years is terrifying. Depending on when you bought shares of iRobot, you're either thrilled or horribly disappointed.

Rotonti: iRobot is one of the companies that -- such a great point, Chris -- it's one of the companies that faces really steep competition. Even though it's this great innovative product that many of us probably use and love better than pushing the vacuum ourselves, especially the heavy type of vacuums on carpet and stuff, it is facing competition from the likes of Dyson, which is another brilliant engineering company, from the likes of Shark, the Shark IQ, and there's others out there as well. Over the last five years, the chart that you're looking at, I believe iRobot has tried to increase prices at least once, maybe twice, and those prices didn't stick, it had to actually roll them back, and so we were talking about the pricing power we are seeing at Facebook. This is the opposite. They have tried to increase the price at least once that I remember reading about and maybe more than once and they didn't stick. What you see is that the gross margin line at iRobot, which is a rough indicator of pricing power, has fallen from 49% to 50% in 2016 and 2017 to 45%, 46%, and then most recently down to 42%. The volatility that you see in the gross margin line, I think, is leading to the volatility that you see in the stock price. It's going to be interesting to see if they can get the last 12 months gross margin of 42%, if they can get that back up into the mid-40% range.

Hill: Thank you for that reminder because I had forgotten about that incident where they tried to raise prices and it backfired on them. Among other things, it's a reminder that, in general, when it comes to consumer technology, I feel like we can put iRobot and the Roomba in the consumer technology space. In general, prices come down over time. A very good flat-screen TV costs you a lot less now than it did five and 10 years ago. Apple really is the outlier in its ability to continue to keep the iPhone at a high price point. You go back 10, 12 years, the first few years of the iPhone, the people who were bearish on Apple, part of their bearish argument was, "Well, look at the history of consumer technology prices, they can't possibly keep this up. They're going to have to lower the price of the iPhone over time." In fact, they did the exact opposite.

Rotonti: It's exactly right, and in order to maintain that pricing power, those average selling prices, you have to continually innovate and add new functionality and new features which Apple has been able to do largely with the iPhone. The thing we should mention about iRobot because you said depending on when you got on that roller coaster you either really enjoyed it or you felt sick to your stomach. One future investors, they like about this, is the stock is not terribly expensive right now, it's trading eighty-something dollars per share, its 52-week high was almost $200 per share, and on a price-to-free-cash-flow basis, it's trading at like a multiple of 15, which is low, Chris, that is low and the reason it's low is because it is such a volatile business, I think. The predictability of the business is not predictable, and so people aren't going to pay high multiples for it. But if you invert that price-to-free-cash-flow multiple, you get a free cash flow yield, and that's a yield of 7%. The higher the yield, the better, a 7% yield that compares to the 10-year Treasury note at 1.3%. A 7% yield also means that free cash flow doesn't have to grow a whole lot to generate mid-teens annualized return, free cash flow only has to grow 6%, 7%. You add the yield plus the growth, 7% yield, let's say 6% or 7% growth, and you get to mid-teens expected return. Now, it's not a guaranteed return, but it's a rough heuristic to calculate that. Maybe it's a decent time to buy this one. I don't know the company well enough to say any more than that, but it doesn't look terribly expensive here.

Hill: John Rotonti, great talking to you. Thanks so much for being here.

Rotonti: Thank you, Chris. Always love being on the show.

Hill: As always, people on the program may have interest in the stocks they talk about and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. That's going to do it for this edition of MarketFoolery, the show is mixed by Austin Morgan. I'm Chris Hill, thanks for listening. We'll see you on Monday.