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Facebook Is Making Billions, but It Doesn't Care About Profit Margins

By Adam Levy - Feb 10, 2016 at 12:08PM

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Facebook posted its best operating profit margin in years. Can investors expect it to continue expanding?

Source: Facebook.

"We still think we're early in investing in the business."

Those are the words of Facebook (META 0.22%) CFO Dave Wehner on the company's recent fourth-quarter earnings call. To his point, Facebook increased its spending significantly in 2015, up 55% on a non-GAAP basis for the year. At the same time, fourth-quarter operating margin increased to 60% last year, up from 58% in both 2013 and 2014.

Despite its focus on investing for the long-term growth of the company, Facebook's 60% operating margin is much higher than comparable businesses such as Alphabet (GOOG 0.19%) (GOOGL 0.33%). Even the mature Google segment generated a non-GAAP operating margin of just 31% during 2015.

Can Facebook investors expect it to continue to make twice as much operating income per dollar of revenue as Google?

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Wehner was clear that he doesn't think the company is done investing. Despite its spending over $20 billion on acquisitions WhatsApp and Oculus just a couple of years ago, Wehner told analysts "we're really investing in new areas today where we see a long-term opportunity for revenue growth."

Research and development expenses grew more in absolute dollars than all of Facebook's other operating costs combined in 2015. Note that that includes a full year of stock-based compensation for WhatsApp and Oculus. On a non-GAAP basis, which doesn't include the increase in stock-based compensation to the WhatsApp and Oculus teams, R&D is the company's fastest-growing expense (percentage-wise). Investors shouldn't expect that to change anytime soon.

But that's not the biggest thing that could drive down Facebook's operating margin.

A quick look at Google's expenses
Up atop the list of Google's operating expenses is its cost of revenues. Cost of revenues totaled about 38% of Alphabet's total consolidated revenue in 2015. Comparatively, Facebook's cost of revenues totaled just 16% last year.

Google's cost of revenues includes all the same things as Facebook's -- data center operations, employee compensation, credit card transaction fees, and so on. But there are also some large expenses that Facebook doesn't have to worry about.

Google pays traffic acquisition costs to various Web browser developers to make sure its search engine pops up when someone types a search query into the navigation bar. It also includes the revenue shared with its network partners that place Google ads on their websites. Last year, Google paid over $14 billion in traffic acquisition costs, about 19% of Google's total revenue for the year and half of its total costs of revenue.

Additionally, Google pays content acquisition costs for YouTube videos and digital downloads on Google Play. YouTube shares a percentage of ad revenue with its creators, and more recently it started commissioning original content for distribution on its platform. Google takes a 30% cut of digital download sales through Google Play, sending 70% to publishers.

One other expense Google pays that Facebook doesn't is its revenue share with mobile carriers. Google pays carriers a share of ad revenue to pre-install its apps such as Gmail, Search, and Google Maps.

Facebook is already becoming more like Google 
Earlier this year, Facebook extended its ad network, the Facebook Audience Network, to include mobile websites in addition to its existing ability to advertise in other mobile apps. The Audience Network was first introduced in the spring of 2014, but it holds a lot of growth potential for Facebook. Facebook shares a majority of the ad revenue from its Audience Network with the app developer or publisher.

Last month, Facebook announced the Audience Network reached a $1 billion run rate in the fourth quarter. That revenue, however, only has an operating margin around 30% due to the revenue split with publishers. Google, for example, only keeps about 32% of its Network Member's ad revenue after its revenue split. While $1 billion is still a small part of Facebook's expected revenue of $25.5 billion in 2016, it's enough to have an impact of more than one percentage point on operating margin. As the Audience Network grows, that impact will increase.

Similarly, Facebook began rolling out Instant Articles earlier this year. The feature takes articles from various publishers and hosts them on Facebook's servers to improve load times. If a publisher taps Facebook to place ads in those articles, Facebook splits the revenue 70/30 in favor of the publisher.

As Facebook users watch more video content on its platform, the company is experimenting with ways to share revenue with creators. While this will theoretically improve the quality of video content on Facebook, it also increase Facebook's cost of revenues.

All told, Facebook investors shouldn't expect operating margins to remain high forever, but all of these efforts provide incremental revenue opportunities, and those dollars should trickle down to the bottom line. How much of that cash ultimately makes it there depends on the company's plans to continue investing in long-term opportunities for revenue growth, which may or may not provide operating margins as high as its core business. 

Margin profiles aside, Google's operating income was nearly four times higher than Facebook's last year. So, it certainly seems worthwhile for Facebook to extend into lower margin businesses.

Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool's board of directors. Adam Levy has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Alphabet (A shares), Alphabet (C shares), and Facebook. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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