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Facebook's Operating Expenses Are Blowing Up

By Adam Levy - May 20, 2016 at 12:20PM

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Facebook saw an increase in operating expenses last quarter, and it's just getting started.

Image source: Facebook.

After Facebook (META 0.94%) posted its best operating margin in years for the fourth quarter of 2015, Facebook's operating margin came back down to Earth in the first quarter. The company posted GAAP operating margin (its preferred metric) of 37% and non-GAAP operating margin of 55%.

The sequential decline in operating margin was driven largely by a 3% sequential increase in operating expenses, its largest first-quarter sequential increase since 2012 and first since 2013.Year over year, operating expenses increased 29% on a GAAP basis and 41% on a non-GAAP basis. And Facebook's management says it's just getting started.

A quick look back at Facebook's 2016 outlook

On Facebook's fourth-quarter earnings call in January, CFO Dave Wehner told investors that the company will continue to grow its investments in connectivity, Oculus, and AI in 2016. For the year, he expected the "year-over-year growth rate for full-year 2016 total GAAP expenses to be approximately 30-40%, and for full-year 2016 total non-GAAP expenses to be approximately 45-55%."

The numbers Facebook posted for the first quarter of the year, 29% and 41% on a GAAP and non-GAAP basis, respectively, fall short of that outlook. That might give investors the idea that Facebook is setting up to produce better-than-expected operating profits this year. Indeed, the company's first quarter non-GAAP earnings per share came in above analysts' estimates, at $0.72 versus $0.62.

However, Wehner warned that investors shouldn't expect that to remain the case, and growth in operating expenses will ramp up throughout the year. "We do expect that investments in areas like video and Oculus will impact the remainder of the year more substantially. So, that's why we're maintaining the annual OpEx growth guidance." As mentioned on the previous earnings call, Facebook is also investing heavily in improving connectivity through Free Basics,, and artificial intelligence.

One more factor that will impact operating margin in 2016

While Wehner is upfront about the areas of investment for Facebook, there's one more area it's investing heavily in that will have a significant impact on Facebook's operating margin in 2016 and beyond: advertising technology, particularly its Facebook Audience Network.

Facebook launched its Audience Network about two years ago now, and by the end of last year, it had already reached a $1 billion run rate. Not only is Facebook investing in the platform to grow its usage by both advertisers and app and website publishers, it will also see an impact on operating margin through its cost of goods sold.

For each advertisement on the Facebook Audience Network, Facebook shares 70% of ad revenue with its publishing partner. On Facebook, the company generally keeps 100% of ad revenue. If 10% of Facebook's revenue comes from the Facebook Audience Network in 2016, the revenue share alone would account for 7% of revenue, ultimately weighing on its operating margin.

As such, the growth of the Facebook Audience Network throughout the year will contribute a lot to the expected 30% to 40% growth in total GAAP expenses for the year. That's on top of the added investment in Facebook's other products. Based on Wehner's comments, analysts have already baked this ramping up into their models and their expectations for Facebook to generate earnings per share of $0.81, $0.87, and $1.11 in each of the next three quarters. If Facebook is going to beat those expectations, it's going to come from better-than-expected top-line growth, not operational efficiencies.

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