Wall Street bashes Facebook for doing exactly what it said it would
Mark Zuckerberg must really be wishing Facebook was still a private company.
The disconnect between the grandiose plans he has for the company's future and the fickle sentiments of public-market investors caught up again with his company today. And all because Facebook did something it had been loathe to do before: guide its shareholders on where it expects its revenue and profit go move next quarter.
It all started with what seemed like a routine quarter for Facebook: Revenue of $3.2 billion (up 59 percent from a year ago) and 43 cents in earnings per share, both modestly higher than analyst estimates. But it was par for the overpriced course that Facebook has been playing on for the past year, and anyway investors this months have been in a bearish mood, so Facebook's stock moved little on the news.
Then came the guidance. Revenue growth would slow this quarter to somewhere between 40 percent and 47 percent. Worse, expenses are expected to rise between 55 percent and 75 percent next year, mostly because of stock-based compensation to employees. Within minutes, Facebook's stock had fallen by more than 11 percent in after-hours trading.
Slower growth and faster spending? This is a recipe for disappointment in a market that lives on evidence of immediate growth. But if any investor is seriously disappointed in the news Facebook delivered today, they have nobody to blame but themselves. Because Facebook is doing exactly what it has been saying it would do all along.
Facebook's revenue has been growing around the 60-percent level for several quarters, thanks to the long-awaited rollout of the ads in its mobile news feeds. (Remember the bad old days when Facebook's stock was languishing because it was moving too slowly on mobile ads?) A year ago, the company made it clear that this rapid growth would slow in time, and now growth is indeed normalizing to around 40 percent, still double Google's growth rate.
The bigger issue seems to be the rise in spending next year. When analysts asked about where the spending would go, the answers were the expected ones: WhatsApp, Oculus, better ad technology. Much of this is coming from stock-based compensation for a workforce that has swelled by 44 percent over the past year. But here again, there's no surprise. The company made it clear it would work to build and expand WhatsApp, Oculus and its core business, which of course means hiring more people.
So maybe investors are disappointed that, after several quarters of strong revenue growth from the new mobile ads, Facebook doesn't have a follow-up act lined up just yet. On the conference call discussing earnings, analysts' questions probed in this area: What about video ads? What about search? What about Instagram?
For anyone listening carefully to the earnings call three months ago, Facebook addressed this too. Zuckerberg and Sheryl Sandberg explained that in these areas the company wouldn't monetize until it had build out a product that consistently engaged a broad scale of users. That, after all, was the approach Facebook took to its original social network, an approach that turned Facebook into a $12 billion a year company.
On the subject of Instagram, Sandberg today took the long view again. Eventually, Instagram will connect a billion or more users (up from 200 million today) but ads would be rolled out slowly and deliberately. Companies like Mercedes are discovering that launching on both Instagram and Facebook are increasing engagement, so the deliberate approach is worthwhile. “We roll out products slowly and then iterate,” Sandberg said. “We're building on the next iteration, then building on the next.”
That approach, maddening to impatient investors, is being applied to other areas like building a search database that Google can't touch or working on the Internet.org - a name that makes investor eyes glaze over when Facebook details it as a social project. But Facebook is iterating its global market – down to tiny experiments like running Gillette ads on feature phones in India. Zuckerberg, asked about China, said he expects the approach there to take decades to play out.
In retrospect, today may mark the day when the gaping disconnect between Facebook and its shareholders became painfully clear. Zuckerberg talked scaling Whatsapp and Instagram into Facebook-sized user bases, but it will take five years. Oculus could be a ubiquitous VR platform, but that could take years longer. But on Wall Street, where the bonus is paid out at the end of every calendar year, who has time to wait for a success story five to ten years down the road?
Spending all those billions on Oculus and WhatsApp sounded good when they were announced, but that was because the bill had yet to come due. But the guidance Facebook gave on spending today suggests the bill may be starting to hit the bottom line next year. Facebook is, by design, a cross-country bus trip. Suddenly, some of its passengers are dinging the bell wanting off at the next intersection.
Not helping was an SEC filing Facebook made regarding WhatsApp's finances. WhatsApp saw a mere $15 million in revenue in the first half of 2014 and spent $13.5 million in net cash. Not spectacular and not terrible, but it recorded $247 million in operating costs because of stock-based compensation. In another WhatsApp-related concern, 178 million shares used to pay for the acquisition will hit the market in the coming quarters.
If there is any red flag in Facebook's earnings, it's not the slowdown in revenue growth the company predicted or the increase in its spending that was inevitable given its ambitious plans. No, the red flag is this: That so much of Facebook's spending is being accounted for by equity as currency. Stock-based compensation is like a quantum particle in a company's accounting. Squint one way and it's a real cost that a company has to pay. Squint another and it's nothing material to worry about, at least for today. But such generous equity packages were a worrying symptom of the dot-com bust, along with outsize valuations. Mixed together, the two can leave a nasty hangover.
And it's here where the short-term focused investors in the public market have a valid concern. Facebook's grandiose plans and the thousands of iterations they involve will require years to realize. A lot of profit may sit at the end of those years, but a lot of unexpected developments may arise in the meantime that could derail them.
Another hallmark of the dot-com boom was the willingness to invest in growth five years down the road. If anyone can manage that long-term growth, it may be Facebook. But then again, can anyone really manage it for long?