It’s been a while, Facebook (NASDAQ:FB) readers. Last time I dedicated a public article to Facebook was last summer, and a lot has changed since then – but not the change you may be thinking.
The last time I checked in, I broke down revenue guidance for the remainder of 2018. I was expecting 33% for Q3 and 22% for Q4. Facebook indeed delivered 33% revenue growth in Q3, but it outperformed and issued over 30% in revenue growth for Q4. This outperformance was curious as guidance was clearly much more downbeat, but it wasn’t surprising.
As you may recall (and you probably don’t, so click the link I provided to my prior article and jog your memory), I said roughly 43% of the downside in guidance was due to currency tailwinds ending and turning into a slight headwind. Some of the outperformance could be attributed to this headwind not being as meaningful as expected. I estimated it at $400M, and it came in at $348M. So, an outperformance of $52M; but that didn’t meaningfully drive the $500M+ revenue beat.
Had foreign exchange rates remained constant with Q4 ’17, total revenue would have been approximately $348 million higher.
– CFO David Wehner on Q4 ’18 call
In any case, the market reacted positively to this beat, and Facebook’s shares outperformed the broader market – as it should have.
But why? How does one reconcile this revenue outperformance with not only no help from forex, but a headwind at that?
Management’s Tactics And Track Record
It’s clear Facebook was able to drive ad revenue higher in spite of this currency headwind. The market took note of the strong earnings showing and considered revenue would have been ten percentage points higher than guidance led on to had currency been constant – a 32% better execution than management estimated. That’s nothing to look past.
But more to the point: how was this possible even in the face of “bad headlines” and GDPR and other bearish talking points?
Facebook is pulling levers it didn’t let on to on the call.
Management has a track record of downplaying its roadmap with transitions to other ad types (Stories and Ad Breaks come to mind) while pulling harder on levers which still have runway left in terms of growth. Management gave the market a narrative that the transition will impact revenue growth without letting on to the fact it can pull current levers further. In other words, management designs its buffers into its plan but not its narrative.
I talked about this a year and a half ago when Stories and Ad Breaks were first hitting the scene. As the company started the ad product development on these two platforms, it was maxing ad load on already established areas like Facebook Feed.
Today, it’s beginning to fully roll out monetization to Stories, and what is management doing? You guessed it: increasing the ad load – this time on Instagram’s feed.
Pulling The Levers Further
Based on my viewing of Instagram, in Q4 of 2018, there was roughly one sponsored post (‘ad’) in my feed per 10-12 non-sponsored posts. Through Q1 I’ve seen this ad load increase to one sponsored post per 4.5-5 non-sponsored posts. What I’ve also seen is a shift from major brands to small businesses and everyday Instagrammers with sponsored content.
No matter how I look at Instagram’s feed, there has been a dramatic increase in the number of ads placed in it. And, having run my own ads through the quarter, the cost for running an ad did not shift materially. This means CPMs (cost per impressions) remained stable with the increased ad load – a good sign for investors.
This is occurring during the transition to Story and Ad Break ads, which is planned to drive revenue in the next phase of growth. Management is handling the transition by downplaying revenue growth, increasing ad load in mature areas, all while scaling up developing products.
Furthermore, the ad load increase in Stories was executed as discussed on the last conference call as I also empirically estimated this load. So, Facebook is executing on its plan for Stories but also bolstering the transition due to the weaker pricing of Stories with a heavier ad load in Feed.
Considering Facebook is facing a forex headwind this quarter in comparison to 2018’s Q1 tailwind, as noted by the below chart, the company will be relying on this ad load increase to drive revenue growth.
Using management’s guidance of “[the] total revenue growth rate to decelerate by a mid-single-digit percentage on a constant currency basis compared to the Q4 rate,” we can place the guided revenue growth at just over 25% for Q1. With the sizable forex shift the company is facing in comparison to 2018’s Q1, I expect a headwind of around $435M. I estimate this by calculating a 0.17 point differential in forex for 2017-2018, the $536M revenue tailwind in the Q1 quarter of those years, and the 0.11 differential for 2018-2019’s headwind multiplied by 25% (to take into account revenue growth). This would mean a guided non-constant currency revenue growth rate of 21.5% for Q1.
Considering the outperformance of $448M in Q4 without the substantial ad load increase on Instagram’s feed, the company can easily cover this forex headwind with the channel checks I’m seeing. In fact, I estimate the company to beat guidance and bring in around $15.1B for the quarter, or 26% revenue growth (29.5% on a constant currency basis).
Risk To The Argument
We’ve seen management play this game in the past and they are keen to overdeliver as they underpromise. The fourth quarter was a testament to that outperformance. However, my argument can be seen in a different light as well. Instead of bolstering the transition to the weaker CPM Instagram Stories, it could be an emergency move because the transition is not seeing CPMs come up as quickly as anticipated. This ad load may be beyond what management originally had in mind, and to close a revenue shortfall, it needed to bring up ad load in Feed.
While this is not out of the question, this isn’t the first time we’ve seen this. The last time was successful in bringing new products online and in a progressively scaled fashion. Management has not erred on the side of too fast but rather painfully slow in some cases (Messenger as an example), so I don’t anticipate this to be an emergency-save-the-quarter type of move. Additionally, this ad load increase began very near the start of the quarter, indicating this was not reactionary.
Earnings A Week Away
All of this will come to light mid-next week as Facebook releases Q1 earnings and provides guidance on Q2. My checks have shown Instagram Feed ad load has remained stable into Q2 and Stories has shown a leveling in ad load, likely to allow for CPMs to gain traction. I expect forex headwinds to be less of an issue in Q2 as the rates between the Q2 periods are closer so there will be an easier hill to climb in terms of revenue growth. This will provide a natural opportunity to let Stories grow in terms of CPMs, which requires demand to catch up to the newly created supply and not require mature products to run at higher ad loads than designed.
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Disclosure: I am/we are long FB. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.