Four risks that could slow Facebook down

Posted on August 1, 2016 by Eric Benjamin Seufert

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Facebook announced its Q2 earnings report last week, beating analyst forecasts for the quarter and causing a 6% rise in the company's stock price in after hours trading. The highlights of the report were:

- Overall ad revenues were up 63% year-over-year, to $6.24BN;

- Mobile ad revenue represented 84% of total ad revenue in the quarter, up from 76% in the same quarter one year ago;

- Net income was up 186% year-over-year;

- Messenger has surpassed 1BN MAUs and Instagram has surpassed 500MM MAUs;

- Mobile-only MAUs have nearly reached 1BN, at 967MM. Mobile MAUs are at 1.574BN.

In the call, Sheryl Sandberg dedicated a significant amount of time to describing and delineating Facebook's various mobile video advertising initiatives; just as in Facebook's earnings call last quarter (which reported similarly impressive results), Sheryl Sandberg went to great lengths in this call to convince investors that the company not only has a mobile video strategy but is executing against it impeccably. In the call, she said:

People have shifted to mobile, and marketers know they need to catch up. Mobile is no longer a nice to-do, it’s a must-do, and we’re working closely with marketers to help them make this transition.

The best marketers understand that people watch video differently in mobile feeds. The goal is to create what we think of as thumb-stopping creative, videos that grab attention in the first few seconds, even without sound...

We’re excited to bring more relevant video ads to people both on and off Facebook. In May, we expanded Facebook Audience Network to include video for brand objectives. This means that advertisers can place video, brand video ads, not just on Facebook and Instagram, but across a network of apps and sites.

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In my post on Facebook's Q1 results, I noted the many new tools that Facebook has brought online to assist advertisers in creating relevant, engaging video ads for users (particularly those on poor connections or with sound turned off). Facebook is obviously investing heavily in this suite of tools and in generally emphasizing video across its portfolio of apps (Mark Zuckerberg mentioned in the call that his ambition is for Facebook to transition toward "video first" content in the mid-term future), and its stock price is a testament to how well it is doing in that regard. It's perfectly understandable why Facebook would be investing so heavily into video on mobile with advertising initiatives and projects like Facebook Live: mobile video advertising is set to grow to $6.82BN by 2019.

And while no one can argue that Facebook hasn't done phenomenally well in transitioning its advertising business to mobile, its continued success isn't quite a foregone conclusion. Facebook faces four principle risks in expanding its mobile advertising reach.

Data availability in developing world

Facebook doesn't have much growth left to achieve in the developed world. This is a graph of growth rates in Facebook's MAU by geography for the past two years:

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Quarter-over-quarter MAU growth has been hovering at or below around 1.5% per quarter in the US and Canada and Europe since Q3 2014, whereas growth is about triple that in Asia Pacific and double that in the "Rest of World". ARPUs are much lower in those geographical buckets than in the Europe / US and Canada buckets:

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Smartphone ownership in the developing world trails that in the developed world by a significant margin, according to a recent Pew report:

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That said, the same Pew study found that internet users in the developing world are more likely to use social networking sites than those in the developed world (probably due to a higher percentage of older adults owning smartphones and using the internet in the developed world):

internet_usage_developing_world

But it's not really smartphone ownership that serves as the impediment to reaching users in the developed world with mobile advertisements: it's the relatively high cost of mobile data in those regions.

Facebook has gone to great lengths to make inroads in India, specifically: the company attempted to connect Indians to the internet (or, rather, a version of the internet with Facebook as its epicenter) for free, but that project, which was called "Free Basics", was banned by the Indian government (along with other so-called "zero rated" programs that essentially give free mobile data to users that allows them to browse certain sites and use certain services). India is important to Facebook, and its failure with the Free Basics project represents a serious problem for the company: at one point, Facebook expected that about 30% of the new users it'd acquire by the year 2020 would come from India.

While Facebook has seen successes in countries like the Philippines and Zambia through partnering with mobile operators to give away free data to use Facebook, India was seemingly the company's most prized destination, and it wasn't able to penetrate that market with the free data strategy. If Facebook faces similar setbacks going forward, and if data remains prohibitively expensive in large-population developing nations, the company's ability to grow its mobile video and advertising products could be compromised.

Facebook can't scale native video content to capture brand advertisers

The battle for attention in mobile video is part of a broader war to win television advertising dollars. Snapchat, for instance, recently struck a deal with Nielsen that will have the latter provide TV-centric performance metrics to advertisers that run video ads in its Live and Discover placements. The metrics provided as part of Nielsen's mDAR package ("mobile Digital Ad Ratings") comprise reach, frequency, and demographic composition.

Of course, Facebook offers more or less the same thing with its Premium Video Ad product in the form of Nielsen Online Campaign Ratings (I discussed this set of metrics in my 2016 GDC presentation about the launch of Angry Birds 2). Sheryl Sandberg devoted a considerable amount of time in the Q1 earnings call to talking about how well Facebook's video ad products accommodated existing TV ad creatives in a clear bid to convince investors that Facebook is ready to start running large brand campaigns on Newsfeed.

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But despite these measurement programs, designed to make brands more comfortable with spending money on mobile, brands haven't yet shifted considerable budget to mobile video en masse (although it is happening to some extent). Native video placements may placate brand advertisers, but it seems that the native video content in which those placements are run attracts them: this is the probable impetus behind Facebook's Live product, on which it has spent a reported $50MM for content from celebrities and video creators.

It's also the likely catalyst behind the original series being created for YouTube Red, including those from PewDiePie, Joey Graceffa, and CollegeHumor. Yes, these series will be ad-free, but the creators are free to strike brand deals for in-show sponsored content -- albeit via Google's sales team.

So Facebook has an iron in this particular fire, but the question is whether the company can scale this content format outside of its Facebook Live product to the extent that it becomes a more attractive destination for brand advertisers than other mobile video properties. Facebook Live, which is heavily integrated into the Newsfeed, may not seem "native" enough, from a content perspective, for brands to feel comfortable spending lavishly. If that's the case, beyond Instagram, what other options does Facebook have? Messenger seems like an awkward place to feature video, as does WhatsApp.

While its possible that Facebook Live could be spun out of the Facebook experience into its own app, it seems more plausible that Facebook would try to acquire an ascendant video property and grow it via a Facebook integration. Which introduces the next risk.

Newsfeed becomes saturated and Facebook can't scale new properties

In the Q2 earnings call, several analysts asked Facebook's CFO, David Wehner, about "ad load", or the percentage of ads relative to organic content across Facebook's properties. Of this, Wehner said:

And really, I think one of the things that’s enabled us to grow ad load has been improving the quality and the relevance of the ads, as you’ve mentioned...

We still see the opportunity to grow inventory from the growth of people and engagement on Facebook, as well as our other services like Instagram. Instagram does have a lower ad load than Facebook.

Interpreting this, it sounds like Wehner expects the ad load in Instragram to increase and for it to stay the same in Newsfeed but for Newsfeed's reach to grow. But from where can that growth in reach be achieved? As was discussed in the first risk point, growth in the developed world is about 1.5% and the infrastructure to deliver video advertising in the developing world is fairly scant.

More likely, this growth would come from additions to the Facebook app portfolio through M&A transactions. And while Facebook has a fantastic M&A track record with high-profile acquisitions like WhatsApp and Instagram, it missed Snapchat. In the Q2 call, Mark Zuckerberg made reference to two video app start-ups, musical.ly and live.ly, that are positioned to appeal to millennials, which proves that he is cognizant of what's happening in that space.

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But acquiring these types of companies early is a proposition fraught with danger: the ones that will ultimately be successful tend to be very viral, but virality alone doesn't guarantee long-term success (for instance, Dubsmash, which was once a Top 10 Downloaded app in the US on iPhone, now languishes in the 300s). Yet waiting until a video app is successful in its own right is sure to drive its price into the stratosphere, at which point that app's creator has likely taken equity financing, with its investors and founders incentivized to stay independent for the duration (see: Snapchat). It's an interesting dynamic that could prevent Facebook from being able to grow its app portfolio through M&A, which is a risk: if it can't, and if Newsfeed becomes too saturated, then its video ad business could falter.

Platform operators intervene

With 84% of Facebook's overall advertising revenue coming from mobile, it's safe to say that mobile app install ads are an important component of Facebook's revenue profile, even if the company doesn't break that particular segment out from the total in its financial reporting. But both Google and Apple have either introduced or announced the impending arrival of direct response mobile app install ads in their respective storefronts, with Apple's taking the form of ads in search results.

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Facebook faces the risk that either platform (but namely, Apple) decides that direct-response app install ads are an important revenue stream that they benefit from bringing into their own walled garden -- that is, by pairing app install ads with proprietary data or tools in a way that creates operational exclusivity to them. In Apple's case, this could happen should search ads prove to not drive the amount of revenue expected (my own opinion on search ads can be found here; opinions seem to be mixed in terms of whether search ads are good or bad for developers). If this proves to be the case, Apple might become more aggressive with respect to discovery and attempt to prevent third-parties from driving installs, preferring instead to capture app install ad revenue within the App Store.

Facebook would certainly feel this. Of course, Facebook wouldn't be alone: it'd be a huge disruption to the existing dynamics of the app ecosystem and would send major shockwaves throughout the app development community. But it's a risk nonetheless, and one that Facebook (or any other advertising network, for that matter) has little control over.