Is VR the bear case for Facebook?

Mark Zuckerberg has been on a publicity tour of late, drawing attention to the company’s accelerated efforts in VR/AR. The Facebook CEO recently participated in a podcast with The Information and spontaneously (allegedly) joined a Clubhouse room, in which he discussed the work of Facebook’s Reality Labs group.

Facebook has been pursuing a VR/AR initiative for years, of course: the company acquired Oculus back in 2014. And Facebook’s VR/AR business has grown considerably over the past few years, with estimates of Q4 2020 sales of the Oculus Quest 2 — Facebook’s $300 all-in-one VR headset — pegged at between 1MM and 3MM units. Certainly, Facebook’s efforts in this direction have already borne fruit, with its hardware sales and cut of first-party content sales growing non-advertising revenue to $885MM in Q4 2020, up 156% from the previous year.

The commercial progress along Facebook’s VR/AR vector is impressive. But seemingly until recently, commercial progress with VR/AR wasn’t a priority: in 2016, Zuckerberg stated that it would take 10 years for VR to reach the mass market. In January 2021, six thousand Facebook employees were focusing on VR/AR and hardware; that number is now 10 thousand — or 20% of the entire company — per a report from The Information. Why has the headcount for these hardware projects increased so dramatically? And why has the Facebook executive team suddenly started to emphasize its commercial progress across VR/AR in earnings calls, whereas these projects were previously described as moonshots that would take many years to manifest?

One straightforward explanation for Facebook’s intensified emphasis on VR/AR is that the company wants to deflect attention away from its trajectory with advertising. As I stated in my recent presentation, iOS 14, Privacy, and the Future of Digital Advertising, Apple’s AppTrackingTransparency (ATT) privacy policy seems almost purpose-built to harm Facebook. Google and Facebook both make money by selling ads — but that’s where any similarity between the companies ends. Google has fortified itself against capricious competitor platform policy changes through establishing its own platform relationships with consumers: with Android and with the Chrome browser. These relationships allow Google to implement clever, innovative mechanics such as FLoC, TURTLEDOVE, Fledge, etc. to retain the efficiency of in-browser advertising.

Facebook has no comparable path forward for retaining advertising performance in light of the extinction of “tracking” — Facebook’s advertising business is fundamentally different from Google’s. Facebook’s advertising revenue is driven by serving impressions on its owned-and-operated sites, and the efficiency of that process is powered by the third-party data it collects from off-site advertising conversions. Facebook doesn’t own the user’s browser or operating system, and so it can’t mitigate the loss of ad targeting precision that results from “tracking” being extinguished in the way that Google can. Facebook is subject to intractable platform dependencies.

Considering the changing advertising environment more broadly: the profile-based ad targeting paradigm that prevailed for digital advertising is being upended, which impacts Google and Facebook both, but in different ways. Google’s answer to that change is its Privacy Sandbox; Facebook’s answer relates to my content subsumption-based “content fortress” theory that tethers to the primacy of first-party data. But Google’s Privacy Sandbox is more or less a reality: in order for Facebook to establish its content fortress, it must first bring the third-party interactions it currently facilitates with ads into its apps. Facebook is attempting to do just that with FB Shops, as was my thesis back in 2017 when I wrote The coming war between Facebook and Apple, but the success of this initiative is by no means guaranteed. Can Facebook become a shopping destination? And if it can, what next? And how long will this take?

There is no better means of understanding Mark Zuckerberg’s intention to disintermediate its relationship with consumers — that is, to own the hardware form factor through which users interact with Facebook — than by reading the leaked, 2500-word email he sent to lieutenants in June 2015 around the potential acquisition of Unity Technologies, the developer of the Unity3D game development engine. From the email (emphasis mine):

I will discuss the main elements of the platform and key apps further below, but for now keep in mind that we need to succeed in building both a major platform and key apps to improve our strategic position on the next platform. If we only build key apps but not the platform, we will remain in our current position. If we only build the platform but not the key apps, we may be in a worse position. We need to build both.

From a timing perspective, we are better off the sooner the next platform becomes ubiquitous and the shorter the time we exist in a primarily mobile world dominated by Google and Apple. The shorter this time, the less our community is vulnerable to the actions of others. Therefore, our goal is not only to win in VR / AR, but also to accelerate its arrival. This is part of my rationale for acquiring companies and increasing investment in them sooner rather than waiting until later to derisk them further. By accelerating this space, we are derisking our vulnerability on mobile.

This mental model from 2015 is clearly still driving Facebook’s strategy with VR/AR. And in his recent interview on The Information, Zuckerberg laid bare his intention to get Facebook hardware into the hands of as many consumers as possible with an aggressive pricing policy that foregoes hardware and app store margins. Facebook is accelerating its efforts in VR/AR with mass-market headsets, smartwatches, and AR glasses in order to own the interaction layer with the consumer and establish defensibility through a bonafide hardware-based content platform.

And yet, I interpret this acceleration as a pessimistic concession by Facebook — as an admission that it has no means of truly circumventing Apple’s AppTrackingTransparency privacy policy or alleviating the pain that it will cause to its core advertising business. I recently estimated that ATT would inflict a 7% revenue headwind on Facebook in Q2 2021: what if the real impact is much more severe than that? And what if that revenue friction is not ameliorated over time as I forecast but exists as a permanent step change? Then it would make sense for the company to celebrate its efforts in a wholly-unrelated business and to accelerate along that trajectory as fast as possible.

This is the bear case for Facebook. If Facebook thought that ATT would not dramatically impair its advertising business, it’d likely be making that point rather than routing attention to its VR/AR efforts. The fact that Facebook is so emphatically and conspicuously making the case that VR/AR will be transformational for the company implies that its advertising business is critically imperiled.

Facebook is an advertising company: for that to not be true, the consumer market for VR/AR hardware and applications must increase by an order of magnitude (Facebook’s advertising business is currently 30x the size of its non-advertising business). I’m not a VR cynic: I remember vividly my first encounter with VR on the rooftop of the San Francisco Marriott Marquis hotel at GDC 2014. I was blown away: my short session was by far the most exhilarating experience I’d had in a game. And I distinctly remember at that GDC hearing that VR was surely on the precipice of becoming mainstream because “the smartest people in the industry” were working in that space.

But I don’t think that’s a good heuristic for thinking about consumer adoption of new content interfaces. The smartest people have the luxury of working on exciting, novel, cutting-edge technology, most of which will fail commercially. Mediocre people have to work on the things that pay the bills. It’s easy to be excited about new technologies: consumer analysts will tell you that all transformative technology begins its life looking like a toy. That observation isn’t interesting, though: I think it’s more relevant to consider why certain transformative technologies evolved past the toy stage. Perhaps a better construction is to acknowledge that every important form of consumer technology initially penetrated into mass adoption as a gaming device.

Certainly, that is the path that VR/AR has taken, but seven years after Facebook’s acquisition of Oculus — and in the waning months (hopefully!) of a global pandemic that saw worldwide consumer spend on gaming increase remarkably — VR still hasn’t reached mass-market scale. VR is often referred to as the “next big computing platform,” but next isn’t a helpful timeframe. Is next soon enough to arrest the potentially severe damage inflicted on Facebook’s advertising revenues by ATT? And more importantly, in this VR-enabled future, is it Facebook that dominates the consumer market for hardware and content, or is it some other company? Too many open questions exist around the future of VR to assume that Facebook’s VR business compensates for impending damage to its advertising revenue.

What I believe underscores a bear case in this scenario is the timing of Facebook’s amplification of investment: the acceleration toward a consumer technology market that hasn’t yet materialized is potentially a capitulation on the business — advertising — that has guided Facebook to a $750BN market cap. Can VR potentially mature into a mass-market consumer category? That’s certainly possible, but it hasn’t. Some of Facebook’s other initiatives, such as FB Shops, are being accelerated in light of ATT to attempt to offset the revenue headwinds it will face in its advertising business. But none of those has inspired a publicity tour by the CEO of the company.