Pando

Facebook gives engineers gazillions of stock options, hoping they'll find the next big thing

By Kevin Kelleher , written on July 30, 2015

From The Employment Desk

Success has alighted on Facebook twice.

First in the form of a Web-based social network that Mark Zuckerberg created in his dorm room. And again on the mobile version of Facebook: In the past three years, mobile ad revenue has gone from next to nothing to just shy of $3 billion last quarter.

Zuckerberg has been looking for ways to lure success into Facebook's finances yet again, whether through ads in Instagram feeds; or people communicating with companies in Messenger; or a 3D, immersive realm via Oculus Rift; or all of the above. The thing is, enticing that fickle bird to alight even one more time requires a lot of spending. And a lot of time. Even as the older successes see declining growth rates.

That is Facebook's conundrum in July 2015, and it's starting to make investors twitchy. Back in the summer of 2013, when it became clear that Facebook's mobile app was not just drawing in users but also the advertisers aiming to target them, the stock took off. It has risen 274 percent since then, leaving the company with a $268 billion market cap.

On Wednesday, Facebook said Q2 revenue grew 39 percent to $4 billion (if not for the strong dollar, revenue would have grown 50 percent to $4.4 billion). Earnings, excluding stock-based compensation, came in at 50 cents a share, up from 43 cents from a year ago. Both figures were slightly above expectations, yet Facebook's stock ended up declining 3.3 percent in after-hours trading.

Meeting headline numbers isn't enough for tech investors anymore. They are looking deeper into other metrics, whether it's new subscribers at Netflix, operating expenses at Google, or gross margins at Amazon. The metric that investors latched onto in Facebook's financial report was its total costs and expenses, which came in at $2.8 billion, when stock-based compensation is included. These costs grew by 82 percent over the last year. That is, they are growing twice as fast as revenue.

This shouldn't have surprised Facebook investors too much. The company has been saying for a while that 2015 is a year of heavy spending, as it gears up for its next big act. Much of this spending has come in the form of stock-based compensation, which is why I keep going back to it. Facebook said it spent $763 million on stock-based compensation, more than twice what it spent a year ago. The bulk of that (79 percent) went toward research and development.

Companies like Facebook will report earnings with stock-based compensation and without (the “with” numbers are required by the SEC). In Facebook's case, the gap between the two is pretty severe. Remember that 50-cents-a-share net profit? Subtract out stock-based compensation (as Facebook would prefer you do), and it shrinks to 25 cents a share. Which is down from 30 cents a share a year ago. This is how heavily Facebook is financing its future on shares that, once exercised, could dilute its EPS growth in coming years.

Beyond all the operating expenses weighing down Facebook's profits this quarter, the company is making between $2.5 billion and $3 billion in capital expenditures this year for data centers and long-term projects. It's not clear whether or how much this capital spending will slow in 2016. Oculus Rift will be costly to roll out, even at the slow pace Facebook is planning. The company has yet to say what it's spending on Internet.org, only that it's available to more than 1 billion people in 17 countries. And scale like that doesn't come cheap.

Facebook has won a lot of confidence from investors over the past couple of years, thanks to its ability to execute on making money from mobile ads. More than three-fourths of its total revenue is coming from those ads, as it phases out the annoying right-column ads on its desktop site. This phasing out caused ad impressions to decline 55 percent last quarter. But along with the shift to the targeted ads showing up in mobile feeds, it caused the average price per ad to shoot up by 220 percent.

Zuckerberg has long seen the need to move past its core mobile app, which is the main reason for new ones like Instagram, Messenger and WhatsApp. Facebook has finally begun selling ads on Instagram, but CFO Sheryl Sandberg warned not to expect much revenue there for a while. “We're going to be really thoughtful and strategic about how we ramp revenue,” she said on Wednesday's earnings call. “It's going to really take time to have significant impact on our growth.”

As for Messenger, the wait is going to be even longer. Facebook talks about how it's focused mostly on the user, while critics say it's mostly focused on ads. The truth is both are areas of focus. It's just that the ads come only when the user experience has been nailed down. Here's how Zuckerberg explained it, answering a question about plans to monetize Messenger and WhatsApp.

“So the playbook that we're going to run with Messenger and WhatsApp is kind of similar to how we thought about building a business in Facebook and News Feed, where if you go back to 2006 and 2007, there were a lot of people who were kind of encouraging us to just put banner ads and kind of inorganic content into the experience, and what we decided was that over the long term, the ads and monetization would perform better if there was an organic interaction between people using the product and businesses.

“So instead of focusing on ads first, what we did was we built pages, and we made that free, that way as many businesses as possible could get into the network. And we built insights to make it so that businesses knew how they were driving business when they used pages for free and could post them to News Feed...

“Messaging, I think, is going to be pretty similar, right? Where right now some people in WhatsApp use the service in order to message businesses, Messenger is, I think, more people-to-people today. We're working on a lot of different things that make it so that people can get value from interacting with businesses... But the long-term bet is that by enabling people to have good organic interactions with businesses, that will end up being a massive multiplier on the value of the monetization down the road.”

It was a long-winded way of telling investors to be patient. Facebook is being Facebook, monetizing new platforms only when it's sure there is long-term growth in them. The qualm that investors seemed to have here is that some of the older businesses are either shrinking or seeing slower growth. Revenue from desktop ads declined by 10 percent last quarter to $919 million. Revenue from payments (remember those?) declined by 19 percent.

Even the stellar mobile-ad growth is slowing. Two years ago, they were growing by more than 300 percent annually. Last quarter, they grew by 75 percent. This slowdown is inevitable because the year-over-year comparisons involve ever increasing bases. CFO David Wehner warned that this trend of declining growth rates in mobile ads would continue for at least the next two quarters.

So what's left to keep investors satisfied until the next new revenue stream starts pouring in? Not a lot. Zuckerberg said that deepening user engagement on News Feed, while feeding in more video ads will be enough. And it may be, since advertisers are willing to pay premiums for targeted video ads that connect with users. But if Facebook takes more than a few quarters to polish its promised follow-up act, investors may be more than edgy. They may start to lose their patience.