Facebook: The Elephant That Sprints

Facebook revenues have increased 7x in five years. Can Facebook keep up this startling, advertising-market-shaking growth rate?

As Christmas 2005 approached, a tsunami swept through our consultancy office. Tectonic plates had shifted, loosened by new code from the minds of a dozen programmers 5,000 miles away in Palo Alto. It started with a single invite and within days, almost every team member had an account. Facebook had arrived.

"Almost everybody" since in those early days only graduates of ‘top’ British universities could join Facebook, creating genuine bad feeling, now barely remembered. It was a fun, addictive concept when broadband was taking off and new, new things kept on coming. Facebook was a new toy, just like Yahoo, MySpace, Napster, eBay and Flickr.

Then things calmed down, or so it seemed. But we had created a couple of dozen building blocks which, replicated a couple of billion times, have fundamentally changed the global media landscape through:

  1. Huge reach: Facebook has significantly changed the media behaviour of 26% of the world population in a dozen years. Facebook’s global penetration of those with internet access is 46%, which is even more remarkable since it has no access to the 20% of the global population living in China.

  2. Audience Time: Facebook, with its sister platforms Instagram and Messenger, takes up 50 minutes of the average user’s day. By comparison, all TV viewing takes up just over 3 hours per day for the average UK viewer.

  3. The Value Chain: Facebook Inc dominates a new - exceptionally lucrative - segment in the media value chain, which takes steadily more value from less powerful segments and chains with hugely disruptive effects on the established, media eco-system.

Facebook Inc’s foundations are its eponymous platform but it has added further social platforms through acquisition: first Instagram, costing a bargain $1bn in 2012, and WhatsApp at a punchier $19bn in 2014. The core Facebook platform remains dominant in terms of revenues – generating around 90% of the total – but it is the family of social brands together with Messenger that makes Facebook’s growth story so much stronger. Instagram is just the first of Facebook’s next generation platforms to be turned into a significant profit centre with revenues estimated to be $3-4bn this year.

We all know that Facebook Inc’s growth has been rapid but do you realise just how breath-taking the take-off has been? Pitons and ice axes are essential to climb the vertiginous mountains of revenue and profit growth shown in Figure 1.

Figure 1
Figure1_facebook_turnover_2

Revenues were $27.6 billion (£21.5bn) in 2016-17 and should break $40bn (£31bn) billion in 2017-18. Operating profits were $12.5 billion in 2016-17.

Some context is necessary to grasp the scale of these numbers. In 2017-18 Facebook’s revenues will be marginally lower than those of Unilever, the 130-year-old consumer goods giant, but Facebook’s operating margin, at over 45% will be 3x that of Unilever. Sensible media comparisons can only be made with US companies. In 2017-18 Facebook’s revenues will not be far from those of Disney in scale and will almost certainly overtake the house of mouse in 2018-19, but Disney’s operating margin is ‘just’ 26%. Only Alphabet’s revenues (Google’s holding company) will be ahead in media land but with an operating margin of 23%, the profit gap between Facebook and Alphabet should close far faster. Not bad for a 13-year-old company whose revenues were negligible 10 years ago.

Facebook's operating margin is twice that of Alphabet.

User numbers are still growing in all major regions and though growth is slower in the US and Europe, where penetration is already high, Facebook is converting more of these subscribers to more valuable, daily users. Asia and emerging market user numbers keep growing at a clip.

Financial metrics make analysts purr: Return on Capital Employed has risen to 23%; EBIT margins are rising; and profits turn swiftly and efficiently into cash. The business creates $1.5m of revenue and $600k operating profit per employee, figures similar to those 7 years ago, despite headcount increasing nearly 10x.

A critical number to watch in any subscriber driven business is ARPU (average revenue per user) and, as you can see in figure 2, the figures rise steadily at around 30% per annum.

Figure 2
Figure2_Facebook_ARPU_5

Put simply, Facebook keeps gaining users; these users become more loyal; and advertisers are spending more to reach each Facebook user, every year.

There are five, closely-linked factors that drive these remarkable numbers.
Facebook Inc is an exceptionally focused business. It does just two things and it does them very well. Facebook Inc builds social networks to enormous scale and it sells advertising. That’s it.

Yes, there have been investments in Augmented Reality (AR) through Oculus and there are other development initiatives (for a later post) but their objective is to drive the growth of and loyalty to the core social networks and to thus sell more advertising. Facebook is certainly not in the business of trying a wide range of speculative investments, an approach that is in the DNA of Alphabet.

Facebook Inc’s objective is to build every platform to at least a billion users.

Facebook Inc has just 4, global brands: Facebook (over 2bn monthly users), Instagram (700m users), WhatsApp (1.2bn users) and Messenger (1.2bn users). Facebook Inc’s objective is to build every platform to at least a billion users with emphasis on the US, due to the scale of its advertising market. One billion is critical mass in Facebook Inc’s terms and Facebook Inc is very good at achieving it, something which Snapchat shows us is not easy to do, still with ‘only’ 300m global users.

Facebook Inc platforms keep growing users and loyalty. Even the relatively mature Facebook platform’s user numbers have kept growing at around 15% per annum since the end of the rocket-fuelled growth of the early years. In the critical US market, over 56% of the population is a daily Facebook user but still growth of 7-8% is being achieved each year.

The business’ nature allows it to be very tightly controlled by a relatively small team. Facebook Inc is a handful of code-based brands, making them easier to manage and market. There aren’t the complexities of production and cost of traditional businesses. There is no global supply chain to manage. Marginal cost per user or advertiser is almost $0. Advertising clients and partner organisations must be cultivated and convinced but then largely serve themselves through defined advertising formats (at least in comparison to the scale of the advertising operations required in traditional media businesses).

There are few things in the world as powerful than a dominant value chain position.

Mark Zuckerberg brings a tech founder’s ambition, vision and zeal while Sheryl Sandberg enforces focus, discipline and hard-nosed commercial bite. This is a powerful combination.

But most important of all is Facebook Inc’s position in the value chain. The tectonic plates moved and carved out for Facebook and the company’s other social networks a new, potent segment, shown in figure 3. There are few things in the world as powerful as a dominant value chain position, right next to the consumer, in a lucrative market.

Figure 3
Value_Chain_2

This segment is so powerful because it not only controls the flow of all content to all users within the network, it also gathers consumer knowledge on a scale that only Google can come close to. By not only using the data from usage of its own, closed social media platforms but also gathering data about users’ other internet behaviours while the app operates in the background (which many Facebook users are only vaguely aware of), Facebook can create something close to consumer-targeting nirvana for consumer marketers across the globe. Inevitably Facebook can squeeze exceptional value from the rest of the chain as a result and, since there is limited or no real terms growth in the spend through the chain, the other segments feel the pain.

Put these five factors together and the result is a fast expanding, elephant of a business with the turn of speed of Usain Bolt.

Can Facebook Inc keep the momentum going beyond its 12-year sprint?

Facebook Inc’s revenues have grown, on average, by almost 50% each year for the last 5 years. 2017 is on track to sustain this. There are several reasons to believe the company can keep rapid, compound growth going for at least the next few years.

Instagram could achieve revenues of $10bn by 2019.

The strength of this value chain segment is phenomenal. At present only the Facebook platform is being effectively exploited as a revenue earner with the company’s other social platforms at very different stages. Instagram is growing users and time spent more quickly and is beginning to be effectively commercialised. Instagram is becoming the international storefront for brands and 1.5 million companies now have business accounts. Citi’s analysis, which assumes a direct correlation between users and time and advertising revenues rising to match those of Facebook argues that Instagram could achieve revenues of $10bn by 2019 – punchy but possible. Messenger and WhatsApp are further away from establishing their business models but the three-step Facebook Inc monetisation process is in progress and creates the prospect of a pipeline of fresh, potential, high growth revenue streams.

Facebook Inc is no monopolist of this value chain segment but is certainly dominant. The competition has proven far less threatening than many expected. Snapchat’s growth has slowed and daily active users at 170m with 71m in the US are dwarfed by the reach of Facebook Inc.. Facebook has the benefit of the networks it has already built up and can simply copy the best Snapchat innovations. If the bigger, more connected network offers everything that the smaller one does, why sign up to the smaller one? Twitter monthly user numbers have stalled at around 320m and show little sign of re-gaining momentum and Twitter is a platform that lacks the consumer data and the targeted advertising opportunities that fit more naturally onto Facebook Inc’s platforms.

There have been warnings from Facebook Inc that the loading of advertising on the core Facebook platform may hold back revenue growth since there simply isn’t the inventory available to satisfy demand. Inevitably, the point when users become annoyed by advertising will come if volume keeps growing but a look at the feeds of friends suggests that this is less of an issue now, though perhaps this will change in the frenzied lead-up to Christmas when advertising spend peaks.

Facebook has options. The first is to increase price. ARPU has grown steadily but Facebook could use its power to squeeze rates higher and could introduce new, premium advertising formats, particularly if it can create more attractive video advertising opportunities. Advertising loading is rising but Facebook has enormous reserves of data and could, by targeting advertising more effectively, achieve higher response rates for clients to justify hikes in yield. Facebook has just released functionality that allows retailers to target consumers who have visited their locations, for example, using the power of the app’s geographical data. One suspects that Facebook is a little scared of its own powers in this area and are aware that users might become spooked by pure demonstrations of just how much Facebook knows about them. Expect this power to be introduced gradually in the same way that Facebook has wrapped previous increases in advertising volume and profile-based targeting by carefully using friends to place advertising in a reassuring and often useful context – such as introducing brands and products liked by your friends.

Facebook’s move into video has been a spectacular success. In the fast scrolling world of Facebook, video has brought more entertainment, longer user sessions and new and advertiser-friendly habits. Now Facebook is innovating in this area, creating bespoke programming with a range of media owners on Watch and is also experimenting with sports rights, starting with Major League Baseball in the US. The recent bid for the streaming rights to Indian cricket shows global intent, even if they missed out to Star, the network majority owned by Murdoch’s 21st Century Fox. If the move into programming and rights works, the triple whammy of more users (sports rights bring new user groups as Sky has demonstrated), deeper loyalty (narrative and passion based programming creates habitual behaviour) and higher advertising rates (brands love Facebook targeting and by linking this up with quality programming the company should win more advertising dollars at higher premiums) should benefit Facebook significantly. Facebook has a huge advantage with its direct access to the largest available global audience, which will help to cover rights costs, even if these costs mean that current super-margins may fall a smidgeon. Facebook would then have the firepower to make serious inroads into television advertising markets globally, worth over $70bn in the US and $35bn in Europe.

Friendster was killed by MySpace, which was in turn replaced by Facebook, all in around 8 years.

What could go wrong?

Powerfully positive networks effects that create rapid growth are equally vicious in decline, destroying usage and revenues with the same speed that they were created. Friendster was killed by MySpace, which was in turn replaced by Facebook, all in around 8 years. Orkut, a Google owned social networking site in emerging markets saw the loss of consumer interest and engagement rapidly turn into a death spiral. Orkut went from being one of the most popular sites in Brazil and India to closure in 6 years.

Could this happen to Facebook?

The answer must be ‘yes’ – switching costs for consumers of and advertisers in social media are low and the entry cost of building a social network, if it goes viral, is relatively low. Instagram was created by 13 employees until it was acquired by Facebook. But Facebook has shown considerable skill in managing the health of its social brands by steadily growing their dominance over a dozen years. Facebook has also become an increasingly emotion-free platform. Facebook is not a platform deeply connected to music, trend or an audience group. Instead, Facebook is becoming something closer to a functional utility delivering a range of social experiences through its feed and that most people use it without thought or feeling. So ‘yes but increasingly unlikely’ feels like a more accurate answer.

The advertising market is competitive and there is another large beast diving into the market – Amazon. This is a more serious threat since Amazon can truly compete in the same segment of the value chain as Facebook and Google. It gathers vast amounts of consumer data for free which it can then sell back to advertisers and Amazon’s data goes to the heart of purchase decision making even if their data on broader interests and media behaviours is less strong. Facebook’s biggest defence against new competition is simply scale – Facebook’s reach is approximately 7 times Amazon’s customer base.

Under 25s and teens have reduced their usage steadily over the last 4 years.

Facebook struggles with the young. Under 25s and teens have reduced their usage steadily over the last 4 years. This is a visual generation that prefers Snapchat and Instagram’s picture and video driven interface and the entertainment of emojis, annotated pictures and altered images which evaporate. This is a challenge that Facebook feels deeply. It is the platform’s deepest, long-term weakness and the reason why Instagram is so important to the wider company’s future. Facebook hopes that its move into video, short formats and rights will create hits that will reinvent the Facebook habit for this generation, creating must-see video formats that will draw them back.

So how long will the elephant keep up its 50% compound growth sprint?

For the next 3 years, the drivers of Facebook Inc’s growth seem too powerful not to succeed at a sprint even if times slip from Usain Bolt pace to those of Linford Christie. On the Facebook platform, the combination of continued success in video with steady audience growth, more audience time and greater use of the vast reservoirs of consumer data will drive ARPU and naturally compound revenues rapidly. Instagram’s user base is growing far faster and the brand is already defining itself as a key shop window for brand advertisers with new advertising formats scaling up the revenues. WhatsApp and Messenger should generate further revenue streams with the commercial creativity that Facebook does so well. If Facebook’s touch remains as secure as it has been, these factors should push Facebook Inc revenues as far as $75bn by 2019. Google will remain ahead – Alphabet’s revenues were $90bn in 2016 – but with Facebook Inc’s operating margin at nearly double that of Alphabet, the elephant could easily be more profitable.

What will Facebook do with as much as $30bn of cash per year?

What will Facebook do with as much as $30bn of cash per year? It certainly gives the firepower to make fresh acquisitions, defend that critical position in the value chain, invest in more development power and fend off regulatory threats.

As Facebook draws perhaps an additional $50bn of revenue from the global advertising market in the next few years, the implications for ‘traditional’ media owners without data power and global scale, will be dramatic. The effect will be magnified as other global players such as Amazon grow their share in parallel. The pain already felt by traditional publishers of newspaper, magazine and lifestyle publications has been enormous but still has a way to go. Television is next in the firing line. But that is a story for another day.

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About Tim Ewington

Co-founder of Shortlist Media. Previously co-founder of media strategy consultancy, Human Capital. Still innovating, consulting and investing.
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