Is A Bubble Forming In Facebook Inc.'s Advertising Business?

By Markets Fool.com

Facebook 's first quarter results showed that its advertising business was still growing at a blistering rate. The social network's advertising revenue rose 46% year-over-year last quarter, accounting for 94% of the its top line.

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Unlike Google or Yahoo, which sell as many ads as possible, Facebook limits the number of ads it displays every quarter. As a result, Facebook's average price per ad spiked 285% annually even as the number of ad views plunged 62%.

Source: Pixabay.

However, soaring Facebook ad prices have also caused critics to claim that its ads are overvalued. In a recent op-ed piece on TechCrunch, Morgan Hermand-Waiche, CEO of e-commerce lingerie start-up Adore Me, warned that Facebook's ad prices hinted at "the rise of a bubble."

Is a Facebook advertising bubble brewing?
Hermand-Waiche points out that Facebook was once a profitable way for start-ups to advertise. But when larger companies moved in, it drove up the average price of Facebook ads, which are sold via auction. Facebook embraced that spike by throttling the number of ads. That caused Adore Me's cost-per-click on Facebook to surge 180% year-over-year during its first quarter.

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Due to that pricing pressure, Adore Me reduced its Facebook spend by nearly two-thirds and diverted those expenses into TV ads. Other start-ups like BaubleBar, Dollar Shave Club, and Birchbox have adopted similar strategies.

However, smaller start-ups slashing their Facebook ad budgets won't force Facebook to change its strategy. According to Facebook, small business advertisers spend an average of just $1,825 to $18,250 per year, versus millions by larger companies.

But in February, Facebook statedthat the majority of its 2 million active advertisers were actually small businesses, although it didn't disclose exact percentages. Therefore, shedding small businesses to gain larger ones might be a more profitable route, but it could also make it less diversified and top heavy.

The problem with conversions
During the first quarter, 73% of Facebook's ad revenue came from mobile devices, up from 59% a year earlier. That sounds great, until we realize that more "conversions" -- or people clicking through ads and making purchases or other actions afterwards -- traditionally actually occur on desktops.

According to Marin Software, 63% of clicks on Facebook ads came from mobile devices during the fourth quarter of 2014, but just 34% of conversions occurred on smartphones or tablets. One explanation is that while a company might have bought a mobile ad, the intended action -- a sale, reading a report, filling out forms -- might not be as mobile friendly on smaller smartphone screens. On desktops, users click through ads and reach a full desktop site, where conversions can more smoothly occur.

Facebook bears will argue that larger companies will eventually notice that trend and reduce their spending on Facebook ads. As pricing pressure from larger companies eases, ad prices could fall in spite of Facebook's ad-limiting strategy. Since higher prices drove smaller businesses away, the top heavy business model could collapse.

Facebook investors shouldn't worry
However, the bears ignore several key facts which indicate that Facebook's ad revenue growth won't slow down anytime soon.

Research firm eMarketer estimates that between 2014 and 2017, Facebook's U.S. display ad revenues will nearly double from $5.3 billion to $10 billion. During that period, Google's U.S. display ad revenues are only expected to rise 35% to $4.1 billion.

Besides app install ads, many of Facebook's ads aren't intended to drive a direct purchase. Like business pages, many Facebook display ads are intended to build brand awareness. Therefore, a weaker conversion rate on mobile devices doesn't necessarily mean that those ads aren't leading to real world purchases. That's why Facebook has insisted for years that measuring clicks is "meaningless."

Meanwhile, critics have warned of a "social media bubble" since 2012. While it's true that some social media dependent companies like Zynga and Groupon have fared terribly, Facebook has been growing at a healthy rate. Between fiscal 2012 and 2014, Facebook's annual revenue soared 145%. Last quarter, its ARPU (average revenue per user) increased to $2.50 for the first quarter, up from $2.00 a year ago.

The bottom line
Soaring ad prices and plunging ad views won't form a bubble in Facebook ads. Smaller businesses like Adore Me might get hurt by that shift, but big businesses with larger ad budgets will easily offset those losses.

The importance of conversion rates remains debatable, but Facebook's strength lies in its numbers. With 1.44 billion monthly active users at the end of last quarter, it's become impossible for major companies to ignore Facebook ads. Therefore, as long as Facebook's user numbers keep growing, it will have the power to inflate prices by controlling the supply.

The article Is A Bubble Forming In Facebook Inc.'s Advertising Business? originally appeared on Fool.com.

Leo Sun owns shares of Facebook. The Motley Fool recommends Facebook, Google (A shares), Google (C shares), and Yahoo. The Motley Fool owns shares of Facebook, Google (A shares), Google (C shares), and Yahoo. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.