Facebook powers all types of ads. Image source: Facebook.
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A little more than two years ago, Facebook (NASDAQ: FB) launched the Facebook Audience Network, or FAN. The ad network extended Facebook ads to other apps, providing app developers a new way to monetize their apps. With over 3 million advertisers working with Facebook, FAN offers developers an opportunity to tap into that huge pipeline of ads.
FAN competes directly with Google's AdMob, which has been a boon to the Alphabet (NASDAQ: GOOG) (NASDAQ: GOOGL) company as more of its revenue comes from mobile. With the recent expansion of FAN to mobile websites, it will also compete against Google's AdSense ads on third-party publishers' websites. These are multibillion-dollar products for Google.
But Facebook investors shouldn't expect billions to come pouring in from FAN. Even after reaching a $1 billion run rate in the fourth quarter of last year, Facebook's Audience Network will only add a few hundred million to the company's top line. Here's why.
How Facebook reports network revenue
Facebook CFO Dave Wehner told investors on the company's second-quarter earnings call that the company is accounting for revenue from FAN on a net basis instead of a gross basis. It won't account for the portion of ad revenue that goes to the publisher at all.
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This method stands in contrast to Google, which uses gross revenue and then tells investors exactly what its traffic acquisition costs were. For example, last quarter Google's ad network generated $3.7 billion in gross ad revenue, and network members kept 70% or $2.6 billion of that. That $3.7 billion counts toward Google's revenue, and the $2.6 billion counts toward its operating expenses.
Under Facebook's accounting, using the $3.7 billion figure, it would have just registered the $1.1 billion in net revenue. Investors will never see the other portion of revenue on Facebook's earnings report unless the company specifically discloses those numbers for some reason.
Google is providing a bit more transparency with Alphabet investors by disclosing exactly what percentage of its network revenue it keeps and what it pays out to publishers. Google is generally upfront in its terms with AdSense and AdMob participants in what percentage of revenue it shares, so it's not hurting anything by disclosing those details in its quarterly reports.
Facebook is a bit more opaque when it comes to the revenue share with FAN. In its FAQ, Facebook simply says "we cannot commit to a specific revenue share at this point." If it reported its traffic acquisition costs, developers and publishers would have a good idea of whether they're on the high or low end of Facebook's revenue share terms, and that could have negative consequences for Facebook.
How this affects investors
When it comes down to it, the difference in revenue reporting won't affect Facebook's bottom line. In fact, some investors may prefer the way Facebook reports to the way Google reports its revenue, and it's highly unlikely Facebook will break out its network revenue like Google does.
Reporting network revenue on a net basis should have a much smaller impact on Facebook's operating margin than if it reported gross revenue and lumped publishers' revenue share into its cost of revenue. In that way, investors who see a continued increase in revenue don't have to worry whether that revenue is coming from FAN or its owned and operated properties.
Twitter (NYSE: TWTR) saw its cost of revenue balloon last year as more of its revenue started coming from its ad network. Forty percent of the increase in Twitter's cost of revenue for 2015 was attributed to increased traffic acquisition costs. Overall cost of revenue grew to 33% of total revenue, compared with 32% in the prior year. Going forward, traffic acquisition costs may have a bigger impact on Twitter's margins as it starts to account for a larger percentage of revenue growth.
Facebook investors won't have to worry about that kind of margin dilution because of the way the company is choosing to report its ad network revenue. While it doesn't provide the same transparency as Google or even Twitter, investors don't have to worry about the minimal impact the product is having on the company's top line.
This is yet another conservative accounting maneuver from Facebook, as it follows the company's decision to start reporting its results on a GAAP (unadjusted) basis, while its peers continue to use non-GAAP measurements. These conservative moves show confidence in the company's ability to continue growing revenue and earnings at a strong clip for the foreseeable future, with no need to juice numbers with revenue that it never really sees in the first place.
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Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool's board of directors. Adam Levy has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Alphabet (A shares), Alphabet (C shares), Facebook, and Twitter. 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.