Facebook Isn't Going to Stop Spending Any Time Soon

By Motley Fool Staff Markets Fool.com

Facebook's (NASDAQ: FB) guidance calls for big spending increases to continue investing in the business. In this segment fromIndustry Focus: Tech, Motley Fool analyst Dylan Lewis and senior tech specialist Evan Niu, CFA,discuss the guidance from the company's most recent quarterly call, and what investors should expect in the future.

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A full transcript follows the video.

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This video was recorded on May 5, 2017.

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Dylan Lewis: For Facebook's main platform, payments and other fees is really the only segment that's declining, or not really showing impressive growth. There's not a huge surprise there, it's all revenue that's tied to games and in-app purchases on the platform. It's a tiny, tiny part of Facebook's top line. I wonder if that would be something that would resonate more on the messaging side. I could also see them doing something along the lines of how ads appear in Gmail right now, where it's part of the experience, it's there, but it's not super intrusive. I'm sure they have a lot of market research that would lead them to either steer toward that or away from it, though.

Evan Niu: Yeah, kind of like the sidebar display ads on the desktop platform for Facebook?

Lewis: Yeah, exactly. Looking forward with Facebook, and looking at their guidance, unfortunately the company is pretty numbers-light when it comes to what might be coming in future quarters. The biggest thing that we have to go off here is a quote from David Wehner, who is the CFO. He said, "We continue to expect that we'll see deceleration in ad revenue growth, and that's going to be particularly pronounced as we get to the second half of 2017 because ad load will be a less significant factor driving growth starting in the second half." I think the message from management is, curb your enthusiasm a little bit. They posted basically 50% year-over-year growth here. I don't think that's going to continue. We don't really have a whole heck of a lot else to go on, though, unfortunately.

Niu: They did give a little bit of guidance in terms of the expense side, even if they didn't clarify on the revenue side. They did say GAAP expenses should go up 40%-50%. With revenue last quarter being up 50%, if that's decelerating, that does imply a little bit of margin contraction if expenses are going to keep rising at that same rate while ad revenue gross was down a little bit. Again, as we mentioned earlier, they have pretty healthy margins to begin with, so it's not a huge issue if that contracts a little bit. But to put that percentage growth into context, that would put 2017 total costs and expenses to about $21 [billion]-$22 billion. Last year, it was about $15 billion. That's a pretty big jump up in terms of expenses. A big piece of that is the capex. 2017 capital expenditures are expected $7 [billion]-$7.5 billion, which they said, they're really ramping up infrastructure investments, which makes sense, because Facebook is so big that it made sense a long time ago for them to really take control of their infrastructure. During the quarter, they did break ground on their their ninth data center in Nebraska. They definitely are investing very heavily on the infrastructure side to really support future growth.

Another quote from the call that's forward-looking that I think is important is, Zuckerberg said something about how, in the next 10 years, they're going to keep building these consumer use cases around technologies they think will be a big part of their business eventually, maybe not for a little while. So, generally, I do like that long-term thinking. 10 years is a pretty long timeline to be putting together these strategies. To invest now certainly makes sense, given how good they are at the data center side. Their infrastructure is really impressive in terms of how much they've built it out over the past few years. Again, they're now on their ninth data center. That is wholly owned. It's only theirs, it's not shared with anyone. They control their infrastructure, and that's probably one of the biggest advantages that they have, is being able to invest in it and have control over how it operates. But, yeah, I think we're going to continue to see them investing heavily in this infrastructure piece. Just need them to put up the growth to help cover those costs, even if there's a little bit of margin contraction.

Lewis: Yeah. I think if we're looking for takeaways for investors with Facebook, I'm a shareholder, I was pretty happy with the results all in all. I know there was a little sell off immediately after they posted. If you want to get a sense of what's going on with properties like Instagram, you have to watch monthly active users and gauge things from there, unfortunately. I think there's still a lot of excitement about what they're going to do with the messaging apps. Over the last year, they've been a little bit clearer in actually talking about what they might be doing in terms of monetization. I don't think we're near that any time soon, but it's clearly something they're thinking about and testing quite a bit. So, that's a big growth runway for them. I still see a lot of stuff that I really like with this business. I don't know about you, Evan?

Niu: I'm also a shareholder, and I'm a big fan of everything they do. I think they're executing very well. To play devil's advocate for a second, I will say, one thing I've mentioned repeatedly over the past few years is, it's been years since they bought WhatsApp, and I'm still skeptical about what they paid for it. They paid some $20 billion for a messaging app that had no revenue. I know their plan is to build this business with it. But it's just so much money. When you pay so much for an acquisition like that, you create so much risk for yourself. If you look at the balance sheet, they have something like $18 billion or so in goodwill intangibles, the vast majority of that is because of this WhatsApp acquisition. If you compare that to Instagram, Instagram is $1 billion. And at the time, everyone thought that was crazy. But now, in hindsight, that's been one of the best acquisitions they ever made because of how much it's growing. But, $1 billion compared to $20 billion, it's a pretty different bar in terms of how well you need to execute to justify that later on. Very specifically, if you can compare WhatsApp to Messenger, these two platforms are very similar in terms of user size, how they're going to monetize it. But Messenger, they developed in house for way less than $20 billion.

Lewis: Yeah, that's true.

Niu: WhatsApp they bought for $20 billion, and now you have these two businesses that are both doing really well operationally, still early days monetization. But one, you paid a whole ton of money for, and the other you paid almost nothing for, because you made it yourself. There's just so much risk. If WhatsApp doesn't work out later on in terms of monetization, they will have to end up taking a humongous impairment on that goodwill that's sitting on the balance sheet right now. I'm not saying that's going to happen, but it's a huge risk factor that's just sitting there on the balance sheet, it has been sitting there for years, and eventually, if they can't make it work out, it's going to be a big hit for shareholders. Hopefully, they will. But it's a huge risk factor that I haven't been able to ignore, and it's still very prominent, and I still don't understand why they paid so much.

Dylan Lewis owns shares of Facebook. Evan Niu, CFA owns shares of Facebook. Evan Niu, CFA has the following options: long January 2018 $120 calls on Facebook. The Motley Fool owns shares of and recommends Facebook. The Motley Fool has a disclosure policy.