Here's Why Facebook Expects Margins to Drop

Facebook (NASDAQ: FB) is unquestionably a social media leader and, more generally, a technology giant. Last quarter, the company reported that daily active users grew 11% year over year to 1.47 billion, while monthly active users expanded 11% to 2.23 billion. The company generated $13.23 billion in revenue (up 42% versus the prior-year quarter) and turned in a whopping $5.86 billion in operating income -- a year-over-year increase of 33%.

The company's business is also quite profitable, with the numbers above implying an operating margin of slightly over 44%.

With that being said, the company's operating margin percentage was down from just over 47% in the prior year, as operating expense growth outpaced revenue growth. Here's why investors shouldn't expect that trend to reverse anytime soon.

Operating margin compression set to continue

During the conference call accompanying Facebook's second-quarter earnings release, CFO David Wehner disclosed to investors that the company is expecting its operating expenses to rise between 50% and 60% in 2018 relative to 2017 levels. The company's revenue isn't expected to grow by the same rate (analysts' consensus calls for Facebook to turn in around 36.9% revenue growth this year), hence the company's operating margin is set to decline in 2018.

The decline in 2018 isn't a one-off phenomenon, either. Wehner went a step further and said that "we anticipate that total expense growth will exceed revenue growth in 2019."

When operating expenses grow faster than revenue, operating margin percentage comes down.

Wehner didn't end the discussion about future operating margin trends there, either. The executive explained that "we would anticipate that our operating margins will trend toward the mid-30s on a percentage basis."

It's important to realize, though, that a compression in Facebook's operating margin doesn't necessarily mean that its total profits won't grow. Instead, it simply means that the company's operating expenses will outgrow revenue. Based on current analyst estimates for 2018, 2019, and 2020, Facebook is still expected to enjoy double-digit operating profit growth.

What's Facebook spending on?

Investors are probably interested in knowing what Facebook is planning to spend all that money on. Fortunately, Wehner provided some insight there, stating that "In addition to increases in core product development and infrastructure, this [operating expense] growth is driven by increasing investment in areas like safety and security, AR/VR [augmented reality/virtual reality], marketing, and content acquisition."

In explaining the rationale behind these incremental investments, Wehner offered the following:

The executive then talked up the fact that Facebook is "continuing to make big investments in innovation."

The reality is that not all investments -- especially for a large company like Facebook that invests many billions of dollars on a wide range of products and projects -- are ultimately going to yield financial returns.

On the bright side, Facebook did attribute some of the expense growth to "increases in core product development and infrastructure." I think it's generally a good idea for companies to invest heavily in the businesses that throw off a lot of cash today so that they can continue to do so in the future.

Additionally, given the noise around security and privacy (Facebook recently disclosed a fairly significant security breach), it makes sense for Facebook to increase its investments there. It's also probably good from a brand image perspective for Facebook to signal that it's making those investments (which Wehner said "are in the billions of dollars per year"), too.

As far as fields like augmented reality and virtual reality, Wehner was quite candid that these investments have a "longer-term return window," and are revenue streams "that will take longer-term to pay off, and those would have a dilutive effect on margins in the near-term."

Clearly, Facebook is willing to leverage its enviable financial position today to make many significant bets on the future. We'll see over the next five years or so how smart those were, but given how much Facebook stock has appreciated since it went public, the company certainly has a good track record of making good long-term investment decisions.

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Ashraf Eassa has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Facebook. The Motley Fool has a disclosure policy.