Facebook: Big Business Means More Business

Aug.12.14 | About: Facebook (FB)

Summary

Facebook diminishes its emphasis on small business ads.

Building a greater experience demands fewer advertisers, but will require higher quality ads.

Sustained growth in ad-pricing will sufficiently sustain revenue growth.

Facebook (NASDAQ:FB) continues to outperform, and it's by far one of my top performing recommendations since 2013. However, some have voiced concerns over Facebook's transition to timeline ads, and its recent move to significantly diminish the effectiveness of brand communication via status messages. In this process, small businesses were left in the dust, as Facebook focuses on ad-monetization.

A change in the timeline algorithm, paired with higher pricing on ads, has pushed some small businesses away from Facebook, according to the Wall Street Journal:

One reason some businesses' Facebook ads are reaching fewer users and costing more is that competition for ad space has intensified. Roughly, 1.5 million firms of all sizes pay to advertise on Facebook today, up from around one million a year ago. Also, there's less space available. Ads in Facebook's right-hand column recently took on a new, larger design, allowing room for fewer per page. In an April survey of 728 small-business owners, 83% said they expect to spend nothing this year on Facebook ads. But 14% said they expect to spend between $1 and $4,999 this year and 1.3% said between $5,000 and $9,999.

Facebook's change in strategy

Going forward, Facebook will become an advertising platform for medium to large sized businesses (companies with 500-100,000 employees). The pricing dynamics, paired with inked partnerships to sell and manage ad space to Publicis Groupe confirms this fact.

Going forward, small businesses will have to depend more heavily on foot traffic, search engine ads, or Groupon/Amazon local promotions. There are better options available to small business owners, and I don't believe there's a whole lot that Facebook can do to capture this part of the market.

Facebook needs better ad engagement, even as it displays fewer ads. In the recent quarter timeline impressions for ads declined, as users were served significantly less content on the timeline. Furthermore, the pricing of ads increased, and the click through rate also increased, indicating that Facebook's ad strategy with larger companies and brands seems to be working. Better ads improve the user experience.

Facebook's focus on more professional display ads keeps the newsfeed from being trashed with poorly designed ads, ads that are scams and ads that are just flat out inappropriate. Obviously, Facebook does have oversight over the type of content that goes down the newsfeed, and can prevent some forms of abuse. But that's just handling the symptoms that small business owners on small ad budgets carry.

The typical small business owner doesn't focus on ad copy-writing, and story-telling the way the professionals do. Furthermore, the budget for creating commercials that can engage a larger audience doesn't come from small businesses. You're more likely to find super bowl quality ads on Facebook from companies like Samsung, and Coca-Cola versus ads from Joe's Sandwich shop down the street. And with super bowl quality ads, comes significantly better engagement, which is why more and more of Facebook's ad space is dedicated to bigger businesses.

Source: Facebook

More big business, for Facebook, is great business for shareholders. The average revenue per user has continued to trend higher, and on a year-over-year basis, the ARPU grew by 40%. This came without any real sacrifices to the user experience, in fact; better looking ads may boost the user experience. As contradictory as that may sound, good ads may actually make Facebook a better website.

Quoted From: Theoildrum.com

Usually, I turn to classical economic theory to help explain what causes price changes. In the case of Facebook total supply declined. This was driven by a change in the newsfeed algorithm so that it would only show content that was relevant to the user. The decrease in impressions per ad, means that for advertisers to reach the same targeted audience they would have to spend more. There were more willing buyers, and the same buyers were willing to spend more as they had increased their social media ad budgets. However, fewer ad slots were made available to them. So what resulted was a massive increase in pricing per ad, which Facebook enjoyed the full benefit of. Classical economics would define this as the inward shift of the supply curve, paired with an outward shift of the demand curve. The combined impact usually leads to massive shortages, which induces scarcity, and causes prices to move exponentially higher.

Dave Wehner (CFO of Facebook) states, "In Q2, the average affective price per ad increased 123% compared to last year, while total ad impressions declined 25%."

Conclusion

The underlying investment thesis is supported by higher ad-pricing, user growth and retention, paired with product line diversification, and acquisitions. I think higher pricing paired with higher engagement is a sustainable trend over the intermediate and long-term future; therefore, I think that even at these elevated levels, Facebook is a stock worth investing into.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.