Analysis: FB GOOGL

After the bell on Wednesday, Facebook ( FB) reported a mixed result with its second quarter earnings result. Revenues of $13.23 billion (up 42% year over year) fell short of the consensus if $13.36 billion, and earnings per share of $1.74 (up 32% year over year) topped the consensus of $1.72.
 
The top line miss was one event, sending shares down to about the $200 level before the call began. But when management provided its financial outlook, the selling pressure ramped up. On the conference call, CFO David Wehner noted that the revenue growth rate decelerated approximately 7% between the first and second quarter, and he expects total revenue growth rates to continue to decelerate in the back half of the year. More specifically, Wehner guided for revenue growth rates to decline by the high single digit percentages from prior quarters over the next two quarters. One cause for the decline is a shift from currency tailwinds to headwinds, a trend similar to what we have heard from several companies reporting this season. Furthermore, Facebook plans to continue its focus on engaging experiences like Stories which carry lower levels of monetization. Management also attributed the revenue deceleration outlook to them offering more choices on data privacy. Now we knew from the company's first quarter conference call that guidance called for revenue growth rates to decelerate throughout the year, but the magnitude of this after-hours decline suggest investors were likely caught off guard when it started showing up more in the results. Plus, when the company blew away earnings last quarter, the market likely looked past these comments.
 
Next , Wehner discussed expenses, and things did not get any better. Full year 2018 total expenses are expected to grow in the rage of 50% to 60% vs. 2017 due to planned spending in safety and security, AR/VR initiatives, marketing, and content acquisition. Management believes AR and VR represents the next generation for computing, so they are sacrificing short-term dollars for a long-term return. Looking past 2018, total expense growth will surpass revenue growth in 2019.
 
Putting it all together, Wehner indicated that operating margins will trend towards the mid-30s on a percentage basis over the next few years. For some perspective, Facebook's operating margin was 44% this quarter, already down from 47% a year ago.
 
Now there is some uncertainly on the exact timeline of this drop as Wehner indicated that it is "several years, so more than 2 but less than many," but the damage was done, no less. One last point piece of guidance to point out is Facebook's plan to spend $15 billion in capital expenditures in 2018, up from $6.7 billion in 2017. Startling to see at first, but this figure is consistent with previous guidance.
Putting this all into context, the steep drop in margins, is likely the cause of this intense selling after-hours, and it will certainly force many analysts to adjust their earnings models. Expectations were just too high and need to come down. And for shareholders, it's tough to see the company emphasize spending a great deal on security and safety, two areas that will do little for near-term revenue growth. But management remained firm in their stance that this is the best course of action from a long-term perspective.
 
Digging deeper into the quarter, advertising revenue increased 42% year over year to $13.038 billion, which was about $302 million more less consensus. This result was also a de-acceleration from the first quarter when advertising revenue increased by 50%.Mobile advertising represented approximately 91% of this figure, which is an increase from the 87% number in the second quarter of 2018. This shift to mobile is similar to what we heard from Alphabet ( GOOGL) , and COO Sheryl Sandberg spoke on the call about how important mobile and video are.
 
The price per ad increased just 17%, and the number of ad impression across its services increased 21%. The ad impression result was a strong figure, indicating that Facebook's ads becoming better at targeting the user. That said, the growth rate in price per ad was not as robust as the first quarter, suggesting that the company lost some of its pricing power. Revenue from payments and other fees was $193 million, a 23% increase year over year.
 
Operating margin was 44%, which is lower than the second quarter 2017's number of 47%, and also down from the first quarter 2018 result of 46%. Facebook spent $3.46 billion on capital expenditures this quarter, a step up from the $2.86 billion they spent in the previous quarter. Expenses as a percentage of revenue were 17%, which is higher than the first quarter of 2018 and the second quarter of 2018. And with management guiding for expense growth to outpace revenue growth, we expect that figure to trend even higher.
Digging deeper into user engagement metrics, daily active users (DAUs) on average for June 2018 were 1.47 billion, slightly below estimates. The 1.47 billion users also represent a 11% increase year over year and a 1.4% increase sequentially. Monthly active users (MAUs) as of June 30 th 2018 was 2.23 billion, which was just below estimates. Year over year, MAUs increased 11%, and from the first quarter of 2018, MAUs increased 1.4%. What stands out most from the trends was the decline of 3 million DAUs and 1 million MAUs in Europe. The company attributed the rollout of GDPR as the driver of this result which they anticipated and provided guidance on during the company's first quarter conference call.
 
Once again, DAUs as a percentage of MAUs-a key metric that provides insight into consistent engagement-held steady at 66% for the tenth consecutive quarter. Although DAU/MAU continues to be stuck at the 66% level, it is encouraging to see that Facebook's daily users, which represent Facebook's highly engaged loyal fan-base, rise relative to its monthly users, who are the more passive users of the platform. And remember, the company kept its balance up after the fallout of the Cambridge Analytica scandal.
 
Worldwide, the average revenue per user (APRU) increased about 26% year over year to $5.97, which is $0.03 better than consensus estimates. So even though Facebook's total revenue and active user growth was light, the company is still generating more revenue per user. This is a real testament to the monetization power of Facebook that will be out shadowed by rising expenses. By region, U.S. & Canada ARPU was $25.91 (up 34% year over year), Europe ARPU was $8.76 (up 39% year over year), Asia-Pacific ARPU was $2.62 (up 23% year over year), and the Rest of the World APRU was $1.91 (up 29% year over year).
 
Some other key points to note. Facebook released how many people use at least one of its apps, including Facebook, WhatsApp and Instagram or Messenger, and the number is staggering. Approximately 2.5 billion people use an app each month, solidifying that the company has a large member base to monetize off. And on Instagram alone, the company disclosed that it has more than 1 billion actives and making an increasing contribution to growth. Also, Messenger has 1.3 billion monthly active users, but monetization is still in its early days.
 
Overall, there is no sugar coating this. Not a good quarter, and the margin guidance was even worse. Although many of the core business trends remain intact, it has become abundantly clear that expenses are catching up to the company, squeezing margins. We admit we didn't see this type of guidance and reaction coming, and the way the stock is acting after-hours, neither did the rest of the market. Having said that, even though shares previously looked cheap on 2019 earnings, we've kept a TWO rating on the stock due to headline risk. And now, those earnings and the company's long-term growth rates will most certainly be revised down. We'll continue to keep our TWO rating on this name despite the stock's 20% fall after hours. Our price target is under-review with downward bias to reflect the margin guidance.