Investing in Facebook: A comprehensive primer and analysis

Part 4

Must-know: Assessing Facebook’s revenue sources

What are Facebook’s revenue sources?

Facebook generates virtually all of its revenue from advertising and from fees associated with its payments infrastructure that enable users to purchase virtual and digital goods from its platform developers.

FB revenueEnlarge Graph

Facebook calculates its revenue by user geography based on its estimate of the geography in which ad impressions are delivered or virtual and digital goods are purchased. The company defines average revenue per user (or ARPU) as its total revenue in a given geography during a given quarter, divided by the average number of MAUs (monthly active users) in the area at the beginning and end of the quarter. Facebook’s revenue and ARPU in regions such as the United States, Canada, and Europe are relatively higher due to the size and maturity of those advertising markets as well as the company’s greater sales presence and the number of payment methods that it makes available to marketers and users.

In 3Q 2013, worldwide ARPU was $1.72—an increase of 33% from 3Q 2012. Over this period, ARPU increased 40% or more in each of the four regions disclosed above. User growth was more rapid in areas with relatively lower ARPU, such as Asia and the rest of the world. Facebook expects that user growth in the future will continue to be higher in those regions where ARPU is relatively lower, such as Asia and the rest of the world, such that worldwide ARPU may continue to increase more slowly relative to ARPU in any geographic region—or potentially decrease even if ARPU increases in each geographic region.

Payments and other fees

Facebook enables payments from its users to its platform developers. Users can transact and make payments on the Facebook platform by using credit cards, PayPal, or other payment methods available on the website. The company receives a fee from its Platform developers when users make purchases using the payments infrastructure. Facebook recognizes revenue net of amounts remitted to its platform developers. Facebook has mandated the use of its payments infrastructure for game apps on Facebook, and fees related to payments are generated almost exclusively from games. The other fees revenue consists primarily of user promoted posts, ad serving and measurement products, and (to a lesser extent) Facebook Gifts revenue. Facebook said that such revenue has been immaterial in recent periods.

In 3Q 2013, payments and other fees revenue was $218 million of the company’s total revenue of $2.02 billion. Total payments and other fees revenue were up 24% year-over-year and roughly flat sequentially. This implies that revenue from payments and fees has failed to keep pace with growth in revenue from advertising. Facebook said payments revenue from games was up 18% from last year.

In July of last year, Facebook launched a mobile discovery platform Mobile Games Publishing, a pilot program that will help developers grow on mobile devices. Facebook will help small and medium developers by promoting their games across the company’s mobile apps. By having a more open games ecosystem (which was previously dominated by Zynga), Facebook has found an enhanced revenue stream, as payments from game developers have grown steadily. With Facebook’s Graph Search, businesses can search for people who like their brand’s page and play games (or a specific game). The data gathered from this search can provide insights into the type of games brand followers favor (thereby helping guide new mobile game development).

Advertising

The company generates the majority of its revenue from advertising. For the first nine months of 2013 and 2012, advertising accounted for 88% and 84%, respectively, of its revenue. Facebook reported advertising revenue of $1.8 billion in 3Q 2013. Asia accounted for $255 million of advertising revenue for the quarter, while the U.S. and Canada continued to generate the highest advertising revenue for Facebook, registering $832 million in revenues for the quarter. The company said in June 2013 that it has 1 million active advertisers globally and that the majority of them are small businesses.

Facebook offers products and tools that enable advertisers to leverage the company’s unique combination of reach, relevance, social context, and engagement. The system is designed to help advertisers show people ads that they find interesting and relevant. Facebook said in its recent earnings call that it’s continually investing to improve its ad targeting to increase their relevance.

Advertisers indicate the maximum price they’re willing to pay for their ad, per click (or CPC) or per thousand impressions (or CPM), and their maximum budget. The system also supports the guaranteed delivery of a fixed number of ad impressions for a fixed price. Facebook’s ad serving technology dynamically determines the best available ad to show each person based on the combination of the person’s unique attributes and the real-time comparison of bids from eligible ads. Facebook also focuses on analytics and measurement tools to evaluate, demonstrate, and improve the effectiveness of ad campaigns.

Facebook’s ad system

When advertisers create an ad campaign on Facebook, they specify the types of users they want to reach based on information that users chose to share. Plus, advertisers can use other products such as Facebook Exchange (or FBX) and Custom Audiences to more precisely target their desired audience.

Facebook Exchange launched in June 2012. It’s a new way of purchasing Facebook ads through real-time bidding. Through Facebook Exchange, advertisers and agencies have been able to use cookie-based targeting through demand-side platforms (or DSPs) to reach their audience on Facebook with more timely and relevant messages. For brands and agencies, the result is a powerful tool for driving direct response goals on Facebook. In October last year, Google said it’s partnering with Facebook to offer its clients access to Facebook Exchange inventory through DoubleClick Bid Manager. Other DSPs include TellApart, Triggit, Turn, DataXu, MediaMath, AppNexus, TheTradeDesk, and AdRoll.

Custom Audiences, launched in September 2012, lets advertisers find their offline audiences among people who are on Facebook, using email addresses, phone numbers, Facebook user IDs, or app user IDs to make the match. It October 2013, Facebook said it will roll out its Custom Audiences ad targeting tool to all advertisers. The feature was earlier only available through its API and Power Editor tool. With this, small businesses in particular would be able to use their current customer lists to reach people on Facebook.

For advertisers that have a large number of products and that advertise to multiple audiences, FBX is the better solution. For businesses that don’t typically work with third parties, website and mobile app Custom Audiences will allow them to show ads to people who have been to their site or mobile applications and still use Facebook’s targeting abilities.

In February last year, Facebook announced that it has expanded Custom Audiences to allow businesses to use third-party data providers Datalogix, Epsilon, Acxiom, and BlueKai to further enhance the ads they run on Facebook. In April, Facebook launched partner categories, by which advertisers could show ads to people on Facebook based on the products and brands they buy across both desktop and mobile platforms. In June, the company announced some changes to simplify Facebook ads, including eliminating different types of ads that had the same purpose and making ads look more consistent. In October, Facebook rolled out new features for Custom Audiences that expanded its capabilities to allow advertisers to deliver targeted ads to people who visited its website or used its mobile app. Facebook recently announced that marketers will no longer be able to purchase sponsored stories separately. Sponsored stories are messages that come from users’ friends about them engaging with a page, app, or event that a business, organization, or individual has paid to highlight so that there’s a better chance people see them. Instead, social context—stories about social actions the users’ friends have taken, such as liking a page or checking in to a restaurant—is now eligible to appear next to all ads shown to friends on Facebook.

Facebook announced in December that it was testing out video advertisements. Advertisers will be able to use this new format to tell their stories to a large number of people on Facebook in a short time—with high-quality sight, sound, and motion. This approach will continue to improve the quality of ads users see in their News Feed. In terms of pricing, the aim is to be a “premium advertising format on Facebook, intended to reach a large audience at specific times.”

Adobe’s first annual Social Media Intelligence Report in 3Q 2013 stated that Facebook’s ad clicks, ad impressions, and advertisers’ return on investment were all higher in 2013 than in 2012. Facebook ads were clicked 29% more often in 2013, and the ROI was 58% higher than 2012. The report said declining costs per click (or CTC) and rising click-through (or CTR) rates make Facebook attractive for brand marketing, but retailers should expect to pay more during the holidays.

The findings

• Facebook CPC is down 40% year-over-year.
• Facebook CTR is up 275% year-over-year.
• Retail CPC is to spike 42% during the holidays.

Another 3Q report by Facebook Strategic Preferred Marketing Developer Spruce Media, released in October 2013, showed that among its clients, cost-per-click prices declined in all areas but desktop. Overall, CPC fell by 5%, with two notable declines in News Feed—mobile only (24%) and News Feed—desktop only (18%). The CPC figure for desktop rose 2%. CTR went up in News Feed—desktop only (28%), Desktop (20%), News Feed—mobile only (18%), and Facebook overall (13%).

To see how design and technology changes affect advertising revenue for web companies like Yahoo (YHOO), see Why Yahoo sees an upside as Marissa Mayer attempts a turnaround.

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