It’s hard out there for a social network.
Companies can post top-line growth of over 100%, as Twitter (TWTR) did this week, and still see 10% of value wiped off the books. Facebook (FB) had a similar story, posting nearly 60% revenue growth while the market crushed its stock by 11% yesterday in after-hours trading.
The market has finally caught on to a game both companies have been playing. Social networks are spending serious cash to meet lofty growth expectations. At times, expenses they incur to obtain revenue can outpace growth in revenue itself. It’s a cannibalization story that likely won’t change anytime soon. But for Facebook and Twitter, it means two different things.
Spending at social media companies can be two-fold. First, companies spend cash to acquire new revenue by buying other companies. Facebook’s well-documented strategy is a great example. The company made pricey bets on WhatsApp and Instagram, turning the firm into something of a venture capital investor. On its earnings call yesterday, Facebook CEO Mark Zuckerberg said that shareholders should expect these kinds of expenses to continue.
The spending doesn’t stop there, however. For newer tech companies to grow, they have to invest heavily in research and development and marketing. For example, WhatsApp had only $15 million in revenue in the first six months of the year but $247 million in operating expenses, generating a loss of $232 million before including non-operating expenses.
As Facebook acquires new companies, spending at these start-ups can chip away at the earnings of the steady businesses. For example, two of Facebook’s three largest cost areas grew by 63% this quarter compared to last, outpacing revenue growth. Twitter showed similar results. It posted 134% growth in its three largest expense categories, while revenues grew by 114%.
But here’s where the two social networks diverge. Twitter is still working on its first business. Facebook is integrating smaller start-ups that it bought with cash it generated from its established business. This suggests that Facebook is in a healthier spot.
This dynamic shows up in another area of Facebook’s financial statements. The company posted margins on earnings before interest, tax, depreciation, and amortization (Ebitda) of 64%, meaning it makes 64 cents of operating cash flow for every $1 of revenue it brings in. Twitter, however, has margins of only 18%. The figures suggest that Facebook has plenty of wiggle room to invest even with its growing expenses, while Twitter could become strapped.
“We’ve noted all along that Facebook’s operating and EBITDA margins were too high relative to its peers,” said Neil Doshi of CRT Research in a note. “Facebook is going in investment mode in 2015, which we believe is the right strategic move.”
For social media companies, having excess cash to invest means everything. Zuckerberg may have to prove his investments will pan out. But for now, he has room to make mistakes. At Twitter, on the other hand, it may be another story.