What Everyone Should Know Before Facebook’s Q3 Earnings Call

Facebook’s earnings call today may be the most anticipated call of Q3. The stock has tumbled since the last quarterly earnings call from a high of $217 in July to a low of $142. Three months ago, Street analysts did not think this was possible – and many still have price targets at $200. I believe bullish financial analysts are distracted by Facebook’s security costs, news feed fatigue and Instagram while underestimating the most important number on Facebook’s earnings call tomorrow –user growth rate.

Background on Facebook’s User Growth Trajectory

Facebook’s rampant growth from 2004-2017 was due to a viral coefficient formula which is also known as the k-factor. The k-factor equation was taken from epidemiology, in which a virus that has a k-factor greater than 1 indicates exponential growth. The equation for virality for websites and applications describes the growth rate:

k = i * c

i = number of invites C = conversion rate

When K is equal to one or greater, you have viral growth.

Facebook’s growth rate trajectory was exponential because people found the network more rewarding when more people they knew joined the network. The same will be true for Facebook’s deceleration, as well. As people start to spend less time on the social network, there will be viral deceleration.

To illustrate, a loss of 1 million users in the United States to Facebook is not a 1:1 loss, like it would be for Netflix or Google, where users are isolated from each other in a “silo.”

• If I stop using Google, your search results are not affected.
• If I stop using Netflix, your programming choices are not affected.
• Even Twitter can withstand user loss as the platform is not based on a reciprocal following structure. This is why a celebrity can have 60 million followers, yet only follow 135 people in return.

If 1 million users close their Facebook accounts in the United States, however, it will be subject to a negative k-factor. These 1 million people who delete their accounts weaken the content on the platform for the 50 million-500 million people who were connected to them (assuming each user has at least 100 friends and some are inter-connected).

Now, if 2 million of the subsequent 50-500 million start to use Facebook less due to the impact the original 1 million had, then another 500 million to 1 billion will have a less enjoyable experience, which will reduce time on site. If 5 million from those 500 million find the platform less interesting because their favorite people have left the platform, the affects will continue to spiral.

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This is why Snap has been a popular short. Snapchat continues to lose daily active users on a quarter-over-quarter basis in North America and Europe. Only last May, Snap began to report a sinking growth rate of 2.13 percent – which was its slowest ever at the time compared to 5 percent in Q4 2017. See below for how Facebook’s user growth rate compares.

It should be noted that this was once Facebook’s strength and Twitter’s weakness. New users on Facebook had a low barrier to entry because total friend count grew relative to how much you reciprocate and follow back. Twitter, on the other hand, has had a tough time attracting new users because there is no reciprocation.

Facebook Reported Slowest-ever User Growth Rate in Q2 2018

The viral-coefficient-in-the-reverse explains why the most important metric for investors to pay attention to in Facebook’s earnings report is the user growth rate. Last quarter, Facebook’s monthly user count grew 1.54 percent compared to 3.14 last quarter. Daily active users grew even slower at 1.44 percent, compared to 3.42 percent last quarter. Previously, the slowest daily active user growth rate was 2.18 percent in Q4 2017. If this number becomes stagnant, the social media platform can decelerate very quickly. This is also why it’s possible for Facebook to report strong earnings and there still be a sell-off. If and when this number goes into the red, Facebook will have reached its peak as a social media platform –and profits will soon follow this trailing decline.

Disclosure: I shorted this stock in April of 2018 and have a put option on this stock as of October 2018 as I expect the user growth rates to continue to decline in the near future. Readers should also note these declines are more likely to occur in high average revenue per user markets (ARPU) such as the United States, Canada, and in Europe.

Read more analysis on how I predicted Facebook earnings prior to Q2 and analyzed Facebook would face GDPR trouble following Q1 2018 here.

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