Facebook and Google: How Online Ads Will Do In the Next Recession

Investors of Facebook (FB) and Google (GOOGL) have been worried about privacy issues and now anti-trust issues for the past couple years. I think an even more important question though, is how cyclical are their ad revenues?

Theoretically, advertising should be highly cyclical. Advertising acts as weapons in business wars for market shares gains, which primarily happens during an expansion.

Think about all the subscale/unprofitable startups that spend over 100% of revenue on sales/marketing. They’re willing to spend lavishly on advertising under the logic that market share begets more market share (network effect); that they will be able to retain customers, and therefore the lifetime value of those customers should exceed sales and marketing expenses. These companies are generally cash flow negative and depend on external funding. In a liquidity risk-off situation that funding get cut off, and their advertising spends on FB and GOOGL could come to a sudden halt.

In short, companies (especially SaaS guys) are treating advertising expenses as capital expenditures, and thus advertising revenues should reflect more cyclical characteristics.

This points to a downside scenario for Facebook and Google (disclosure: I’m long both). We will at some point hit a recession. Google and Facebooks’ revenues may not just stop growing but actually decline (volume and price both drop). Then you have operating deleveraging, lower margins, and earnings and free cash flow gets destroyed.

What Happened During 2008-2009

The easiest way to see how something might fare in a recession is check how well it did during 2008-2009. There the data is surprisingly good – online ads actually did well during the great recession. Google’s revenue growth slowed but never turned negative. 

Here’s a Harvard Business Review article from 2009 that discusses the strength of online advertising:

“Despite a deepening recession, marketers spent 14% more on online ads over the first three quarters of 2008 than they did over the same time frame in the previous year.”

There are structural and cyclical components to this phenomenon. The structural part is easy - digital ads were in its early innings during that time as people were still moving online.

The cyclical component is also intuitive. Companies become more budget conscious in a recession. They want more measurable ROI and more precise targeting as opposed to a scattershot approach. Both factors favor digital ads over broad based TV ads.

People also lean on their social networks more in a downturn, for job networking as well as emotional support. This resilient usage of social networks makes it a good media for ads. 

Differences Then vs Now, Conclusion

Granted, the current situation has important difference compared to 2008. Online ads are no longer in the early innings – 2019 will mark the first year digital ads make up over 50% share of advertising market. Furthermore, Google’s revenue was growing 50-60% a year heading into the 2007 downturn compared to the mid to high teens growth rate it now shows.

Both Facebook and Google have made strong moves into video advertising, where they still have the advantage of more quantifiable ROI and precise targeting against traditional TV. However, the competitive edge is less overwhelming nowadays with smart TVs like Roku that can also do targeted advertising.

The two companies will also have to fend off new entrant Amazon.

Despite these differences, some of the behavioral patterns should still hold. In a recession I think people will still network more, lean on their social circles more, and probably spend more time online searching for jobs and information.

Weighing these factors, my recession scenario for Google and Facebook is as follows:

• Ad prices should take a hit to maintain ad buyer ROI – (as conversion rates go down in a recession).
• Volume down 5-10%.
• Overall mid teens decline in revenue.
• Margins and earnings will take a hit and stock prices will get punished as well. 

Looking beyond though, there’s no question FB/GOOGL have the balance sheet to survive a recession. Once recession recovers, ad volumes would spike back up.

So for the long term investor, the question goes back to structural growth opportunities. Here the prospects are bright. Both companies continue to develop new products, both for consumers and for advertisers. Both have established strong presences in digital video advertising and taking the lead in trialing new formats to optimize advertiser ROI. From that perspective, they’re still in the early innings.