We like Meta (NASDAQ:META). It’s a simple story. The company generates revenues and earnings by running advertisements on social media networks it owns and operates. Predominant among the platforms is Facebook, which although admittedly appears reaching saturation point in subscriber growth, is still the largest social media network on the planet, profits associated with which are unlikely to disappear overnight. Meta’s Instagram platform, which capitalizes on the growing popularity of image and video sharing among 18 to 34 year olds, social media’s key demographic, is rapidly expanding its subscriber base. Further, the firm’s WhatsApp application, which presently is barely monetized as it does not display advertisements, represents a significant potential growth driver, as policy eventually shifts, and advertisements become central to the service. Based, on these segments alone, META appears well-positioned for growth.
Nevertheless, to counter the eventual demise of Facebook, and to ensure growth over multiple decades, the company is investing substantially in research and development efforts associated with a virtual reality based communication network, called the metaverse, which thought leaders believe is the next iteration of the internet. The project is ambitious not only because the metaverse is still an abstract concept, but also because the endeavor will require massive investments of resources and time on the part of Meta. Nonetheless, as a pioneer of the metaverse, the corporation will secure considerable first mover advantage to attain a near monopoly on advertisements in the space, once it is established. (Although additional metaverses are being built, given the scale of META’s metaverse, we consider it the metaverse).
Considering the current and future growth opportunities associated with its business, Meta is a mandatory investment for folks that are willing to ignore short-term environment driven headwinds, to secure significant returns on investment over an elongated time horizon. We are initiating on META with a Buy Rating and 1-year Price Target of $398/share, based on inputs to our 10-year Discounted Cash Flow model, which includes a perpetual growth driven terminal value.
Investment Thesis
META was founded as Facebook in 2004, at Harvard University. The company’s headquarters are located in Menlo Park, California. Meta has offices in 80 countries across North America, Europe, the Middle East, Asia Pacific, Africa, and Latin America. In addition, the firm’s 18 data centers are situated all over the world.
META’s business is comprised of two segments: Family of Apps (FOA), which includes revenues from Facebook, Instagram, Messenger, and WhatsApp; and Reality Labs (RL), which generates sales from virtual reality (VR) headsets, augmented reality (AR) smart glasses, and the Horizon Worlds, metaverse platform. Over nine months ended September 2022, FoA represented 98.3% of total revenues (advertisements contributed 97.6%), and RL accounted for 1.7%. In addition, during FY2021, 43.7% of total revenues were attributed to North America, 24.6% to Europe, 22.7% to Asia Pacific, and 9% to the rest of the world.
The predominant issue that appears to be concerning investors about Meta is whether the recent unfavorable change in the firm’s business performance is fundamentally driven? The secondary element surrounding the story is what is the long-term financial outlook for META? We provide answers to the queries below.
Better Days Ahead Business Poised For A Recovery
Over nine months ended September, 2022, Meta experienced a perfect storm of events that reflected in severe underperformance in financial outcomes, compared to recent years. However, based on our analysis, the factors that drove the downturn are not systemic, and are likely to reverse as macroeconomic conditions improve, and strategies the firm has implemented to ignite growth begin to generate traction. Overall, the current challenges appear unlikely to have any long-term implications for META. Based on the strength of its business segments, the company appears well-positioned to deliver growth for awhile.
Facebook is Meta’s largest profit center. When the service was launched in 2004, it was the only social media network of its kind, where people could interact. Therefore, the platform’s user base expanded exponentially over a limited span of time. However, the day of Facebook has come and gone. Nowadays, a significant fraction of the activity it experiences is within the older population, with families using the service to remain in touch. Younger folks, between the ages of 18 and 34, and particularly teenagers prefer images and videos to communicate, as well as immersive 3D experiences provided by video games.
Therefore, although Facebook’s monthly active user base continues to advance, the growth is down to single digits, even in stronghold regions, such as Asia Pacific. Even META’s internal research revealed that ~45% of the platform’s teenage population is likely to defect between 2019 and 2022. In addition, given that Facebook is well penetrated in almost all countries, except territories such as China and Iran, the brand has limited white space to secure growth through expansion.
Given the dynamics, Facebook’s monthly active user base appears poised to shrink, eventually. Therefore, as advertisement revenues are a function of impressions and clicks, it appears likely that Facebook’s advertisement revenue growth will continue to decline. However, considering the platform’s most recent monthly active user base of ~2.96 billion, the shortfall will take awhile to turn material. Facebook’s revenues are unlikely to disappear suddenly.
Instagram is Meta’s image and video sharing application. It is the company’s response to the fading popularity of Facebook due to its focus on text as a primary medium of communication. Given Instagram’s concentration on images and videos, it is highly popular among 18 to 34 year olds, which constitute ~62.2% of its subscriber base. To benefit from the high demand associated with video content, META added the Stories and Reels features to Instagram. Stories encourages users to share their day in form of images and/or videos that disappear within 24 hours. Reels provides subscribers the opportunity to share 15 second videos, that also disappear within 24 hours.
Stories was launched to counter Snapchat’s (SNAP) popularity and successfully stymied the brand’s growth. Reels was introduced to mitigate the impact of TikTok, and since the platform’s launch in early 2022, has managed to garner more than half the viewing time of TikTok, outside of China. As TikTok is banned in India, it is shut out of a potentially large market. In addition, TikTok bans are being implemented on devices associated with the U.S. government.
Based on estimates, ~2 billion users log into Instagram every month. The platform’s revenues are expanding rapidly and reports suggest that they have surpassed those associated with Facebook’s U.S. operations. The recent momentum in Instagram’s sales is likely to be sustained, based on several elements.
These include, growth in the subscriber base due to: further penetration in the U.S. market, where research indicates that Social Media Influencer is among the top aspirational career choice among teenagers; greater adoption of the service in developing markets where uptake remains relatively low; and improved penetration among the ~3.7 billion FoA users that are not currently enrolled in Instagram. As advertisement revenues are driven by impressions and clicks, larger audiences represent opportunities for greater monetization. In addition, Instagram revenues are poised for an uptrend, as cost per click in markets outside the U.S. catch up with monetization rates associated with Facebook, in those territories. Overall, Instagram appears to represent a strong long-term growth driver for META.
WhatsApp is a Meta platform that subscribers can access to deliver texts and images, one-on-one or as a group, through the internet, as compared to SMS that requires a telephone service. The initiative supports voice calls, video calls, and recorded voice messages. Since its acquisition by META in 2014, WhatsApp has expanded rapidly and currently is estimated to have a monthly active user base of ~2 billion people, across the globe. The platform is available in 180 countries and in 60 languages. WhatsApp is most penetrated in Europe, specifically the Netherlands, at 85%, as well as Spain and Italy at 83%. With ~488 million, monthly active users, India is WhatsApp’s largest market.
With respect to revenue growth, the home market of the U.S. with merely ~29 million users, represents an opportunity. In addition, although WhatsApp is presently monetized through payment systems and premium features, Meta does not utilize the platform to generate advertisement revenues. However, reports indicate that the company might introduce advertisements within the Status feature of WhatsApp. Nevertheless, as policy is likely to eventually shift towards running advertisements on core segments of the service, potential advertisement revenues from WhatsApp, represent a long-term growth driver.
In regard to the pipeline, META is focusing its efforts on developing the metaverse, a 3D virtual space currently experienced primarily by gamers. The platform is a digital space that folks can access individually or within a group, for work, sports, fitness, entertainment, travel, and gaming. Face and eye movements as well as physical actions performed in the real world get simulated in the virtual space, noticeable to all participants, partaking in the activity. Presently, the metaverse comes alive when one wears a VR headset, but eventually when you put on a pair of smart glasses as a form of AR (also called mixed reality), where the digital world gets superimposed on the real world. Beta versions of Meta’s VR headset Quest 2, and that of its Horizon Worlds metaverse are now available to early adoptees of the technologies.
META’s objective is to establish the ecosystem of the metaverse, including the structure and protocols associated with presence, avatars, home space, teleporting, privacy, safety, interoperability, governance, and virtual goods. In addition, the company seeks to develop a metaverse platform for work, where colleagues can meet in a conference room and collaborate. The Horizon Workspaces beta version is integrated with Microsoft’s (MSFT) Windows, Office 365, and Teams, and includes a whiteboard, where what a participant writes on his desk gets reflected. Meta’s metaverse project was announced in October 2021, and is in very early stages of development. Expectations are that the initiative will require more than a decade to become functional enough for mass consumption.
With respect to monetization, the metaverse will derive a majority of its revenues by running advertisements in the space. To illustrate, Coca Cola could sponsor a pavilion, Procter and Gamble could promote its products on a digital billboard, Ford could pay for the use of its virtual cars in the space, Gucci could launch a virtual store, and Comcast could sponsor signage, plying its wares. Additional revenues could be generated through the sale of virtual real estate and varieties of status symbols.
Revenues associated with the metaverse are expected to be several times that of Facebook, as while folks might be accessing Facebook multiple times a day, they would be spending significantly larger fractions of their day, immersed in the metaverse. Based on META’s projections, within a decade of launch, time spent in the metaverse could reflect that spent watching television in the 1990’s, or perusing Facebook in more recent times. Moreover, considering that Meta is building the metaverse block by block, first mover advantage could provide the firm with a land-grab opportunity to secure the largest advertisement contracts, for significant time horizons.
The project is certainly ambitious, as it requires over hundred billion U.S. dollars in spending, and roughly a decade of effort. However, given that the payout associated with the metaverse is likely to substantially exceed that of Facebook, which considering competitive conditions appears poised to incur heavy losses in advertisement revenues over time, the endeavor appears necessary and prudent.
Overall, with Instagram and WhatsApp as long-term drivers of growth, Facebook as a still powerful franchise, and a pipeline with the potential to establish VR and AR on Main Street and ensure the firm’s growth for decades, META appears well-positioned.
Business Fundamentals Indicate Strong Growth Over Numerous Years
Meta has underperformed over nine months ended September 2022. Factors that drove the shortfall in earnings included lower growth in advertisement revenues due to: promoters limiting spending to adjust for lower expected sales as a function of macroeconomic weakness; unfavorable foreign exchange dynamics related to a stronger U.S. dollar; and the change in Apple’s (AAPL) policy towards off-platform tracking, whereby applications distributed through devices running iOS 14.5 or higher are required to request user permission for permitting cookies, damaging META’s ability to personalize advertisements. In addition, over the duration, spending increased substantially due to investments in infrastructure and significant expansion of the workforce.
Specifically, for nine months ended September 2022, revenues were ~$84.4 billion, representing flattish year-over-year growth, net income came in at ~$18.5 billion, reflecting a decline of 16.3%, compared to the same period over the prior year, and earnings per share was $6.82 versus $10.11 over nine months ended September 2021. During the period, total operating income was ~$22.5 billion, representing a decline of 34% on a year-over-year basis. FoA operating income was ~$32 billion, reflecting a decrease of 22% over the prior year’s same period.
For nine months ended September 2022: FoA revenues were ~$83 billion, representing flattish growth on a year-over-year basis, comprised of advertisement revenues of ~$82.4 billion, largely inline with the previous year’s same period; and RL revenues were ~$1.4 billion, reflecting an expansion of 3% compared to the nine months ended September 2021 period.
In addition, as a percentage of revenues, cost of sales of 20%, advanced by 100 bps relative to the same period during the prior year, research and development expenses of 30%, escalated by 9% on a year-over-year basis, marketing and sales costs of 13%, increased by 200 bps compared to nine months ended September 2021, and general and administrative spending of 10%, expanded by 200 bps, versus the same period over the previous year.
Further, compared to nine months ended September 2021, gross margins decelerated by 100 bps to 80%, operating margins contracted by 14% to 24%, and profit margins decreased by 13% to 22%. FoA operating margins were 41.9%. At the end of nine months ended September 2022, META had cash and cash equivalents of ~$14.3 billion, and long-term debt of ~$9.9 billion, on its balance sheet.
Although, recent financial results appear dismal, it is important to note that elements that drove the underperformance appear transitory, and unlikely to reflect in long-term repercussions on the company.
The global economy will eventually recover and the U.S. dollar will revert to its median trading range. Moreover, to mitigate the revenue losses associated with AAPL’s updated cookies policy, Meta is utilizing artificial intelligence and machine learning to derive superior insights from first party data. Furthermore, to support the firm’s efforts, advertisers are bringing in their own data on customers, and utilizing Facebook’s user engagement information. In addition, advertisements are leveraging subscriber interests to support personalization and targeting.
On a secular basis, considering business conditions described above, we expect FoA revenues to advance significantly. In addition, margins are likely to improve due to: revenue leverage associated with higher sales growth; and lower spending, as the recent down-sizing of the employee base takes effect, hiring related to the metaverse moderates, infrastructure development contracts, and metaverse expenditures level-off, as the endeavor evolves into later stages of development. Considering the potential growth in revenues and margins, earnings and free cashflows are likely to surge, over an extended period, in our judgment.
Incorporating these inputs into our 10-year Discounted Cash Flow model, we arrive at a 1-year Price Target of $398/share for META. We assume a normalized 10-year revenue growth rate of 18%, (vs. the FY2021 revenue growth rate of 37.2%). Based on our analysis of META’s historic financial reports, we model normalized 10-year operating cash flows as 35% of revenues/year and straight line 10-year capital expenditure as 16% of revenue/year. Furthermore, we deploy a perpetual growth rate of 3% and a weighted average cost of capital of 7% to reach our terminal value and present value of free cash flow figures. We utilize the current diluted outstanding share count of 2,687 million to arrive at our 1-year Price Target.
It is noteworthy that we have not projected sales and earnings related to the metaverse, as its expected launch time-line is beyond the duration of our valuation model. Financial outcomes associated with the metaverse are evolving. The firm expects the sale of ~100 million in VR and AR hardware within in a decade of launch of the platform. In addition, Meta believes that a metaverse subscriber base of ~100 million would generate more revenues than a user group of ~1 billion in the real universe.
Risks
Zuckerberg Caves Into Pressure On The Metaverse-Considering, the poor visibility surrounding the development of the metaverse, there are folks in the industry and investment community, arguing for limiting funds and efforts devoted to the endeavor. We view the criticism levied by Brad Gerstner of Altimeter Capital, and John Carmack, the former consultant Chief Technology Officer of META (who spent 20% of his time at the company), as unfair.
Most large scale projects in nascent stages of development require tremendous amounts of funding and efforts, before the requirements for resources levels off. In addition, Meta recently laid off 11,000 employees, and scaled back funding associated with some metaverse initiatives, to adjust for softer operating earnings, during recent quarters.
It is not as if the metaverse is a pipe dream. The company has announced a plan, deliverables, and a time-line. Further, the beta version of the headset that will serve as the gateway to the platform, is the best selling VR headset in the world, with ~15 million units sold, since launch in October 2020. In addition, 300,000 users are already active on Meta’s Horizon Worlds, metaverse platform.
Given that Zuckerberg changed the name and structure of Facebook to accommodate the metaverse, it appears that he is convinced that the product represents a significant leap forward in human evolution, and that META is well suited to integrate virtual reality (through the metaverse), into the every day life of the post-modern world. Further, with controlling interest in Meta, Zuckerberg has the capacity to see the project through.
Down-side case, as he pointed out in a recent interview, the metaverse would culminate in an updated version of MSFT’s Xbox, which given the gaming platform’s FY2022 revenues of ~$16.2 billion, appears worthwhile.
Bottom Line
META is one of the planet’s largest companies, in terms of profits. Not surprisingly, the business has strong foundations. Near-term downturns in earnings are par for the course for large corporations. A lot has to unfold for them to definitively be driven into a permanent decline. Meta is far from such conditions. The firm has significant long-term growth drivers and a strong pipeline. The current weakness in META’s stock is an excellent opportunity to gain exposure to a world-class business, which appears poised to deliver substantial returns on capital, for awhile.
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