Fritz Jorgensen
I have written an article on Meta (NASDAQ:META) that illustrates an opportunity for a huge rally in the second half of 2022. While the focus on Meta has understandably been more on the metaverse, I think that the opportunity for Meta in the near term lies beyond the metaverse. The real near-term opportunity and catalyst is in its Family of Apps and more importantly, Reels. As we look to Meta’s experience and learnings from monetizing and ramping up Stories, I am of the view that the opportunity for Reels in terms of engagement and monetization is much more. This article aims to explain this and provide an update on my investment case for Meta.
Reels improving engagement
With Reels, I think the message that management has been wanting to bring across is that it is growing rather quickly, and perhaps faster than they would have anticipated. As mentioned in my earlier article, Reels took up about 20% of the total time spent on Instagram, which to me, was rather encouraging given that Reels is in its early days. In the current quarter, this time spent increased by more than 30% on both Instagram and Facebook, implying that about 26% of total time spent on Instagram was in Reels.
While most of these gains in the early days are likely driven by advances Meta has made in its artificial intelligence, I also think that this proves the point of the importance of Reels and short-form videos for Meta as a social media company today. An example of AI improving time spent on Reels was that there was an increase of 15% in time spent on Reels in Facebook after the addition of a recommendations AI model. In my view, there is without a doubt that the company will need to continue to make improvements and add new AI models to, over time, increase engagement and time spent of Reels across its platforms.
In building Reels, it is becoming clear that Mark and the team have a vision for it based on the past experience in building social media products for consumers. The focus is on connecting people as a social media company and this involves creating a flywheel effect through its network. As such, the important thing is for consumers to comment on and interact on these platforms. As such, I think that Reels is headed the right way as more than half of the content that consumers have been sharing on Instagram is Reels. This implies to me that Reels is helping improve engagement on Instagram and helping elevate the platform through better interactions and ultimately create a strong moat for Meta in Instagram.
With regards to how Reels could add to time spent on Meta’s platforms, I get the sense that Reels could result in some form of cannibalistic effect on the overall company. However, management has reiterated that while there will be some form of cannibalistic impact from rolling out reels, there are incremental benefits to time spent on the company’s platform. Put it in another way, I am of the view that Reels, while having some cannibalistic impact, will see a net positive effect as short-form videos like Reels are the way to go moving forward to improve engagement in the long run. As such, it would be beneficial for Meta in the long run to focus its efforts on Reels to boost engagement of its platform.
Reels monetization shows huge potential
I think that the Meta team is doing good work in the monetization progress for Reels, given that Reels ads have officially reached the $1 billion annual revenue run rate. The progress that has been made for Reels at this point in time is actually faster than the monetization progress and pace for Stories a couple of years ago. As such, I am of the view that while we cannot hurry the monetization process for Reels as much as investors would really like to, the current progress made thus far has been really decent, especially when benchmarking it to Stories.
While Reels is currently at a faster pace of monetization in a similar time frame compared to Stories, I think we have to be patient with the monetization process for Reels. A successful strategy does not happen overnight. For Stories, the monetization journey really began in 2018 and in 2022, and the company just reached parity on it. As such, I would expect Reels to take a multi-year process to fine-tune and optimize monetization in a way that works best for the businesses, consumers and Meta.
While Meta reached a $1 billion run rate faster for Reels than for Stories, I think that the optimism that this brings should be put into perspective. This faster monetization was a result of Meta having a familiar playbook it could rely on where it has been successful in making products that its users love, and to integrate advertisement formats that works for its customers. As a result of its experience and lessons learnt from Stories, this $1 billion run rate was achieved faster than Stories. However, there are still challenges Meta faces in its monetization of Reels. One example of a challenge includes the video format of Reels being more difficult for small businesses that are more used to static photos as an advertisement format. As a result, some form of adjustment is necessary for Meta to take to drive further monetization results from Reels.
So, what is next for Reels monetization? It is really about improving the performance and ramping up of Reels ad load. The use of AI will be crucial to ensure that the relevant videos are being pushed to consumers while the relevant ads are used to target these consumers. Meta gave an example where Wild Alaskan Company’s use and testing of ads on Reels resulted in 36% return on their spend as well as 26% decrease in cost per new subscriber.
Second quarter results
While there were fears about headwinds from a weakening demand for digital advertising, Meta reported 2Q22 advertising revenues that were better than expected, rising +3% year on year. However, operating margins disappointed as there were pressures from both Family of Apps and Reality labs. This came as management was spending more in 2Q22 than expected as they invested heavily into core business investments of AI and machine learning, needing to spend and invest in talent and infrastructure. In addition, Meta continued with its share buybacks in 2Q22, with a total of $5.2 billion worth of shares being bought back.
Meta announced further reductions to its guidance for expenses from by about 3% to 4%, with the mid-range being around $89.5 billion. This lowering of expenses is part of management’s continued efforts to align the expectations and cadence for investments with its growth in revenues and margin profile.
Weakening demand for digital advertising a near-term headwind
Although 2Q22 beat on revenues and missed on operating margins, management’s commentary suggests that the opposite will be true in the next few quarters. This is due to more uncertainty in the macroeconomic environment while the company focuses on streamlining its costs structure in the next few quarters.
While Mark’s commentary that we are seemingly about to move into an economic downturn is no surprise given the latest news about the economy, it is still pertinent to take this into account given that Mark did comment that he views the current macroeconomic environment as worse than 1 quarter ago. This will have an impact on the whole digital advertising industry and thus, if prolonged, could have a material and severe impact on Meta’s business.
As such, the company’s guidance for 3Q22 implied a negative 10% to negative 2% growth for the quarter, which was lower than my initial expectations. This weakness was driven by the current sentiment on weakening demand for advertising as well as headwinds from foreign exchange.
The metaverse
As elaborated by Mark several times, Meta will, over the next decade, be building a platform for the metaverse across use cases including work and gaming. The focus on developing these platforms comes as Meta will then have the freedom to develop experiences in ways it wants without any external constraints. As this will be an expensive project that will take up heavy capital expenditures in the years to come, the metaverse project is a work in progress and provides the upside to Meta as it works towards being ahead of its competition.
I firmly believe that the company’s near-term catalysts are unlikely to be the metaverse, and the metaverse then is likely to be a medium to longer-term project. However, as updated in the second quarter, Meta is looking to expand its metaverse platform, Horizon, as well as make improvements to its Avatars platform. These efforts will help to improve the user experience and user engagement in the metaverse to achieve its end goal.
With regards to hardware of the metaverse opportunity, Mark has committed to releasing Project Cambria later in the year. This hardware will be focused on professionals, and it is expected to be a high-end device.
As highlighted earlier, the main focus right now is more on its Family of Apps rather than on the metaverse opportunity, although the company is and intends to invest into the metaverse for the long term. What it has announced so far is only the beginning in a rather long-term opportunity, and this project requires patience in the near term.
Valuation
The negative sentiment around Meta has caused its P/E multiple to contract significantly from more than 1 year ago as concerns about increasing competition, weakening advertising demand and significant spending on the metaverse weighed on the company.
Meta is now trading at 11.9x 2023F P/E and 10x 2024F P/E based on my estimates. Multiple expansion is very much in the cards given that it is trading at a discount to its peer group.
Applying a 15x P/E multiple on 2024F EPS, I derive a target price of $225 for Meta, implying an upside potential of 50% from current levels.
Key Risks
Weakness in demand for digital advertising
This risk was highlighted in the management’s commentary in 2Q22, and I think we could see this demand weaken materially if the global macroeconomic environment worsens. This has an adverse effect on Meta given that it will also reduce demand and thus, spend on digital advertising during the period of the downturn.
Competitive pressures
As everyone knows, TikTok remains one of Meta’s most prominent competitor and threat. It is able to drive high engagement in its users and continues to grow rapidly globally. As TikTok and Meta both compete for time spent on social media apps, Meta needs to tackle this threat by TikTok and has been doing so by introducing and investing heavily in Reels. Only time will tell if Reels can be a worthy competitor to TikTok, but the risk remains that competitive pressures may dilute the Meta brand and its Family of Apps.
Apple’s focus on user privacy
With Apple’s (AAPL) increased focus on its customer’s privacy following the iOS update that adversely affected companies like Meta, this resulted in Meta needed to find ways to alter its AI and machine learning models to provide advertisers with the same result as before. As a result, the iOS changes that resulted in greater difficulty for Meta in tracking and identifying consumers was a huge hit for Meta. In addition, there could be further risks if Apple does more actions for the benefit of its user’s privacy at the detriment of Meta.
Regulatory risk
With governments around the world taking down Meta and other Big Tech companies, Meta may have to face greater regulatory scrutiny in the future as there could be regulations and laws put in place that may hamper or slow down growth in the future. In addition, with increasing pressures on improving data and privacy rights, this may pose a future risk to Meta’s business.
Heavy capital expenditures into the metaverse
While management has guided that they are reducing capital expenditures and investments into the metaverse to suit the current business conditions, there is the risk that management spends too much on the metaverse that may not yield the expected returns in the future.
Conclusion
With Meta’s huge audience across its Family of Apps, I think that this is one of their major competitive advantages as the company seeks to reinvent itself in a different world across different formats. Meta, to me, remains well positioned globally as it continues to invest heavily into new growth priorities and as history has proven, Meta will continue to prevail and thrive.
I am of the view that as we see increasing adoption of and engagement in Reels as well as improving monetization, Reels will help Meta challenge the rising threat of TikTok while having a solution for the fast-growing short-form video format. After all, Reels is not a good to have, but rather a necessity for Meta in order to survive in a new order. My target price for Meta is $225, implying an upside potential of 50% from current levels.
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