Chip Somodevilla
Meta Platforms, Inc. (NASDAQ:META) just released its second quarter earnings. The release was a miss on revenue as well as on earnings. Revenue of $28.8 billion fell 1% while earnings fell 32%. Meta stock tumbled after hours on the news.
Overall, it was a mixed release. Most of the metrics declined, although Reality Labs revenue managed to grow slightly. META is virtually guaranteed to experience volatility in the days and weeks ahead, though it may be worthwhile in the long run. In this article, I will explain my bullish thesis on Meta Platforms stock in light of its mixed second quarter earnings.
Meta’s Earnings: The Background
To really understand what happened in Meta’s second quarter, we need to know the background story. For most of its history, Meta has been an extraordinarily fast-growing company, boasting 40% CAGR revenue growth over the past decade. However, some things happened last year that interrupted that growth and sent Meta’s stock tumbling.
Meta’s troubles started in 2021. That year, Apple brought in a set of privacy changes it named “app tracking transparency” (ATT). The changes required that developers ask users whether they wanted their data to be tracked. Predictably, not very many people opted in to tracking. As of the most recent reports, the ATT opt in rate was 44% for social media apps. That’s better than initially feared (Meta’s team modelled for a 10% opt in rate), but it still hurt Meta’s ability to deliver targeted ads. In the first quarter, Meta’s revenue grew just 7%. That was by far the slowest growth in the company’s history. In the earnings call shortly after results were reported, Meta’s CFO David Wehner directly attributed the weak growth to ATT, saying it would take a $10 billion bite out of revenue in 2022.
A few months after that, Snap Inc. (SNAP) released its second quarter earnings, which seemed to confirm investors’ worst fears. In the quarter, Snap missed analyst estimates by a wide margin, sending its stock tumbling. Not only did SNAP sell off after the release, Google and others did as well. Snap was the first ad-tech company to report this earnings season, and it set the tone for the other players. Snap is not a particularly big ad-tech company, but its user base (319 million) is big enough to potentially signal industry-wide trends. So, the reaction after Snap’s release was partially justified. It didn’t justify the 10% selloffs we actually saw, but it merited some kind of an adjustment.
Flash Forward to Today
Today was not only Meta’s earnings date but also the date of a Federal Reserve FOMC meeting. Investors have been worrying about rising interest rates all year, and when you’ve got one of the country’s largest companies reporting alongside an FOMC meeting after a competitor dropped the ball completely, you tend to get a little apprehensive.
It’s no wonder, then, that the reaction to Meta’s release was harsh. There were many things happening in the lead up to the release, and tensions were running high. It’s inevitable that Meta would encounter some turbulence. In light of that fact, let’s take a look at Meta’s earnings release in more detail.
Earnings Recap
For the second quarter, Meta announced:
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$28.8 billion in revenue.
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$8.3 billion in operating income (“EBIT”), down 32%.
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$2.46 in EPS, down 32%
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$4.45 billion in free cash flow (“FCF”), down 48%.
Overall, it was a mixed showing. Every single performance metric declined, partially due to currency exchange impacts. Some 25% of Meta’s revenue comes from Europe, and the Euro collapsed below parity with the dollar this year. Had that not been the case, revenue growth would likely have been positive.
Long-Term Business Outlook
Having looked at Meta’s financials and valuation, we can turn to its long-term business outlook. In today’s release, Meta guided for $26.5-$28 billion in Q3 revenue, so we know what it thinks about the short term. The question is, “what about the long term?”
Meta has two main business units: family of apps and reality labs. The first of these is much easier to model than the second, so we’ll start with that one.
Family of Apps is Meta’s business unit that most people are familiar with. It consists of Facebook, Instagram and WhatsApp. It generates revenue mainly by advertising but has plans to roll out paid services (e.g., creator subscriptions) as well. It was responsible for 98% of Meta’s revenue in 2021.
Advertising was historically a cyclical industry, but that changed with the rise of digital advertising. In a 1962 Journal of Business article, a writer demonstrated that in his day, advertising revenue generally followed the business cycle: it rose in expansions and fell in recessions. This dynamic has been less prevalent in the digital age. Meta and Alphabet both had positive constant-currency revenue growth in Q2. Alphabet had 31% revenue growth in 2008, the year of the great recession. Most ad-tech companies had solid growth during the 2020 recession.
Studies still say that advertisers cut spending in recessions, but that hasn’t stopped Meta and Alphabet from growing their sales. It could be that online ad platforms taking market share from newspapers and TV drives the recession growth of Meta and GOOG. In that case, we would expect the growth to slow and become more cyclical in the future.
So we have a reason to think that online ad revenue will grow but become more cyclical. This is borne out by industry forecasts, which say that online advertising will grow at 10-11% CAGR over the next few years. That’s slower than the expectations for some tech sub-sectors, but still pretty good.
Can Meta actually achieve growth in line with the industry norm? That’s an interesting question. In the past, it grew faster than the industry, but today it’s facing competition from TikTok and losing revenue to Google. We know that the impact from Google’s ATT victory is $10 billion per year. That’s David Wehner’s estimate, and we have no reason to doubt it.
The impact from TikTok is harder to quantify. TikTok is currently higher on the app store than any Meta property is, but that doesn’t mean it has more users. “App store rankings” are based on new users added, not total users. Instagram actually still has more total users than TikTok, though the latter is growing faster. If we assume that Meta simply retains its current user base, then it should be able to grow its revenue modestly over time, as it can boost revenue by hiking ad rates, adding features, etc. So it seems quite realistic for Meta to grow at 10% annually over the next five years.
The second part of Meta’s business is Reality Labs. It is harder to model this segment because it is a big gamble that could work out, or lose money indefinitely. It is not currently profitable. In Q2, it produced a $2.8 billion loss. It wouldn’t be conservative to build a model that assumes Reality Labs someday becomes profitable, but Meta’s bottom line can grow if ad revenue grows while Reality Labs costs stay flat. Currently, Meta is doing a hiring freeze and considering layoffs, so costs will not grow in the near term. Therefore it’s not unreasonable to expect Meta to deliver 5%-10% bottom line growth from 2023 onward.
Valuation
Having looked at Meta’s financials and business outlook, we can now turn to its valuation.
According to Seeking Alpha Quant, Meta trades at the following multiples:
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P/E: 12.
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Price/sales: 3.7.
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Price/book: 3.5.
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Price/cash flow: 9.
These are all very low multiples. They are much lower than the same multiples for Microsoft (MSFT), Apple (AAPL) or Google (GOOG, GOOGL), so Meta is cheap compared to its peers. However, it’s possible that the entire group is overvalued, so we’ll need to do a discounted cash flow (“DCF”) model to get a more objective appraisal.
If we assume that Meta will grow cash flow at 5-10% CAGR from this point on, as I estimated previously, then its shares are currently undervalued. We can demonstrate this by doing a DCF analysis assuming 0% growth. If Meta’s stock is worth less than fair value under a 0% growth assumption, then it’s even more undervalued with a 10% growth assumption.
In a recent article, I showed that with 0% assumed growth and a 3.5% discount rate, META stock was worth $400. I took some criticism for using such a low discount rate, but if I had used 8% in place of 3.5%, I’d still have gotten a $178.5 fair value, which is upside to today’s price.
It is worth updating my previous model for the latest earnings release. With the latest earnings release, Meta’s TTM FCF per share shrunk to $12.83. Using that amount of FCF and an 8% discount rate, we get a $160.83 terminal value. That’s only very slight downside to today’s price. So in any universe where Meta delivers positive growth, the stock is undervalued.
The Big Risk to Watch Out For
As I’ve shown in this article, Meta is fully valued if FCF grows at 0% indefinitely. That certainly makes it look like a tempting investment. However, thanks to Reality of Labs investments, Meta’s earnings are going down this year. If Reality of Labs continues to be a money pit forever, then Meta could see sub-0% growth for many years. If that happens, then the stock is not undervalued. Using a 0% growth assumption and an 8% discount rate, you get very slight downside to today’s stock price. If you change the growth assumption to -5%, you get significant downside. So if you buy Meta today, you are implicitly betting that Mark Zuckerberg will not plow increasing amounts of money into the Metaverse forever as it continues to lose money. If Reality Labs losses widen, instead of remaining flat, then my bullish thesis is busted.
The Bottom Line
The bottom line on Meta Platforms is that Meta’s a super cheap tech stock that has incredible margins and a decent competitive position. Its competitive position is not as good as it was 2 years ago, but it’s still pretty good. Even if Reality Labs goes nowhere, the core ad business will drive solid profits for many years to come. If Reality Labs actually succeeds, on the other hand, then META could end up being one of the best tech investments of the decade. There is real risk here, but it’s a risk I’m willing to take.
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