Chip Somodevilla
Meta (NASDAQ:META), aka Facebook, has been my worst stock investment over the last several years. Many investors are in a similar situation and weighing whether to dump Meta or keep holding it waiting for recovery.
I documented my decision to invest in Meta in two posts: Facebook: To Invest or Not and Facebook: Underpromising, Overachieving, Unloved. Both titles appear ironic in hindsight.
Why I invested
Mostly because of two reasons:
1. Facebook is the only World Directory covering most smartphone users (outside of China) and millions of businesses. Participants voluntarily supply valuable dossiers on themselves. Facebook knows more about individuals on the Directory than anybody else and can profitably exploit it.
2. Facebook’s content is free for the company and is extremely attractive to the audience since every member has convenient one-place access to the content generated by his/her friends, family, and favorite businesses. Enjoying the uniqueness of this content, the audience was supposed to remain glued to the app.
The growth of the Directory seemed guaranteed due to the growing number of smartphones. WhatsApp monetization, shopping within social networks and simple financial operations (sending/receiving currencies, Facebook pay, etc.) represented low-hanging incremental opportunities.
I considered the chorus of Facebook haters as largely irrelevant and estimated the probability of damaging government actions rather low.
Valuations were high but did not seem excessive weighed against the growth rate and economic moats the company enjoyed. Meta had only to take good care of the audience and businesses on its networks to keep its superior positioning intact.
Competition
Meta’s business model makes direct competition next to impossible. The network effect of the Directory represents a formidable moat as the unsuccessful introduction of Google+ proved. But rivals can compete indirectly for advertising dollars either by limiting Meta’s monetization tools – this is what Apple (AAPL) did, or by offering extremely attractive content outside of Meta’s apps – I mean other social networks and TikTok.
These strategies may appear damaging now but I would argue that their effects are temporary as they do not undermine Meta’s competitive advantages. It seems particularly clear to me in the case of TikTok.
TikTok’s business model implies a certain level of creativity but does not have moats. Meta can either emulate TikTok’s attractive features or even improve them as it has enough human, financial, and technological resources at its disposal. And as far as we know, Meta’s response to TikTok – Reels – is progressing well. Ramp-up will be gradual, require incremental operating expenses, and incur some cannibalization of other services but nothing prevents it from the ultimate success.
The situation is different with the loss of signal from iPhones outside of Meta’s apps due to security features implemented by Apple. Meta’s response has been in deploying AI at scale in an attempt to recover, at least partially, the information lost. Please note that changes implemented by Apple are unlikely to make digital advertising less attractive for marketers compared with other forms of advertising and should affect all digital advertisers to some extent. Apple’s ambitions in digital advertising are still unclear. Meta has an opportunity to recover lost dollars by honing its advertising system. The process is expensive as Meta has to deploy a big network of AI servers materially increasing its capex.
While it is not guaranteed, I expect Meta to eventually overcome these difficulties provided it remains focused and committed to significant financial outlays for both opex and capex in the protection of its core business.
Meta’s optimists
Those who are optimistic about Meta shares think that a) the company’s difficulties in handling TikTok competition and Apple security features are temporary; b) earnings from the core business will recover; c) Oculus Quest and the metaverse, in general, are possible upsides.
There are two main metrics to measure Meta’s financial results: net income and free cash flow (FCF). Because of the high capex related to deploying AI servers, I prefer to use FCF as it accounts for capex directly as soon as it is incurred. The current FCF yield for TTM (FCF/EV) is 4.3%. This is rather high by Meta’s standards but not in absolute terms. Until 2017, this yield had been below 4%, shot up to 4.8% at the end of 2018, and was at 3.9%, 3.2%, and 4.2% at the end of 2019-2021 respectively.
The FCF yield of 4.3% implies that the market is cautiously optimistic about Meta. It is lower than the 4.6% FCF yield of Alphabet (GOOG) (GOOGL) even though the latter is arguably in a stronger position.
The owner-operator
Is Mark Zuckerberg aligned with other investors? Superficially, the answer is obvious as he owns about 13% of the company worth ~$59B. He should be surely interested in the financial success of the company, shouldn’t he?
However, Mr. Zuckerberg primarily owns supervoting B-shares (88.7% of the class) and controls 56.9% of the voting power. Initially, Mr. Zuckerberg’s input was commensurate with both his economic ownership and voting power. Gradually, more and more people were contributing to Facebook’s rise and they were awarded stocks – otherwise, they wouldn’t work for the company. Investors have participated in the effort with their money. The other’s economic power keeps growing in line with their cumulative input but their combined voice is still hardly heard. It does not seem fair to me but that is of secondary concern. Here is the primary issue: does it benefit the company?
Over years, I have come across many companies with owner-operators. Here are some of them: Berkshire Hathaway (BRK.B) (BRK.A), Alphabet, AMERCO (UHAL), Enterprise Products (EPD), Apollo (APO), and so on. In general, this factor is probably beneficial but varies from case to case. To form a judgment, one has to consider specific issues regarding the owner-operator him/herself and the company including the size of economic and voting stakes, absolute and relative wealth, single-class or multi-class structure, other owner’s assets, industry, age, ambitions, capabilities, character, family situation, etc. Some of these factors seem very much in play in the case of Meta.
The impregnable voting control, personal ambitions, and incredible wealth makes Mr. Zuckerberg’s interests diverge from the ones of retail investors. Two differences are obvious: Mr. Zuckerberg can tolerate more risks and has a longer investment horizon than almost any retail investor.
He started Facebook when he was 20 (2004) and became the youngest self-made billionaire at the age of 23. Since 2008, Time magazine has named Zuckerberg among the 100 most influential people in the world as a part of its Person of the Year award, which he was recognized with in 2010. In December 2016, Zuckerberg was ranked tenth on the Forbes list of The World’s Most Powerful People.
So he used to be a wunderkind, accustomed to worldwide recognition from a very early age. Now he is getting closer to 40. Do you think his claim to glory today is comparable to what it used to be, say, 5 or 10 years ago?
I doubt it. Multiple Facebook missteps together with the rise of personalities such as Jeff Bezos or Elon Musk have made Mr. Zuckerberg’s luster less noticeable and appealing. Perhaps more importantly, Meta’s technology has been losing luster as well and today seems stodgy compared with Apple’s, Alphabet’s, Amazon’s (AMZN), or Tesla’s (TSLA). But Oculus Quest defies this trend and is a real technological breakthrough.
I do not have any evidence to support it, but Oculus Quest and the metaverse, in general, might be considered by Mr. Zuckerberg as a way to the very top again, both personally and technologically. Coupled with the mentioned risk-tolerance and long investment horizon, it could become the crucial divider between Mr. Zuckerberg’s agenda and other investors’ interests.
Metaverse
Anybody following Meta should be familiar with the concept of the metaverse and I will skip explanations. Instead, I will pose several specific questions:
1. Is the metaverse going to materialize in some significant way? I believe so but we should still allow for some transformation of this concept or perhaps this concept will be subsumed by something else. While the metaverse as we think of it now seems very probable it is not guaranteed.
2. Will the metaverse become a money-maker for the industry? Again, “yes” seems the right answer but we still know that some significant industries have not become particularly profitable as airlines example demonstrates.
3. Will Meta become one of the leading players in the industry? Perhaps but not guaranteed at all. It has certain advantages of the first mover but no scale and no moat. No doubt that Apple will make its move shortly and I will be surprised if Google, Microsoft (MSFT), Amazon, and others, including still unknown actors, will not make their presence palpable. Nobody knows the names of the ultimate winners.
4. Do you believe that metaverse products will produce significant margins for Meta in, say, 5 years? I am skeptical: during the first half of 2022, Meta lost ~$6B in their Reality Labs segment on ~$1B of revenues without major competition. “Significant margins” for Meta means something like $5B for half a year. Accounting for 50% hardware margins and the constant level of R&D expenses, Meta has to produce revenues of ~$20B per half a year to reach this level in a competitive environment.
5. Do you believe that Meta has enough financial resources to maintain the metaverse arms race in a competitive environment for many years? Until recently, Mr. Zuckerberg was quite confident about it due to the high profitability of its core business and cash in the bank. No longer. Here we have clear evidence of Meta’s possible miscalculations.
In Q4 2021, Meta spent ~$19B on buybacks at a share price above $300! During Q2 2022, with a share price at $160-200 for most of the quarter, Meta spent only $5B on buybacks. Several days ago, for the first time in its history, Meta raised $10B by issuing bonds. This chain of events shows that Mr. Zuckerberg might’ve failed as a capital allocator and this could be very negative for the company.
The wasted funds could have been profitably deployed at the low-hanging opportunities I mentioned at the beginning of my post. Has WhatsApp become a money maker? Only in a very limited way primarily through the Click-to-Messaging tool. Is Amazon concerned about Shops? Unlikely. What about different financial tools that Meta could have developed to complement its core business? They remain to be seen at scale. These promising opportunities need both money and focus which are being sucked away by metaverse efforts.
Conclusion
I have ambiguous feelings about Meta. The economic moats of its core business have not disappeared. Focusing on this core business may change the company’s fortunes rather shortly, perhaps, within 3-4 quarters. But it cannot be done without sacrificing at least some of Meta’s metaverse ambitions. So far, this objective has not been clearly stated even though the company is trying to rein in its expenses now as was indicated in the last earnings call.
With the metaverse ambitions unabated, Meta’s financial future seems less certain. And its valuations are not so cheap. Consequently, Meta has become less appealing as an investment even at its current price.
At this point, I responded by cutting my position but stopped short of dumping the shares altogether.
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