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Investment thesis
While the Metaverse opportunity is a long-term one for Meta Platforms (NASDAQ:META), I came out of the Meta Connect 2022 event more positive on the direction Reality Labs is taking. I increasingly appreciate that the use cases for the products and solutions that Reality Labs does add value to consumers’ lives. In addition, the continued heavy investments into Reality Labs will accelerate technological advancements that will bring the company an added advantage in the Virtual Reality (“VR”), Mixed Reality (“MR”), Augmented Reality (“AR”) and the Metaverse space. In addition, we could see upside to Reels in the coming quarter as Meta has ramped up the ad loads on Reels in the past few months as it looks to increase the monetization opportunity for Reels.
Enterprise applications for the Metaverse
First, I think that most who were watching the Meta Connect 2022 event would have noted that the company has a new partnership with Microsoft (MSFT), as we saw Microsoft CEO Nadella say that Microsoft will make Windows, Office and Teams, as well as other Microsoft programs available on the brand-new Meta Quest Pro as well as the current Meta Quest 2 virtual reality headsets. I think what this means is that with the partnership with Microsoft, more investors can have the confidence that more enterprise users will adopt Meta’s platform over time.
By bringing Teams meetings as well as Windows 365 products to Quest products, this will bring in a larger number of functions on Quest products and increases their use cases as Meta works to expand into enterprise applications, and there is no better partner than Microsoft for that. In addition, Zoom (ZM) will be integrated into Meta’s workplace in early 2023, while 3D models in Workrooms was also disclosed in the event.
From gaming to social, fitness and education
While the main theme for the 2022 Meta Connect event was enterprise applications, I think that I started to see more use cases outside of the traditional gaming use cases for Quest products.
Gaming remains one of the main uses for Quest products and I think that it is encouraging to see that top games like The Walking Dead: Saints & Sinners have exceeded $50 million in sales on Quest alone. On top of that, we will be seeing about 5 new launches for the remainder of 2022 and 2023. With the new release of content as well as more verticals, I am of the view that Quest will bring in a wide variety of gaming audience. In addition, there are several tools listed in the top category of the Quest store that pertain to social applications like VR chat, YouTube VR, for example. As more Quest users begin to start using these social applications, I think that as the social applications start to gain traction, we could see more new Quest users come forth as a network builds.
In addition, we are seeing more fitness use cases like the Quest Companion App, as well as the integration of the iPhone health app. This looks to be the beginning of other health use cases to emerge as more applications start emerging on the Quest store.
Lastly, partners have been joining the ecosystem with companies like Accenture (ACN), Unity (U), and Coursera (COUR). Accenture has actually already deployed more than 60,000 Meta Quest 2 headsets and onboarded 150,000 employees using the platform as an education content layer.
New Quest Pro
Meta released its brand-new Quest Pro VR/Mixed Reality (“MR”) headsets, selling at $1,500 per set. Quest Pro is the first of a new line of more advanced headsets that have MR features that can help with improving workplace applications. According to Meta:
Meta Quest Pro is the first entry in our new high-end line of devices, and it’s packed with innovative features like high-res sensors for robust mixed reality experiences, crisp LCD displays for sharp visuals, a completely new and sleeker design, plus eye tracking and Natural Facial Expressions to help your avatar reflect you more naturally in VR.
I think what differentiates Meta’s Quest Pro is the next-generation optics as the Quest Pro has couple of new and big improvements over the Quest 2. For one, Quest Pro has an entirely new optical stack that helps to reduce the depth of the optical module by 40%. In addition, the new Quest Pro is expected to have displays with 75% more contrast, 37% more pixels per inch than the Quest 2. On top of these improvements, there is an 50% improvement in the peripheral region as well as 1.3 times larger color gamut than the Quest 2.
The Metaverse revenues will come
I think that while the Reality Labs segment is still in its early days, there have been encouraging signs of increasing interest and take-up as well as improvements in the technology and platform experiences that helps to remove the barriers to adoption.
First, we have seen that Quest 2 sales was more than 7 times larger than Quest 1. This, in my view, comes as Quest 2 has significantly improved functionality as well as the improved acceptance of VR globally. The next step for Meta is to continue to improve the experience to drive further adoption.
Second, I am seeing more monetization opportunities for Meta as it continues to invest in Reality Labs. With more than $1.5 billion having been spent on the Quest Store’s games and apps, this is a far cry from the expectation of $200 billion in virtual marketplace value by 2026 by McCann WorldGroup.
There are currently 33 apps out of the more than 400 apps on the Quest Store that generates more than $10 million in revenue. I think that as Meta brings in more levers to monetize its business, like that of the Avatar Store, we could see Meta launch a large marketplace for digital goods when that happens.
Continued investment into the Metaverse as a long-term opportunity
As we have seen above, the use cases for Meta’s vision of the Metaverse continue to grow and the experience is increasingly becoming more realistic and improved from prior generations. As the technology involved is still in relatively early days, I think that we have to be practical in the amount Meta needs to invest in this long-term business project.
As an example, the company spent $7.8 billion in 2020 on Reality Labs, while the figure nearly doubled to $12.5 billion in 2021. While the pacing of increase has decelerated due to near-term needs to match spending to revenue growth, the Metaverse remains in need for heavy investments. As such, I think we will see that in 2022F and 2023F, Meta will be spending $15.5 billion and $19 billion respectively to further its plans and continue to improve on the technology and experience in the Metaverse.
While I expect that Meta’s investment in Reality Labs will continue to increase, there are certainly near-term challenges like the announcement to cut costs by 10% in the next few months, along with hiring freeze, I think that while Reality Labs is still important in the long-term, there could be some investments in the business that will be pushed further out to the future to ensure near-term sustainability.
Reels monetization continues to improve
In addition, Reels monetization is increasing as we see more ad loads in Reels. This will bring new ad products and bring more monetization opportunities for Reels. According to Citi, their tracking of Instagram Reels ad loads reached 14% in September compared to just 8% in July, with the initial ad exposure being brought forward for the average user.
While I think that Reels monetization is still in its early days and Instagram Stories only reached parity after almost 4 years of operations, any sign that Reels could take off will be appreciated by the market.
Despite cost cutting, Meta intends to continue to focus on not just Reality Labs, but also on Reels. As highlighted in my previous article, Reels already achieved a $1 billion run rate much faster than Instagram Stories and I think this again suggests the strength of short form videos as a format, as well as that of the Meta group of platforms.
Valuation
Meta is now trading at 10.3x 2023F P/E and 9.2x 2024F P/E. While there are some risks and uncertainties facing the business, when looking at the company from 1 year ago, I see that Reels have started to develop into something great, and the opportunity for Reality Labs looks very promising.
As such, I continue to think that Meta will see multiple expansion in the medium term as we look at the discount it is trading compared to peers. I assume a 15x P/E multiple on my estimates for 2024F EPS, I derive a target price of $225 for Meta, implying an upside potential of 70% from current levels.
Key Risks
Global macroeconomic environment
As a result of worsening global macroeconomic conditions, we could see that the demand for global advertising may shrink. This will affect Meta adversely given the company’s dependence on the global advertising budget.
Competition
While Meta is actively addressing the threat that TikTok brings to the social media landscape, there is no doubt a risk that the actions it takes and the investments it puts into Reels does not materialize into solid accretive returns for investors. As the new generation of Gen Z associate TikTok as the platform where everybody is at, this may threaten Meta’s ability to try to tackle competition from TikTok, especially if Reels does not take off or does not perform as well as expected.
Capital spending requirements for the Metaverse
While the Metaverse appears to be increasingly attractive, we need to remember that this is more of a longer-term opportunity. As such, management needs to make sure that the capital expenditures spent on Reality Labs is kept in check and in-line with the current business and market conditions.
Conclusion
I used to take a view that Meta’s Reality Labs is really just an optionality that could bring an upside in the long term. However, based on the recent Meta Connect 2022 event, I left the event becoming more convinced by Mark Zuckerberg and Meta’s vision of the Metaverse. The use cases will range not just from gaming to other segments like education, enterprises, fitness and social. In addition, there are multiple levers to pull to generate revenues from the investments and outcomes of Reality Labs. In addition, I thought that it was also encouraging to see management continue to increase ad loads for Reels and explore ways to increase monetization of Reels in the near term. My target price of $225 for Meta, implying an upside potential of 70% from current levels.
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