At current prices around $110 per share, we think Meta Platforms is one of the best investment opportunities we have seen in our careers.
Meta, the parent of Facebook, Instagram, WhatsApp and Reality Labs, is down about 75% YTD. It has gotten cut in half since the small initial investment we made in Q1 which we blogged about here. As a result of this precipitous fall, the enterprise value is less than $300 billion today, meaning that the company trades at a record-low valuation. While earnings have been disappointing since Q1, our core thesis remains unchanged, and the valuation is now significantly more attractive. We’ve aggressively added to our position, resulting in an average price around $130.
In our Fundamental Value strategy, we generate alpha by identifying scenarios where investors are buying or selling securities for non-economic reasons. We think there are two non-economic reasons investors are overly pessimistic on Meta – one structural, and one behavioral.
First, Meta has experienced a stall in revenue and profit growth this year after a decade of lofty gains. For better or worse, the market tends to segment companies and investors into “growth” and “value” buckets. When a stock makes a rapid transition from growth to value, a large proportion of its previous owners – growth investors – are no longer interested in owning the company. They must find new owners – value investors – to sell to, and they often must offer the stock at a steep discount in order to induce value investors to step in and catch the falling knife. This structural artifact of the market can lead to security mispricing, and we think it is a contributing factor to the discount in Meta today.
Second, the crash in Meta’s revenue and profit growth is due to a trio of problems facing the company: a slowdown in advertising revenue, massive growth in expenses, and large losses in the “Reality Labs” segment. All three issues worsened since our purchases in Q1. However, we believe the problems are transitory. We believe the current share price does not reflect the fundamentals of the business, but instead reflects a fundamental misunderstanding of the business. Many investors are likely falling prey to extrapolation bias: the tendency to uncritically extrapolate short-term trends into the indefinite future.
These two factors have combined to create vast amounts of non-economic selling pressure that is weighing on Meta’s share price. This affords us the rare opportunity to buy a transcendent business in a secular growth industry at ~5x its core earnings power.
Family of Apps revenue slowdown
Meta’s core business is digital advertising in its “Family of Apps” (Facebook, Instagram, and WhatsApp). This revenue stream has suffered a severe growth slowdown in 2022. As recently as 3Q21, ad revenue at Meta was growing 33% YoY; for 3Q22, that number was -4%. This sharp fall in growth is not unique to Meta – digital advertisers have suffered across the board. Advertisers are reducing spend because the macro situation has deteriorated, and digital ads have not been immune from the reversal of pandemic pull-forward that is currently affecting many other lockdown beneficiaries. Furthermore, Apple’s App Tracking Transparency (ATT) – crippling changes to iOS privacy policies – has resulted in a >$10b annual revenue headwind according to Meta by impairing the company’s ability to tie ad spend directly to conversions. Currency was also a 6% headwind to growth in the quarter.
But despite the fall in revenue, we remain confident that Meta’s advertising business will grow handsomely over the years. In the long term, advertising in general, and the digital advertising market in particular, will continue to grow, with Meta positioned to continue to capture a large share of it.
In the short term, Meta’s properties continue to show significant strength under the hood despite the top line disappointments. Ad impressions were up 17% last quarter. Usage was solid as well, with the CFO explaining that time spent on Instagram and Facebook are still growing, both in the US and globally:
So on time spent, we are really pleased with what we’re seeing on engagement. And as Mark mentioned, Reels is incremental to time spent. Specifically, in terms of aggregate time spent on Instagram and Facebook, both are up year-over-year in both the U.S. and globally. So while we’re not specifically optimizing for time spent, those trends are positive. And we aren’t specifically optimizing for time spent because that would tend to tilt us towards longer-form video, and we’re actually focused more on short-form and other types of content.
In contrast to the strong growth in impressions, Meta’s price per impression declined -18% in the third quarter. This is not as concerning as it appears. First, the very weak macro backdrop and difficult YoY comps are likely driving some of the drop.
Second, in its history Meta has suffered two other periods of declining pricing coupled with growing impressions: during the transition from web to mobile, and after the introduction of Instagram Stories to compete with Snap. Both times, Meta introduced new products that increased engagement, but because the new products didn’t monetize as well as the existing formats, Meta saw a temporary hit to pricing. Both times, advertisers quickly flocked to the new formats and pricing recovered. We believe this time is similar due to Meta’s introduction of Reels, its short-form video TikTok competitor, which has been increasing engagement but does not yet monetize as well as the rest of the platform. We see no reason to believe that it won’t; advertisers will follow the eyeballs.
Third, Apple’s ATT changes have seriously dented Meta’s business. Meta’s value proposition to advertisers has been rooted in direct response advertising, where the goal of the ad is to drive an immediate transaction, rather than brand advertising, which merely contemplates increasing brand awareness with hope of future transactions. With direct response advertising, advertisers can track and measure their ROI on ad spend with precision and immediacy. This uniquely enables small direct-to-consumer businesses and mobile gaming companies to thrive and maximize their profitability. But the direct response advertising model requires that Meta can identify which impressions lead to transactions, necessitating user tracking after ad clicks. Post ATT, however, most iOS users have opted out of tracking, impairing Meta’s ability to identify conversions and hurting ad prices.
We believe that Meta will be able to close most of this loop with time. Privacy is and will continue to be important to all players, but it is in the interest of everyone – Apple, Meta, advertisers and consumers – that the advertising ecosystem continues to be successful. Apple is introducing API changes that preserve user privacy but allow better attribution. Meta is investing billions in probabilistic attribution so they don’t need perfect information to know whether an advertiser’s campaign is successful. And Meta is going to bring more commerce directly onto its platform so it doesn’t need to track users across the web like it once did.
Top line slowdowns are concerning. But while a decline in engagement might presage the beginning of the end of Meta’s dominance, that is emphatically not what we are seeing. Instead, we see a decline in pricing driven by temporary factors – macro, YoY comps, dollar strength, and ATT headwinds, as well as product improvements – and believe that revenue growth should quickly rebound.
Family of Apps expense growth
Another investor concern is out-of-control expense growth. Part of this is because management planned their hiring cadence in 2021, when the business was going gangbusters. And without a concomitant growth in revenue this year, the hiring spree caused EBIT margins in the “Family of Apps” segment to fall from 46% in Q3 2021 to 34% in Q3 2022. This drop, coupled with management’s guidance that expenses will continue to grow in 2023, caused the stock to fall more than 20% after their Q3 2022 earnings release.
Despite all this, we are confident that Zuckerberg will eventually right-size the company’s cost structure. While we were initially dismayed at the lack of urgency on this issue displayed on the Q3 earnings call, the company has since announced it would lay off 11,000 people (13% of the workforce). Over time, increased discipline on expenses should help the company improve margins from the 2022 nadir, especially if we see a rebound in ad pricing.
Meta’s capital expenditures, like its operating expenses, have also been exploding. This year, it appears that capex will be around $30b and consume >60% of operating cash flow. This is more than Apple, Tesla, Uber, Twitter, and Snap combined, as Brad Gerstner recently pointed out. The company’s guidance on the Q3 call for another increase in 2023 caused further alarm.
Management has explained that this is primarily for the Family of Apps segment, and is needed to build out data center capacity and make large investments in AI. But while investing tens of billions in AI – which thrives on expensive GPU clusters – would be ridiculous for most companies, there’s a strong case it makes sense at Meta. This is because improving content recommendations, ad targeting, or ad attribution — all of which utilize AI — can have a large impact on Meta’s $100b+ of ad revenue. AI is crucial to Meta’s efforts to plug the revenue hole from ATT. Furthermore, Meta is reengineering their products from being primarily based around your social graph (like Facebook Timeline), to being based around content discovery (like TikTok). Meta is uniquely positioned to create a content engine that combines the best of both social graph and discovery, full of pictures, text, and, increasingly, short-form video. We think this is the right path for the products, but creating a mixed-medium personal discovery engine for three billion people will require major investments.
Still, the amounts in question are gigantic, with guidance for 2023 capex at $34-39b. Meta is arguably overinvesting. In its defense, the company has said they will be scrutinizing the ROI of these AI investments before continuing them into 2024. In his letter to employees announcing the layoffs, Zuckerberg said he is in the process of performing this review:
I’m currently in the middle of a thorough review of our infrastructure spending. As we build our AI infrastructure, we’re focused on becoming even more efficient with our capacity. Our infrastructure will continue to be an important advantage for Meta, and I believe we can achieve this while spending less.
We think Zuckerberg will cut back on AI capex if it doesn’t bear fruit.
Reality Labs losses
The third issue that has been worrying investors is the Reality Labs segment, which lost $5.8b in the first half of 2022 alone. Meta guided for even bigger losses in 2023. On top of the financial losses, the segment has also come under fire from analysts and the media; the WSJ recently reported that there were only 200,000 users of Meta’s “Horizon World” software, down from 300,000 earlier in the year.
But while usage has not met expectations, it is still early days. And when it comes to unit sales of VR devices, Meta is far ahead of the pack. According to data from IDC, Meta shipped 78% of the combined AR/VR units during 2021, with second place coming in at just 5% of the market. The market is growing fast, with unit sales projected to grow 5x by 2026. At that point VR would be one of the largest software platforms in the world and would garner significant developer and consumer interest. Rumors are that Apple will be releasing a VR headset soon, so if Meta wants to have a significant stake in this new computing platform, it is imperative they get their devices into consumer’s hands as quickly as possible.
We don’t think that Meta should be making these enormous investments in VR. It would be much more appropriate if Zuckerberg made these bets through a separately funded company, rather than using the prodigious cash flow from Family of Apps as a piggy bank with no accountability. However, while we don’t ascribe any value to the Reality Labs business, we also believe it is highly unlikely that losses on the current scale will continue indefinitely. At the risk of sounding like a broken record, we trust that Zuckerberg will either build a business that justifies the investments being made, or he’ll shut down the project. And given Meta’s lead in hardware sales, current technological superiority, and the future growth ahead for the VR medium, we do think there’s some chance of success.
On the bright side, the scale of the Reality Labs losses have obscured the profitability of the core business, and for that we are grateful: it has given us an opportunity to own the company at a deep discount to intrinsic value.
When valuing Meta, we believe it is appropriate to ignore the Reality Labs losses and growth capex. We are far from certain those investments will earn an attractive return for Meta investors, but nonetheless they are long-term investments that we believe are highly unlikely to continue indefinitely if they don’t start to yield a return. Thus, when valuing the company, investors should not put a multiple on these expenses, as explained by NYU professor and valuation expert Aswath Damodaran in this video.
We view Meta’s normalized earnings power from its core Family of Apps business as roughly $55b of EBIT, in line with 2021 results. Profits in 2022 will be lower as Meta suffers from the transient headwinds we mentioned above. But the average margin in the Family of Apps segment from 2016 to 2021 was 46%, and we expect these margins to return, especially given the new willingness to cut costs as evidenced by the recently announced layoffs. Net of cash, Meta trades at ~5x this $55b normalized EBIT, an extremely attractive level.
Furthermore, we believe that even with some relatively conservative assumptions, there’s a strong case for substantial earnings growth from there. Let’s assume the digital advertising market grows 15% a year (down from ~20% over the past decade), Meta’s market share stays constant at 22%, Meta’s margins recover to 46%, and Reality Labs losses go to zero. In this hypothetical, Meta would be earning over $100b in net income in 2028, or $38 in EPS. At a 20x multiple, that’s $760 per share.
These are relatively conservative assumptions for a market leader with unique properties in a secular growth industry. Suffice to say that in a bull case – where AI or Reality Labs investments bear fruit, or where Meta continues to gain digital advertising market share (from 5% in 2012 to 22% today), or where margins continue expanding (from 36% in 2013 to 49% in 2021) – this investment could easily be a ten bagger.
We believe this is one of the best investment opportunities we have ever seen. Meta’s extremely low valuation provides us with an attractive risk/return profile even if earnings never exceed their 2021 highs. But there are ample reasons to believe that earnings will grow – and we expect they will. Finally, Meta comes with some free embedded options that add true home run potential to this investment.
We can scarcely believe that the market has afforded us the opportunity to buy a transcendent business at such a wonderful price. We doubled down on Meta in October at prices below $100 per share, making it our largest position.
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