Meta is the current FAAMG ugly duckling. Immerse in a whirlwind of problems plus a massive investment program into the Metaverse blue ocean, Meta is suffering the rage of the markets. But how much of it is the narrative and what is the actual reality?
As you might be already used to, this is not going to be the classic infinite investment thesis. This is just a zoom out to see the fundamentals behind Meta Platforms, trying to be as objective as my own bias allows me.
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Recession trumpets, interest rates hikes and an expensive transition to the unknown. Meta reported the first revenue decline year over year since the company went public a decade ago. Is Meta business exhausted?
Digital storefront
Facebook, together with Google, revolutionized the advertisement industry some years ago. Advertisers were finally able to measure and analyze the impact and profitability of their campaigns. They opened the doors so millions of SMB could access an industry previously accessible only to the big bucks of the corporate budgets.
Google and Meta are the clear industry leaders. But make no mistake, the services they provide are very different. Google gives companies the ability to show themselves to customers who are already looking for something specific. It sets companies in a VIP seat in the customer comparison process with the rest of the competitors.
Obviously, Google Ads service has the advantage that the customer is already interested in the service/product. Meta, however, allows companies to proactively seek out new customers. Meta is the storefront located in front of the customer's eyes, right into their phone screens. That is why the growth of Amazon Ads should impact Google's business model more than Meta. However, this difference in the origination model also puts you in a disadvantage when marketing budgets are reduced. Companies simply have fewer resources to go out and find “new” customers.
A “lasting” competitive advantage
3 billion daily active users (2 billion only on Facebook). This is more than one-third of the entire world’s population, and increasing. However, rather than exposing advertisers to this vast audience, the true strength of Meta lies in the granularity with which advertisers can target users.
A decade ago, we shared with Meta some personal data that most would never consider to do again. This is an irreplaceable treasure nobody else will ever have access to. These intangible assets, together with the AI engine, presents advertisers with a unique opportunity to tailor advertising messaging to target audiences in ways previously considered impossible.
TikTok hysteria
Does this network effect and massive data base translate into a real competitive advantage? Meaning, do they have pricing power? Well, numbers seem to confirm it. Meta has had consistent gross and operating margins over 80% and 40% respectively, a FCF conversion north of 75% in the last decade and returns on capital in the 20s.
During these years, Meta has faced some problems that menaced the company severely. Past commentators saw Facebook succumbing under the transition to phones, the irruption of Snapchat or the privacy issues with Cambridge Analytica. Anyway, I am looking at the past, and we invest in the future.
Meta faces currently a bunch of challenges on top of the macro headwinds and a capital intensive transition to “the next big thing”. We can call them TikTok (fierce and addictive competitor engaging younger generations), Apple IDFA (impacting Meta’s capability to measure advertiser’s ROI and the reason for a 15% decrease in the ad price) or the negotiations with the all-bureaucratic European commission to keep transferring user data back to the U.S.
I am sure there are infinite articles out there explaining all the problems better than I could do. These are important problems, but so they were in the past. Take a look at the business fundamentals along the years in the graph and try to guess when the previous existential crisis happened. Irrelevant over the long term. I am not saying they won’t impact the business, I just say the noise covers the reality of the impacts.
Show me the numbers
Surprisingly, and despite all these headwinds, the company is performing relatively well. What? Isn’t it going to disappear tomorrow? Numbers speak differently. In the worst crisis Meta has ever faced, the business keeps having 80%-30% gross and operating margins. It is quite remarkable to have these numbers even with the oversized headcount increase and consequently operating expenses, together with the highest level of R&D investments ever. It doesn’t look like a company going bankrupt.
But there are still some concerns. First, as already mentioned, an increase of a 30% in the headcount at the peak of the cycle and unemployment bottom comes together with very high salaries and an exorbitant bill of 3 billion in stock based compensation just the last quarter. 60% of the FCF!
In the second place, and even if I was quite comfortable with the capital allocation in the last few years, I am concerned that the massive share repurchase program done last year was a huge capital misallocation given the circumstances. It was nice to see how Meta increased repurchases at moments where the share price dropped due to non-fundamental reasons (Cambridge Analytica or Covid). End of last year share price were closer to the intrinsic value and the management invested a huge part of the cash reserves at the top of the cycle and with a demanding roadmap of CAPEX ahead. Now, with the share price extremely depressed, buybacks are accounting for more than the FCF but very low levels in comparison and with a reduced amount of dry powder at hand.
The Metaverse narrative
Stop thinking about the Metaverse. Forget about VR glasses, avatars and digital clothes. What if we rename the investment of all this CAPEX into building the best AI infrastructure ever or driving the development of new consumer wearables and productivity enhancement devices. Sounds sexier, doesn’t it? People always stay in the anecdote, not in the long term vision (although I have to admit Mark does not help sometimes).
Facebook’s mission - and now Meta’s - is to make the world more open and connected. I used to despise mission statements as pure marketing. I don’t do it anymore. I want to see that the company’s mission is the polar star that guides any decision. It is the essence of any company. Zuckerberg has seen the global reach of the Family of Apps is almost achieved and growth eventually would lower to the secular digital advertising industry levels (~10%-12% in the next few years). Zuck is obsessed with the next platform and he is investing all in. But so is Microsoft or Apple (obviously coming with a wider source of revenue streams).
Thinking in probabilities: valuation
Buffett would never invest in Meta. When Buffett repeats endlessly that he needs to understand a company, what he really means is that he has to be able to predict quite fairly the future cash flows. Meta is investing huge amounts of capital in a blue ocean. The terminal value is completely unknown, but with unexpected and unaccounted levels of optionality.
What are the chances that Meta will not exist in 10 years? That’s the first question one should answer. These possibilities are not 0, but they are very low in my opinion.
I have done a simple DCF model considering 5 scenarios with different probabilities associated to each of them and different FCF CAGR in the next 5 years depending on the different outcomes of the two business lines. All of them discounted at a 15%. I think results speak by themselves.
Bear in mind digital advertising is expected to grow at 10-12% annually. Meta has increased its FCF at a 22% annually the last 5 years. I consider this approach as extremely conservative as in 4 out of the 5 scenarios, FCF in 2026 will be lower or similar to the one in 2021. In the past 5 years, FCF doubled.
This is without considering that all these investments may give rise to new business models such as the use of its AI models and infrastructure for other businesses (similar to AWS, an on-demand cloud AI model), and many other business models not yet invented.
Meta is, to put it bluntly, insultingly cheap. When markets already price the worst, investment risk is gone.
In Zuck we trust
In my extensive piece on rebel capital allocators, I wrote that when we invest in a company, we are ultimately investing in the people running the business. Better said, we invest in the integrity and culture of these people.
Meta’s core values are “move fast” and “focus on long-term impact”. In the last earnings call Mark said:
“We invest a lot in building infrastructure. And culturally, we focus on moving and learning faster than everyone else. And I think that those are sustainable advantages.
And so certainly, I think that the AI technology infrastructure that we’re building, I think it can compound and be better than others in the industry and that will be an advantage and make the products better over time.”
We all would love to keep having the printing cash machine Facebook was and stay still. But capitalism and competition are fierce. Don’t forget he is the only founder among the Bit Tech still at the wheel, he is only 38, and even more important, his whole wealth will have the same fate as that of his shareholders.
Independently of the market views, we won’t know if he is right or not for the next 5 years. If you can not live with it, there are more secure investments out there. If you can, do yourself a favor and don’t look at the share price for the next few years. You might be extremely surprised. As I like to say: Patience might be the ultimate competitive advantage.
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Disclosure: I have part of my portfolio in Meta. Everything expressed here is only my opinion. Always do your own research.
#19 Meta: short term narrative vs long term reality
Where most analysts just scratch the surface focusing on the current price or the trend followed during the past months, Edelweiss once again carries out a comprehensive analysis. Congratulations.
Sin palabras, un trabajo excelente. Gracias