Meta Exits Value Territory As Headwinds And Risks Mount

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Reality Labs losses are expected to grow in 2024, and the timeline to see returns on the capital Meta has spent there appears to be pushed out farther.

It’s been an excellent run for Meta Platforms (NASDAQ:META) over the last year, surging some 270% from late 2022 lows to a closing price of $336.31 on November 14, 2023. But with increasing pressure on advertising revenue, indications from executives that revenue may not impress in 2024, and projected growth in expenses, investors should seriously consider taking their profits and exiting Meta for now.

Let me provide some background on how I have thought about Meta over the last couple of years, since I haven’t written about it before. I made my investment in Meta before I started writing for Seeking Alpha, entering on February 7, 2022 at $225.53 and buying the dip on November 7, 2022 at $94.99 – fortuitously catching it pretty close to the bottom.

My thesis for those investments was that, while the social media side of the business may not grow at the impressive rates it did over its first decade as a publicly traded company, the Family of Apps should throw off a pretty reliable $12 to $15 per share of annual earnings, and was thus worth somewhere around $180 to $225 on its own at a 15x multiple. As long as the rest of the business had positive value, it was a freeroll – and at some point Meta would either show a profit on the Reality Labs/Metaverse side of the business or stop lighting money on fire. I didn’t see Meta failing to return to that price level over the ensuing years, and thought it could go higher. So I saw an enticing asymmetrical bet.

I felt that investors were also underestimating the potential business applications of the Reality Labs/Metaverse research and development, instead focusing on the admittedly shaky Horizon Worlds game. While I still think that’s the case, it’s no longer such an asymmetrical bet. It seems quite plausible that Meta could drop to the $180 to $225 range again if potential headwinds come to fruition.

Overall, Meta still checks a few of the boxes for value investors. Their earnings growth over the last decade has been impressive, with only a couple blips on the radar. They have low levels of debt and a strong balance sheet with plenty of cash on hand.

The problem is, with the stock now trading at more than seven times its tangible book value and nearly 30 times earnings, there’s no margin of safety. A bad quarter could send the stock spiraling again, and further growth from here will require earnings growth or a strong expectation of earnings growth.

These ratios don’t take Meta outside its five year norms, but they do take it outside of the value territory it was in over the last couple of years and towards the upper end of its normal range.

A couple of quotes stood out on the Q3 earnings call with regard to revenue for Meta going forward. First, the price per ad dropped by 6% according to Meta Platforms Chief Financial Officer Susan Li.

“In Q3, the total number of ad impressions served across our services increased 31% and the average price per ad decreased 6%. Impression growth was mainly driven by Asia-Pacific and Rest of World. The year-over-year decline in pricing was driven by strong impression growth, especially from lower monetizing surfaces and regions. While overall pricing remains under pressure from these factors, we believe our ongoing improvements to ad targeting and measurement are continuing to drive improved results for advertisers.”

Obviously growing ad impressions is good, and those two figures combined do add up to growing revenue. However, they do also point to one of the key challenges facing Meta as it continues to grow. Most remaining growth will be in less valuable markets, thus pulling down its price per ad. As it eventually runs out of room to grow its audience, it will be more subject to macroeconomic volatility.

On that note, Li referenced that very factor in a quote that I view as softening expectations for eventual 2024 guidance.

“We obviously have not shared a 2024 revenue outlook yet. You asked about what are some of the significant puts and takes, and I’d maybe point back to what I said earlier about the Q4 outlook just to highlight what a volatile macro environment we believe we’re in. I think that will obviously have a big impact on the advertising market next year, and it’s something we’ll be keeping a very close eye on. But ultimately, we’re very subject to volatility in the macro landscape.”

She also noted that the comparisons for next year will be up against strong periods, which will provide headwinds to the year-over-year numbers that investors often focus on. Paying such a high multiple of earnings seems extra risky in an environment where there could be significant macroeconomic volatility, which Meta warns will have a big impact on their results.

In addition, Meta has a growing reliance on revenue from China, during a time when geopolitical tensions between the United States and China are on the rise – presenting potential threats to those revenue streams. Stay tuned for more on those risk factors below.

As Meta’s “Year of Efficiency” winds down, it sounds like 2024 is going to have more headcount growth than perhaps had previously been expected, on top of growing infrastructure costs. On the most recent earnings call, Li spoke predominantly about the rising operating costs.

“You also asked about the kind of the expense philosophy next year, whether expense growth will be tied to revenue growth. Obviously, the revenue outlook is uncertain. We talked a little bit about the — what’s going into the preliminary expense guide for 2024. The big components there are around infrastructure expenses. We do expect, given the increased capital investments that we have made in recent years, that depreciation expenses in 2024 will increase by a larger amount than in 2023. And we expect to incur higher operating costs from running a larger infrastructure footprint.”

However, that’s not all. After layoffs to improve efficiency, Li makes it sound like there will be significant hiring in 2024 before it slows back down going forward.

“The net effect of our efforts to close out our 2023 hiring underruns and our efficiency-focused 2024 budgeting process is that we expect to end next year with reported, in-seat headcount meaningfully higher than our current headcount, but to grow at a slower rate beyond that. We also expect a step-up in infrastructure-related expense growth next year as we recognize higher depreciation and operating costs from running an expanded infrastructure footprint.”

Assuming that comes to fruition, it seems likely to draw some pushback from Wall Street, as the consensus among investors seemed to be that the layoffs and more streamlined business made Meta a more appealing investment. If this is an ongoing battle between Mark Zuckerberg’s vision for Meta and Wall Street’s preference for a leaner structure, there’s a risk that renewed growth in headcount draws the ire of investors.

Obviously a lot of capital has been plunged into Reality Labs, and it remains to be seen whether or not those bets will pay off. However, reading between the lines of Zuckerberg’s comments on the Q3 earnings call, it appears things may not be moving as quickly as he expected.

“On the hardware side, I mean, obviously, the smart glasses that we just rolled out, we sort of thought were a precursor to eventually getting to displays and holograms for augmented reality, and I think we will eventually get there still. It’s not that far off. But I think that now the ability to deliver AI through smart glasses may end up being a killer use case for that even before you get to the kind of augmented reality type of use cases.”

While I do think this is still an area that offers some upside, it’s concerning to hear Zuckerberg say that he thinks they will eventually get there still. That feels like a lot of qualifiers on his confidence. I think the potential for augmented reality is massive, and if that’s farther away than expected, that’s a big disappointment.

Li also cautioned that Reality Labs will see its losses grow year-over-year, “Finally, for Reality Labs, we expect operating losses to increase meaningfully year-over-year due to our ongoing product development efforts in AR/VR and our investments to further scale our ecosystem.”

Another concerning factor on the Reality Labs side of things was what appeared to me to be a ducked question on the pricing of Quest 3. When asked about early demand and whether it was priced to at least breakeven, Li’s response avoided answering the pricing side.

“Sure. So the first part of your question was early sort of signals with Quest 3. We are not sharing any explicit expectations for Quest 3, either Q4 Reality Labs revenue, unit sales, et cetera. But we are very excited to have Quest 3 in market, in particular, during the holiday shopping period. We think early reviews have been great. And we’re very excited to have a product out there that are going to introduce a lot of people to mixed reality experiences for the first time. So it’s very early. I think we don’t have very many more specifics. But again, we’re quite excited to have it in the market and to have it in particular during the holiday marketing season.”

This could have been an oversight, but it seems to me that Meta wanted to avoid providing details on margins for the Quest 3, which is probably not a great sign. If they are still struggling to price it to even break even, that doesn’t bode well for the future of the platform.

In addition, while the Ray-Ban Meta Smart Glasses look pretty cool, I consider it disappointing for the long-term potential that they’re partnering with Ray-Ban instead of producing their own glasses in house. That seems to limit the potential upside, and call into question their ability to follow in the footsteps of other tech companies and bring tangible products to market that drive growth.

It sure seems like Meta is going to be in perpetual conflict with regulators going forward. This was likely inevitable, but it seems to me that both from an investment standpoint and in society, we’ve let this news arrive in drips and drabs and perhaps haven’t thought enough about what it really means.

We’ve only lived in a world with social media for about two decades, and it’s a pretty recent development that we understand a lot of the risks and downsides societally. As a result, I think it’s reasonable to think about the old days as almost a “Wild West” of social media. From a global perspective, I view it as unlikely that social media is ever less regulated than it is right now.

I don’t think it’s particularly likely that social media companies will be severely impacted by regulations, but it’s possible – so it’s a risk. More likely, it’ll be a small but consistent drag on their earnings and growth potential.

Below is the quote from Li during the earnings call that got me thinking.

“In addition, we continue to monitor the active regulatory landscape, including the increasing legal and regulatory headwinds in the EU and the US that could significantly impact our business and our financial results. Of note, the FTC is seeking to substantially modify our existing consent order and impose additional restrictions on our ability to operate. We are contesting this matter, but if we are unsuccessful it would have an adverse impact on our business.”

Li also pointed out that they’re changing their legal basis for processing personal data in the European Union and Switzerland, shifting to a consent model. That seems like something that could significantly impact their business in those regions.

One key tidbit on the accelerating ad revenue was that it was “due primarily to strong demand from China advertisers,” according to Li. This drew a question, and her response to the follow up was illuminating.

“And you kind of alluded to whether there’s — the sustainability of the China advertising revenue. And even though we’ve seen particularly strong growth this year, I would say that there has been a longer-term trend of overall growth with this segment dating back to past years and also periods of volatility in the past, like in the last two years, we’ve seen periods with higher shipping costs with lockdowns, with regulation weighing on demand. So we recognize there’s the potential for volatility in the future as well and especially given that there are so many macro factors at play that are quite hard to predict.”

The macro factors and geopolitical factors stand out to me. Going through a cycle of reshoring in industry, it remains to be seen how things ultimately shake out with the shipping and logistics for products from China. One might think less shipping demand will drop prices, but it could also coincide with a decrease in available supply of shipping space. So perhaps it’s best considered an unknown. If it becomes harder to ship goods across the Pacific and sell them profitably in the US, that could significantly impact Meta’s ad revenue.

In addition, growing geopolitical tensions between the United States and China could come to a head and lead to less trade between the countries, stifling a major source of ad revenue for Meta. I would currently categorize these risks as relatively unlikely to manifest, but they could be extremely detrimental if they do.

Obviously demand for ads will not completely crater, but if Chinese advertisers are providing significant upwards pressure on pricing, that revenue stream could be diminished significantly.

It’s not all negative for Meta, and there are plenty of reasons for second thoughts. Along with Alphabet Inc. (GOOGL), Meta was providing some of the most reasonably priced exposure to AI that existed. Exiting this position means leaving some of that artificial intelligence upside on the table. That feels risky, to be sure. On the other hand, a lot of the upside from artificial intelligence will bleed into the entire market. It’s hard to capture, and there will likely be significant competition between tech companies that lowers pricing and allows their clients to realize a lot of the growth.

That said, Meta also gets to deploy it across their social media apps. On the Q3 earnings call, Zuckerberg contemplated the possibility of using artificial intelligence to directly generate content for users.

“And I think over time, maybe we’ll even get to the point where we can just generate content directly for people based on what they might be interested in,” Zuckerberg said. “I think that, that could be really compelling.”

While this one is less immediate, there is also some potential growth to the Family of Apps based on some of the devices that will come out of the Reality Labs research and development. Devices could allow users to generate more content, that will perhaps be compelling enough to get users to spend more time on their apps, according to Li.

“Longer term, obviously, we think there’s a lot of value from operating our Family of Apps experiences on top of a new computing platform that we helped develop, for example, having glasses on that enable you to have our Meta AI assistant with you at all times. And as glasses scale, they’ll make it increasingly easy to capture compelling content from a first person point of view while you’re staying in the moment or the activity that you’re doing and sharing that content should enrich our content ecosystems even further.”

My general goal as an investor is to identify a broad range for fairly valuing a company, and buy well below that range. If a stock is around fair value, I’m happy to sell and find another bargain that can deliver better forward returns.

I am usually looking for a stock to hit on seven of my 10 value indicators to provide a strong margin of safety and a high likelihood that it will beat the broader market. For Meta, that price point is around $185. Given the artificial intelligence upside and growth potential of Meta, I would consider buying if it popped up on six of my 10 indicators, which would happen around $215 based on the current numbers.

Now, that means a fair valuation is significantly higher than that range. Somewhere in the neighborhood of $260 to $325 seems reasonable based on a few factors.

For a company with strong growth, I’m usually willing to pay 15 to 20 times earnings if their balance sheet is strong. Meta’s balance sheet is fine, and forward earnings projections for 2024 are $17.29 per share.

That would give a range of $260 to $345, but growth is projected to slow from there and I think there’s a risk those projections drop over the next few months based on what was said on the most recent earnings call, so I think the top end needs to be a bit lower, thus settling it at $260 to $325.

By no means do I think Meta is a bad company. I’d definitely be interested in investing in Meta in the future, if the price returns to a value level. At the moment though, as a value investor, I believe there are better deals available that are likely to offer higher returns than Meta over the next couple of years.

Since it’s currently towards the high end of a fair price range with a number of risks and potential headwinds on the horizon, I’m rating Meta a sell and will look for a better re-entry point in the future. All of the risks are ones I’d be willing to carry, but they need to be offset by more available upside and a better margin of safety than exist at current prices.

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