Long-term vision collides with near-term fear.
Below is a chart that depicts a steep 75% drop in Meta stock over the course of just one year — a ferocious market cap decline of ~$750 billion.
Most investors don’t care about the next 10 years, they cannot see past the next 6-12 months, at best. They are quick to judge and critique over short-term results, especially when stock is dropping at such a rapid pace. They take what they can see and measure, which is the latest quarterly results and project them into the future, often ignoring many intangible variables that could be a major value driver for the company over a longer investment horizon.
All that Wall Street currently sees and wants to focus on is the near-term guidance of flat revenue growth, significantly increased operating costs, significant capital expenditures and rapidly declining operating income and free cash flow.
Before we join the herd of “Doom & Gloom”, let's take a look at what Zuck & Co. have been able to accomplish since Facebook IPO’ed 10 years ago. Please take a look at some key financial figures we prepared below:
As a CEO of Facebook, Mark Zuckerberg oversaw a staggering growth in revenues from $3.7 billion in 2011 to $118 billion in 2021 (that's a compound annual growth rate of 41%). Earnings per share (EPS) have also grown 41% per annum from $0.43 to $13.77 over the same time period. Free cash flow per share has increased 42% per annum from $0.40 to $13.68. Gross margins for this business have been 80%+ since 2014 and operating margins have been 40%+ since 2014. How many companies in the world do you know that can put up these kinda numbers? You can count them on one hand…
Before we judge and ‘pour dirt’ all over Zuck and his company, like the click-thirsty media is quick to do, maybe we should first take a moment to appreciate what this extraordinary entrepreneur (arguably one of the best of our lifetime, with the likes of Gates, Jobs and Musk) has been able to accomplish with his incredible vision, execution and leadership. He has built one of the most recognizable, powerful and profitable companies in the world that reach 3.7 billion people on a monthly basis and 2.9 billion people daily — I don’t think there is any one of us that doesn‘t use at least one of their Apps or services.
What should also be noted is that Zuckerberg deservingly built an incredible fortune for himself ($140 billion at the peak last September) and recently witnessed his fortune collapse by nearly $100 billion. Despite experiencing the biggest loss in net worth that any person has ever experienced, he continues to be unfazed as he is single-mindedly continues to pursue his vision for his company and to invest in order to deepen his company’s moat over the long run. Now that is the CEO that truly eats his own cooking!
In our recent letter, we discussed the mentality of a passionate Founder/CEO that drives a completely different thought process and decision-making, which could make all the difference in the long run. The following is relevant quote by Brian Armstrong, Founder and CEO of Coinbase:
“I can speak with some authority and say we are not going to do that because this is not why I started the company — I don't have to give any other justification. Rather than the professional CEO that comes in that is accountable to Wall Street and quarterly earnings may start thinking about the company differently. One of the most scarce things in companies today is risk tolerance. For example, take Tesla vs. Waymo. Tesla launched self-driving cars while Google didn’t. The reason is the founder-CEO (Elon Musk) said that I care enough about the mission that we are ready and we are gonna go for it. Whether a professional CEO is thinking about his/her career trajectory, the founder CEO doesn’t care about the next job and only cares about the mission.”
Is Mr. Market looking forward far enough?
We completely understand that the stock market is a forward-looking discounting mechanism and that Wall Street is looking forward beyond the extraordinary Facebook results of the past 10 years. But is it looking forward far enough?
In our opinion, all Wall Street is currently focused on is the flattening of near-term revenues due to economic impact on digital downturn and a dramatic increase in expenses from $71 billion in 2021 to an estimated ~$99 billion in 2023, which will cause a drop in operating profits from $46.8 billion in 2021 to our estimate of $28 billion in 2023 (please note that even then, their operating margins are still expected to be above 20%). Combine that with a dramatic increase in capital expenditures from $18.6 billion in 2021 to estimated $36.5 billion in 2023 and we have the herd selling and asking questions later.
Should we be so quick to discount Zuck and Meta Platforms based on next year's forecasts of operating profits and free cash flow? Is he really burning all that cash without a consideration of future returns for the company?
Let’s take a look at the pressing issues that Zuck & Co. have been dealing with:
Competitive threats from TikTok
Signal loss from Apple’s iOS changes
Economic downturn that is having a broad impact on digital advertising business
If you were a CEO of Meta, how would you deal with these threats/concerns, and how would you position the company for long term success?
Before we dive into the long term investments that Meta is currently undertaking, let's first take a look at the health of the core business (Family of Apps), which we feel is being completely ignored by the Street. There has been a lot of speculation about the decline of Facebook and engagements on their apps, so let's look at the facts. The following is straight from the Q3 ‘22 earnings call:
“On Facebook specifically, the number of people using the service each day is the highest it's ever been — nearly 2 billion — and engagement trends are strong. Instagram has more than 2 billion monthly actives. WhatsApp has more than 2 billion daily actives, also with the exciting trend that North America is now our fastest growing region. Across the family, some apps may be saturated in some countries or some demographics, but overall our apps continue to grow from a large base. We're also seeing engagement grow — especially strong growth in Reels.”
Now, lets further explore how Zuck is addressing the major threats/challenges to his company outlined above?
Competitive threats from TikTok
His first primary area of focus and investment is on the AI discovery engine that’s powering Reels and other recommendation experiences, their ads and business messaging platforms. From Q3 ‘22 earnings call:
“Reels continues to grow quickly across our apps — both in production and consumption. There are now more than 140 billion Reels plays across Facebook and Instagram each day. That's a 50% increase from six months ago. Reels are incremental to time spent on our apps. The trends look good here, and we believe that we're gaining time spent share on competitors like TikTok. Over time, I expect a few things to set our products apart here. First is that our discovery engine work allows us to recommend all types of content beyond Reels as well, including photos, text, links, communities, short and long-form videos, and more. Second is that we can mix this content alongside posts from your family and friends, which can't be generated by AI alone. Third, as more social interactions move to messaging, we're developing a flywheel between discovery and messaging that are going to make these apps stronger. On Instagram alone, people already reshare Reels 1 billion times a day through DMs.”
When it comes to monetization, the growth of short-form videos (reels) creates near-term challenges since Reels do not monetize at the rate of feed or stories yet. That means as Reels grow, they displaces revenue from higher-monetizing surfaces. Now in theory, they could mitigate this short term headwind by pushing less hard on growing Reels, but that would be worse for their products and business longer term since they're confident that Reels will grow engagement overall and quality will eventually monetize closer to feed.
Would an agent-operator “hired gun” CEO be willing to make that kind of a decision, to sacrifice a very profitable business today in order to position the business competitively for the future? In most cases, we doubt it! The incumbents are typically very slow and resistant to change until they become dinosaurs in the face of innovative competition. On the contrary, Zuck had successfully transitioned Facebook to mobile from desktop and to stories, even though it was risky and detrimental to short term profits at the time. He is doing the same thing with Reels, which is currently very unappreciated by the market.
Signal loss from Apple’s iOS changes
“As I've discussed before, our approach here is to grow first-party understanding of people's interests by making it easier for people to engage with businesses in our own apps whether that's through business messaging, shops, or new ads products. For example, Click-to-Messaging is part of our business messaging strategy that is growing quickly — with 40% of our advertisers already using this format.
The AI wave that we're riding is a tailwind for all of these solutions. Advances in AI enable us to deliver better personalized ads while using less data. It powers automated messaging and creation tools that let businesses run better performing campaigns — which is particularly important for small businesses that don't have big marketing departments and that have been hit hard by Apple's policy changes. Overall, there's a lot of work to do here — and a lot of the investment is in AI compute capex — but I'm confident that if we invest in building the new infrastructure we need, then we’re going to come out of this downturn with even more superior ad products and a meaningful technology advantage over other industry players.”
By the way, we believe there is a big misconception out there that the $32.6 billion in Capex in 2022 and the planned $36.5 billion in Capex for 2023 will be unprofitably burned on the Metaverse. This is absolutely not true! The following is straight from Q3 ‘22 earnings call:
“For 2022, we expect capital expenditures to be in the range of $29-34 billion, driven by our investments in data centers, servers, network infrastructure, and office facilities. As we discussed previously, this range reflects a significant increase in our artificial intelligence and machine learning investments, which will support a number of areas across our Family of Apps. While our Reality Labs products and services may require more infrastructure capacity in the future, they do not require substantial capacity today and, as a result, are not a significant driver of 2022 capital expenditures.”
So this is a necessary investment that management thinks it needs to make in order to defend its core business (Family of Aps) from two main threats: TikTok and App Tracking Transparency (ATT). That is because the answer to both challenges is more AI, and building up AI capacity requires a lot of capital investment.
Is Metaverse a waste of time and money?
There is a great quote by Theodore Roosevelt that answers this question perfectly:
It is not the critic who counts; not the man who points out how the strong man stumbles, or where the doer of deeds could have done them better. The credit belongs to the man who is actually in the arena, whose face is marred by dust and sweat and blood; who strives valiantly; who errs, who comes short again and again, because there is no effort without error and shortcoming; but who does actually strive to do the deeds; who knows great enthusiasms, the great devotions; who spends himself in a worthy cause; who at the best knows in the end the triumph of high achievement, and who at the worst, if he fails, at least fails while daring greatly, so that his place shall never be with those cold and timid souls who neither know victory nor defeat.
There are many opinions on the topic of Metaverse and most investors are very skeptical and critical of Zuck’s efforts and would prefer he would focus on the core business instead. In 2021, Zuck published a Founder’s Letter where he outlined his vision. These are his thoughts on the topic from the most recent earnings call:
“The metaverse is a massive opportunity for a number of reasons. Most importantly, it enables deeper social experiences where you feel a realistic sense of presence with other people, no matter where they are – whether you’re playing games or working for hours at a time, or you’re just jumping in for just a minute at a time to say hi to a friend or collaborate on a project quickly. By helping develop these platforms, we’re going to have the freedom to build these experiences the way we and the overall industry believe will be best rather than being limited by the constraints that competitors place on us, and our community, and on small businesses. Given some of the product and business constraints we face now, I feel even more strongly now that developing these platforms will unlock hundreds of billions of dollars, if not trillions, over time. This is obviously a very expensive undertaking over the next several years, but as the metaverse becomes more important in every part of how we live – from our social platforms and entertainment, to work and education and commerce – I’m confident that we’re going to be glad that we played an important role in building this.”
The losses for Reality Labs in the past 12 months have been substantial amounting to $12.7 billion. However, when we compare it against the very profitable core business (Family of Apps) and its operating profits of $48 billion, which by the way enjoyed operating margins north of 40% before they fell to 34% in the recent quarter, it could be argued that these investments are sustainable and Zuck is not betting the house as the media loves to portray. We do agree that current investments are staggering and have a very uncertain future payoff profile, which makes the investment community uneasy. At the same time, we truly believe that the company should be making these important investments, which is the future of communication. We stand by the “man who is actually in the arena, whose face is marred by dust and sweat and blood; who strives valiantly.”
Current valuations of Meta makes no sense to us
Meta is estimated to make close to $120 billion in revenues this year. Gross profits are still around 80%. The core Family of Apps business generated $48 billion in operating profits over the past 12 months, and the entire market cap is currently $240 billion (5x core operating profits). Free cash flow over the past 12 months netted at $26 billion, even after the heavy capital expenditures we described above.
Since 2017, Meta had invested $210 billion into R&D and Capex — close to the current market cap (please refer to the chart above). In 2022 alone, they are investing $65 billion into R&D and Capex (in comparison, Apple is doing about half of that). Is Zuck just burning through piles of cash? Given his incredible track record, his unique ability to see where the world and technology is headed over the next 10-15 years and to execute against his vision, we would not bet against him.
Alex and Joe
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