Has the Market Panicked Too Much for Meta?

The Finance Ghost talks about how Meta is one of the most important and impressive companies in the world, yet shareholders get thrown around like ragdolls after earnings. Explore the company's diverse offerings beyond social media, its ambitious AI and Metaverse projects, and the potential for growth amid market volatility.

So much more than Facebook
As the change in name from Facebook to Meta in 2021 made clear, there’s a lot more to this group than iconic social media platform Facebook. It was the start of Zuckerberg’s success and remains the most impressive social media story in history, but Meta considers this to only be one component of its Family of Apps business. There are over 3.2 billion people that use one of Meta’s apps each day, which is an astonishing number of people.

When Zuckerberg focuses the earnings call on revenue in Family of Apps and cost saving efforts across the business, the market shows its appreciation and the share price rallies. When he goes down the Artificial Intelligence (AI) / Metaverse path, the market hits the SELL button. Meta may well be the only company in the market where people punish any references to AI!

A quick glance at this share price chart (and particularly the nosedive on the far right) tells you that the latest earnings call jumped straight into Zuckerberg’s passion projects – AI and the Metaverse:

Llama drama

Meta’s AI model is called Llama 3, with Zuckerberg aiming to build the world’s leading AI service. The goal here is for the model to be used within WhatsApp, Messenger, Instagram and Facebook.

If you’ve recently updated your WhatsApp, you would’ve noticed that the search bar at the top has now been changed to “Ask Meta AI or Search” – a classic example of Meta’s approach of early product launches and then an iterative process to fix them. Basically, you type a question and get the answer back as a WhatsApp message. Think of it as an alternative to Googling or using ChatGPT.

Meta has direct access to a spectacular user base and certainly intends to use it. By keeping users engaged on Meta apps rather than on competing platforms like Google, the group is increasing the overall value of its ecosystem. It’s just not immediately obvious how this translates into profits, which is why the market tends to get nervous. Zuckerberg hasn’t been shy to throw money at his dreams before and we aren’t exactly living in a Metaverse yet, so the jury is still out on most of it.

If there is a bright spot to point to, it would be the relative success of the Ray-Ban Meta glasses that the company is building with EssilorLuxottica, the owner of Ray-Ban. They certainly make more sense than the ridiculous VR goggles.

At least Zuckerberg now knows what to expect from the market when he announces an expensive product investment cycle. Here’s the important excerpt from the earnings transcript:

“As we're scaling CapEx and energy expenses for AI, we'll continue focusing on operating the rest of our company efficiently. But realistically, even with shifting many of our existing resources to focus on AI, we'll still grow our investment envelope meaningfully before we make much revenue from some of these new products. I think it's worth calling that out that we've historically seen a lot of volatility in our stock during this phase of our product playbook, where we're investing in scaling a new product but aren't yet monetizing it. We saw this with Reels, Stories as newsfeed transition to mobile and more. And I also expect to see a multiyear investment cycle before we fully scale Meta AI, business AIs and more into the profitable services I expect as well.”

Long story short: they are going to throw everything at winning in AI. If they get it right, Meta shareholders will be well rewarded over time. If they don’t, it’s a long way down again. The only certainty at Meta is volatility in the share price, which is of course a risk and an opportunity.

Don’t underestimate Meta’s ability to adapt
Remember when Facebook and Instagram were “dead” because of TikTok and the obsession with short-form video? Today, Meta has successfully transitioned its apps to a position where 50% of the time spent on Instagram is on reels. The lesson here is that when you own an audience, you can pivot the offering to adapt to trends.

Although not a Meta-specific example, just consider how Microsoft introduced Teams and cut Zoom off at the knees in the process. The trend was video calling. The product was Teams. The real power was Office, being the enterprise software suite through which Microsoft could deliver the product. At Meta, the Family of Apps segment has the power to introduce new products to adapt to trends.

It doesn’t always work though, as Threads hasn’t really taken meaningful share from X (previously Twitter). Zuckerberg notes that there are 150 million monthly active users on Threads, but that’s not particularly strong adoption and Threads is unlikely to move the needle for Meta.

The fuel for the capex fire
The wonderful thing about Meta is that the cash being invested in the AI and Metaverse side of the business is being internally generated by Family of Apps, which remains incredibly strong. Meta reported revenue growth of 27% in the first quarter of 2024 vs. total expenses up just 6%. The restructuring efforts in the business have certainly paid off.

The revenue engine is Family of Apps, where revenue grew 27% year-on-year. Ad revenue is by far the most important source of cash, coming in at $35.6 billion for the quarter. Other revenue (like business messaging revenue in WhatsApp) was just $380 million – up 85% but off a small base. Family of Apps boasts an exceptional operating margin of 49%, with operating profit of $17.7 billion.

Reality Labs, which is where the mad science happens, achieved revenue growth of 30%. Before you get excited, that takes revenue to just $440 million. Expenses were a whopping $4.3 billion, so the operating loss came in at $3.8 billion. The Metaverse doesn’t come cheap.

Meta’s balance sheet is enormous, with $58.1 billion in cash and marketable securities and $18.4 billion in debt. For more context to those numbers, their capital expenditure was $6.7 billion in this quarter. They repurchased $14.6 billion in shares and paid $1.3 billion in dividends. They will need this balance sheet strength to support their ambitions in AI, as capital expenditure guidance for full year 2024 has been increased to between $35 billion and $40 billion and they expect it to keep rising.

Speaking of guidance, they decided not to give full year 2024 guidance for earnings. The market tends to worry about this kind of thing, as it points to uncertainty in the business. It also doesn’t help that they don’t have any concrete answers on return on investment (ROI) for the AI spend, as the monetisation still needs to be proven.

Is Meta worth holding?
This isn’t Zuckerberg’s first adventure into the unknown. This chart of quarterly free cash flow from TIKR shows what happened in 2022 when they got completely carried away with the Metaverse and terrified the market, with free cash flow almost going to zero in the third quarter of 2022:

Lessons were learnt from this. As you can see in the chart, subsequent quarters showed a strong recovery and so did the share price. Although the warning to the market is that the AI push will require significant investment, it’s very unlikely that Meta will take the kinds of risks seen in 2022.

Let’s have a go at the maths.

Even a fairly conservative assumption of free cash flow of $40 billion a year and revenue over the last twelve months of just over $140 billion puts the group on a free cash flow margin of around 28.5%.

The best US growth stocks regularly trade on valuations that imply as low as a 3% effective free cash flow yield. On a 30% margin for the sake of round numbers, this means a revenue multiple of 10x. If revenue is $100 and free cash flow is $30, then paying a price of $1,000 for the asset means the effective free cash flow margin is $30/$1,000 = 3%.

The market is still nervous of Zuck and his grand plans, so Meta has been trading at a higher effective free cash flow margin. Just before these earnings, it traded at 9.3x revenue on a free cash flow margin of roughly 32.5% over twelve months. That’s an effective free cash flow yield of 3.5%.

Using the conservative margin of 28.5% and applying a 3.5% effective yield, it looks like a revenue multiple of around 8.15x is the maximum that I would want to be paying for Meta right now.

Here’s the trick: after the latest sell-off, the revenue multiple is at 7.9x at time of writing. This doesn’t leave much margin for upside, but it means that Meta doesn’t look expensive at this stage either.

I’ve owned Meta previously and I would like to own it again. At the current price, it’s tempting to put in a conservatively sized position. This leaves room for me to buy more if the share price comes under more pressure.

The market tends to panic when it comes to Meta, which creates opportunities. Just be aware that a strong stomach is required to take advantage of them.

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