Disclosures / Disclaimers
This post is only for informational/educational purposes. Cognitive Quant provides a due-diligence platform and is not a recommendation service / newsletter
We have a position in FB/META - however, it shouldn't serve as a positive/negative consideration as we may add/reduce/exit at our discretion. Please conduct your own due-diligence prior to investing your valuable capital
Introduction / Discovery
Meta Platforms, Inc's stated mission is to "give people the power to build community and bring the world closer together..." For the most part, its revenues are generated from selling ad placements on its Family of Apps (Facebook, Instagram, Messenger) and third-party apps and websites. Its other reporting segment, Reality Labs, focused on Augmented Reality (AR) and Virtual Reality (VR), generates revenues from the sale of hardware (Meta Quest and Facebook Portal) and associated software and content.
Meta has been facing significant headwinds and has declined by ~40% since the beginning of the year. It is currently in the cheapest 20% of stocks covered by our platform and in terms of quality, among top 15% of stocks and came up as one of the prospects to be considered using our preferred investment process. Our preferred approach can be summarized as:
Investing in high-quality companies with strong balance sheets and robust business models at prices near their more certain sources of intrinsic value and with ample margin of safety.
Checklists
A quick-look at the checklist shows Meta has a strong balance sheet with no net debt. On a quantitative basis it has been an exceptional business -- a huge FCF generator (~$40B in FCF and ~30% FCF/Sales in 2021) with ROIC consistently above 30%.
The checklist highlights two important qualitative aspects to consider:
It is a cyclical business as it derives revenues from advertising which tends to be cyclical -- even though the relentless shift towards online advertising from < 20% in 2012 to over 60% in 2021 has meant that, for the most part, participants in online advertising have not experienced a cyclical pullback in revenues.
Legal proceedings that it is currently subject to could be material. Please note that this is an algorithmic assessment which is *not* a substitute for human judgement. Reviewing the Legal Proceedings section extracted by the platform (see below) shows that there is a litany of legal issues that Meta is facing currently.
As seen on the right (and in video above towards the end), around $3.3 Billion has been accrued as of now for loss contingencies in regard to legal matters. Although it is hard to know for sure if this would be sufficient, it seems reasonable --especially given continuing accruals for additional loss contingencies.
From a business model perspective, Meta seems to be quite robust with no disclosed customer, product/service, supplier, or credit concentration risks. That said, a review of Fundamental Sentiments in the platform shows that Meta faces significant platform / distribution risk given its acute dependence on mobile platforms from Apple and Alphabet:
Meta's current focus and considerable investment in Metaverse/AR/VR is understandable in this context as a potential pathway to be more in control of its destiny.
However, despite the real/perceived risks from regulatory scrutiny, platform risks (Apple ATT/IDFA, Android privacy changes), slowing user growth etc., in our view, Meta should be able to address its challenges - as it currently has a huge audience, good user engagement, and the highest monetization rate (see table below). In addition, it has an exceptionally strong balance sheet with ~$48 Billion in cash and short-term investments that should give it the flexibility to optimize for the long-term.
Company | US Mobile DAUs (millions) | Intl. Mobile DAUs (millions) | Avg. Daily Time per daily iOS user | U.S ARPU¹ ($) |
177 | 1,667 | ~42 mins | $81.16² | |
87 | 749 | ~54 mins | - | |
Snapchat | 60 | 238 | ~22 mins | $9.61 |
TikTok | 48 | 210 | ~89 mins | - |
34 | 164 | ~28 mins | $23.59 |
¹ Data represents average revenue per daily active user
² ARPU is for Meta overall
Source: SensorTower estimates, Company Filings, and BofA Global Research for 4Q 2021
Valuation
Even though we are reasonably optimistic that Meta would be able to address the challenges it is facing - the future remains uncertain and we do not have a crystal ball! And so, it is helpful to consider a few scenarios when considering estimates of intrinsic value.
Please note that we prefer an Earnings Power-based segmented valuation approach as it provides a better assessment of value by separating more certain sources of value (assets and current sustainable earnings power) from more uncertain sources of value (i.e. from future growth). In practice, this translates to investing in high-quality companies when you have to pay little to nothing for expected growth. We will be using this approach in each of the scenarios discussed below.
Scenario 1: Cyclical pullback followed by anemic growth
Key Assumptions:
- 10% decline in revenue, followed by 5% growth (a steeper decline while possible seems quite unlikely given the continuing shift to digital advertising)
- 27% Operating income margin (vs ~40% currently)
- 35% ROIC (vs ~56% currently)
Scenario 2: Likely pre-earnings expectation
Key Assumptions:
- 15% revenue growth for next 5 years (vs ~12% forecasted CAGR per eMarketer)
- ~40% Operating income margin (at median)
- ~54% ROIC (at median)
If one considers this to be the most probable scenario - then at the current price, growth is essentially available for free. At a minimum, this segmented view can help caution investors from paying up too much for future (and uncertain) growth.
Scenario 3: Modest growth with Margin Compression
Key Assumptions:
- 7% revenue growth for next 10 years (quite conservative in our view given the continuing shift to digital advertising and Meta's proven ability to drive revenue growth over many years - though the future can unfold very differently from our expectations)
- 35% Operating income margin (to account for ATT challenges - though Meta's ad business continues to have strong margins -- ~48% in Q4 2021. From a historical perspective, operating margin was meaningfully below 35% only once - in 2012 because of significant share-based compensation expense subsequent to its IPO)
- 45% ROIC
In our view, the most probable scenario is likely closer to Scenario 3 above -- and our preferred approach is to patiently wait and pay as little as possible for uncertain future growth - this will help minimize losses even if the future plays out differently. That said, here are some additional considerations that bolster Scenario 3 as a plausible scenario:
Meta's management team has a great track record - over past 9 years, revenues, EBIT, and FCF grew at CAGR of 42%, 66%, and 67% respectively
Meta has managed transitions well in the past: desktop →mobile, Wall →Feed, Feed →Stories and should be able to manage the transition to short-form video as well
Even if they are currently behind in adequately addressing ATT/IDFA changes, SNAP's recent earnings shows that these challenges are not insurmountable. Meta's advertising business is nearly 4x that of SNAP - and it could be taking longer for Meta's advertisers to adopt new measurement and targeting tools
Yes, Facebook's DAUs declined for the first time, and so did engagement (i.e. time spent) - but revenues still increased 20% YoY, and both U.S. and Intl. ARPUs increased by ~15% on a YoY basis in Q4 2021. And while there is understandable consternation about the expected impact of Apple's ATT changes in Q1, 2022 - it is important to note that Q3 2021 was the first full quarter under the impact of Apple's ATT policy changes. In this regard, the following exchange from the Q4 2021 Earnings Follow-up Call Transcript is interesting:
Notwithstanding the competitive intensity from TikTok and ATT policy challenges, it is likely that quite a bit of Meta's expected slowdown in growth is because of macro factors -- given the slowing but still substantial YoY revenue growth of 36% in Q3, and 20% in Q4 of 2021 (vs the 3-11% guidance for Q1, 2022 under reasonably similar conditions).
The cautious outlook and increased investments may also help highlight the competitive intensity and potentially receive some reprieve in regulatory scrutiny -- besides providing the space for getting the consumer experience right for monetizing Reels. It may even provide the added benefit to Meta of increasing the regulatory scrutiny on mobile platform providers such as Apple and Alphabet.
It is quite possible you have a different perspective and would like to explore other scenarios. FB is an open ticker on our platform currently (no registration is required).
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Additional perspectives:
It is important to consider multiple view points - here are a few that touch upon different aspects of the evolving advertising landscape and Meta's changing prospects:
