Meta Is Not Out Of The Woods Yet (NASDAQ:META)

Obviously, Meta Platforms (NASDAQ:META) stock has been suffering as of late, being down more than 70% since its high set in August 2021. That’s a lot to lose in little more than one year, for a company whose business is supposed to be stable, highly profitable, and dominant.

When we survey Seeking Alpha’s landscape, we see that at the current levels, most seem optimistic regarding Meta’s future. There’s been a single negative article on the name in the last month, and all others are buys or strong buys. Likewise with the analyst community, in the last 90 days, out of the 56 analyst opinions, 64% are buy or strong buy, and only 5% are sell or strong sell.

It’s reasonably easy to see why the landscape looks like this. Meta is facing some headwinds, but if it merely manages to get back to its 2021 profitability, it would today be trading at just 8.1x earnings. Even considering the analyst consensus for 2023, which is going to be a difficult year, it’s trading at 14.1x earnings, which isn’t a lot for a business of Meta’s quality.

However, as I’ll show, there are at least 2 developments which Meta might be facing in the future and which might not yet have filtered through to the market’s sentiment and consensus estimates.

Let us first go over the main factors affecting Meta, positive and negative, which the markets talk the most about.

Apple Privacy Changes Are Now Fully In The Numbers

A headwind which Meta faced was Apple’s change to its privacy policies back in Q2 2021. These changes have meant advertisers stopped being able to easily track an individual across apps and websites.

Hence, for instance for Meta, Meta stopped being able to know about all the individual’s interactions on the web, and instead was only able to understand this individual’s behavior in its own apps. This meant that when selling ads, Meta wasn’t able to provide as good a targeting for the advertiser as before. If an advertiser can’t target a consumer as effectively, the ad directed to this consumer will be worth less for the advertiser, and hence the advertiser will also be willing to pay less for it.

Gladly, for Meta, the full effect of this change came in Q3 2021, and now since we’ve gone through Q3 2022, arguably all the effect is already in the numbers. It’s thus one less worry for Meta investors.

Engagement Trends Remain Normal

Since Meta’s stock fell so much, it was only natural that some investors started worrying about whether Meta’s social destinations, namely Facebook and Instagram, were seeing less engagement.

This was not the case. Indeed, a recent Seeking Alpha article focused precisely on the fact that engagement hasn’t deteriorated, so I’m not going to repeat the detail here. Suffice to say that engagement metrics (DAUs, MAUs) remained healthy and in a growth trajectory.

Furthermore, Meta claims that Reels has been additive to the time spent on its platforms, which is yet another form of engagement improvement.

No problems with engagement, then.

WhatsApp Remains To Be Broadly Monetized

Another positive angle that Meta is developing is the monetization of its messaging apps, WhatsApp chief amongst them. Since these apps have massive reach, any possible monetization is bound to produce significant accretive revenues and profits. It’s perfectly normal to be optimistic about this prospect.

For now, what Meta already managed, is to grow click-to-messaging ads into a $9 billion run rate. These are ads where clicking on them can lead directly to messaging with a company representative. Initially this started with Facebook Messenger, but it’s also expanding to WhatsApp. Clearly, for a business having direct contact with a potential customer is more valuable than just throwing him into a website page.

We can also expect some advertising to show up in the messaging apps.

Finally, Meta expects to also expand paid messaging, for corporations to reach out and communicate with its user base.

All of this makes it likely that over time, messaging is going to contribute to Meta’s revenue and profit growth. And that should thus help in getting back to 2021’s profitability level, as well as go beyond it.

Metaverse Is A Black Hole But It’s A Black Hole Under Meta’s Control

Of course, the elephant in the room is the Metaverse. There isn’t much of a business there, but the Metaverse is creating prodigious amounts of cost. In Q3 2022, 39% of all operating income produced by Meta’s core business went into the Metaverse to never be seen again.

Moreover, during the Q3 2022 conference call the following was claimed:

We expect Reality Labs expenses will increase meaningfully again in 2023, with the biggest drivers of that being the launch of the next generation of our consumer Quest headset and hiring that has been done in 2022, but for which we are going to be paying the first full year of salaries next year.

So, not only is the Metaverse cost black hole large, but there’s the prospect of it growing significantly in 2023. Anyway, the impact that the Metaverse is having on Meta’s profitability is widely known and commented upon. I’ll just add something that isn’t entirely new either:

• The Metaverse is a self-inflicted problem. It’s a problem that Meta has control over. Meta can choose to simply shut down most of its investments and costs in this area if it doesn’t see a way towards profitability. Of course, the Metaverse is apparently Zuckerberg’s love child, and hence it’s probably harder to take such a decision. As a result, it’s my opinion that if Zuckerberg was to announce his resignation, Meta’s stock would react very positively.

Anyway, the Metaverse is also not the focus of this article, though its impact, both current and into 2023, is very relevant.

Forex Pressures Are Now Easing

Another factor which has been punishing Meta’s revenues and earnings is the strong USD. Since Meta has a large business outside the US, when foreign currencies weaken versus the USD they translate into fewer USD, both in terms of revenues and foreign-earned profits.

Meta reports both its revenues, and a growth number based on stable currencies, where this impact can be seen. For instance, in Q3 2022 revenue growth was as follows:

Let’s begin with our consolidated results. All comparisons are on a year-over-year basis, unless otherwise noted. Q3 total revenue was $27.7 billion, down 4% or up 2% on a constant currency basis. Had foreign exchange rates remained constant with Q3 of last year, total revenue would have been approximately $1.8 billion higher.

So, a 6% impact. Meta guided towards a 7% impact in Q4 2022. However, since the end of Q3 2022 (September 30) and since Meta’s earnings report, things have improved forex-wise. For instance, the EUR/USD went from 0.98 on September 30 and 0.995 on October 25, to 1.046 now. The same can be seen on the JPY, GBP, etc.

Hence, the forex pressure on Q4 2022 will, if the USD “holds its weakness”, less than expected (less than the 7% revenue headwind put forth by Meta).

Issue 1 – Facebook And Instagram Are Changing

Let’s now talk about the issues which get less press.

The first one is more commonly commented on, but it might still gain in relevance and thus affect Meta’s profitability.

The issue is actually a successful growth initiative. Reels. Reels are expanding quickly across Meta’s platforms. These reels are most often created by third party creators – people who are neither your friends nor your family.

In there lies a big change to Facebook and Instagram’s business. Previously, you tended to get your feed built out of content created by people you were familiar with. However, that’s now changing, and Meta’s algorithms are now more often exposing you to content produced by “professional” creators, most prominently in terms of short videos termed as reels.

These reels are growing powerfully and constitute a novel form of content that’s more sustainable to keep you engaged than your boring family and friends. There’s always new exciting content with this approach. It works.

It works, but monetizes worse. That is, the revenues Meta gets from this otherwise successful product are lower, for the same engagement, than those it gets from your common feed / stories. Here’s what Meta had to say about it:

Moving to monetization, I’ve discussed in the past how the growth of short-form video creates near-term challenges since Reels doesn’t monetize at the rate of Feed or Stories yet. That means that as Reels grows, we are displacing revenue from higher monetizing surfaces. And I think this is clearly the right thing to do, so Reels can grow with the demand that we are seeing, but closing this gap is also a high priority. Even with the progress we have made, we are still choosing to take a more than $500 million quarterly revenue headwind with this shift, but we expect to get to a more neutral place over the next 10 – sort of 12 to 18 months. I mentioned last quarter that Instagram Reels had crossed a $1 billion annual revenue run-rate. We continue scaling monetization across both Instagram and Facebook and the combined run-rate across these apps is now $3 billion.

A $500 million revenue hit. That’s not pretty, it’s a $2 billion+ yearly revenue headwind.

But what’s worse is what was left unsaid. Not only are these reels leading to a revenue headwind, but they likely represent an even larger profitability headwind. After all, Meta is taking on costs to deliver this content, is losing revenue due to delivering it, and on top it’s sharing with creators the revenue it gets as well (which is a large cost, creators get 55% of the revenue). Remember, on feeds/stories nobody pays you, your family, or your friends for the content you all generate.

Since this is the fastest-growing content segment that Meta has to deliver, this revenue and profitability impact is, for now, only likely to get larger. Meta is trying to monetize this content better, of course.

Issue 2 – The True Macro Headwinds

This is the more relevant issue, which I feel doesn’t get enough consideration. Sure, already Meta is talking about macroeconomic headwinds. In the call, it was disclosed that advertising pricing was down 18% in Q3 2022:

In Q3, the total number of ad impressions served across our services increased 17% and the average price per ad decreased 18%. Impression growth was driven by Asia-Pacific and rest of world. The year-over-year decline in pricing was primarily driven by strong impression growth, especially from lower monetizing surfaces and regions, foreign currency depreciation and lower advertiser demand. Family of Apps other revenue was $192 million, up 9%, driven by strong business messaging growth from our WhatsApp business platform, partially offset by a decline in other line items.

The previous issue (Reels) responds for part of it, and geographic mix for at least another part. But still, some macro headwinds are already put forth as a problem hitting advertising demand as well.

Yet, the problem is that the US, and Europe, aren’t really into a recession yet. That is, if such a recession comes, the macro headwinds will become much stronger than they are now. And a recession seems likely in 2023, in both geographies, because:

• Interest-sensitive sectors, like housing and car sales, as well as everything tied to housing, are just now starting to reflect the extreme increase in interest rates in the last 12 months, where interest rates doubled or more across geographies. This isn’t yet reflected in the overall economy, though housing sales have already started collapsing. More real-time measures (for immediate economic activity), like housing starts or especially housing completions, lag, so most of the economic impact still hasn’t been felt.
• In Europe, there’s the added problem of energy costs, driven both by Europe’s energy policy and the Ukraine war. This will take away money from the consumer, and pressure the broader economy, on top of the interest rate effect.

Now, advertising is an extremely cyclical business. It’s one of the costs that companies, pressured by lower demand, can cut quickly without seeing immediate impact on their businesses. Most studies indicate the impact is there (for cutting marketing during a downturn), but for companies dealing with an immediate crisis, the distant future is of lesser concern.

Since Meta, along with Google, are a large part of the “online advertising market” (more than half of the US online advertising market in 2022), a drop in overall market will necessarily impact both (in aggregate) at nearly the same pace as the market itself is impacted. That wasn’t so in previous crises, since both still had a lot of shares to gain. However, today things are different, and both are actually struggling to hold on to the share they already got — so if the market contracts and their share holds steady or declines, in aggregate both will contract as much or more than the advertising market.

Hence, a macro headwind which will make the entire market shrink, will nearly perfectly translate into a similarly-sized drop in revenues for the aggregate of these two companies. This kind of headwind might be as large as a 10-15% contraction in overall spending, judging from the 2009 recession.

There is, however, another problem.

The 10-15% drop wouldn’t necessarily fall on both companies’ shoulders in an equitable manner. This is so because search advertising is typically less impacted than social advertising. Such happens because search advertising is more often local and used as a way to get immediate business, instead of also having brand-building or brand awareness components. Companies can’t cut on advertising which directly drives sales. Now, while Google (GOOG) dominates search, Meta dominates social. And with the overall advertising compressing, whatever doesn’t hit search, will tend to come out of Meta’s social.

We can see this dichotomy even right now, before a true recession hits. In Q3 2023, Google was still printing comfortably positive revenue growth (+6.1% yoy), while Meta had already fallen all the way down to negative growth (-4.5%).

Hence, in a true recession, we won’t be talking about +2% (constant currency) revenue growth. We’ll instead be talking about as much as -10%, -15%, -20% impacts. And Meta’s future certainly does not discount anything of the sort. The revenue growth consensus for 2023 stands at +5.5%.

A 10-20% drop in revenues would be devastating to Meta’s earnings. The impact on earnings would be far larger than what the market discounts for 2023 (-13.2%). It would be especially large, if we consider that although Meta didn’t guide for 2023 revenues yet, it did guide for its costs:

Turning now to the specific expense outlook for ’22 and ’23, we expect 2022 total expenses to be in the range of $85 billion to $87 billion updated from our prior outlook of $85 billion to $88 billion. This includes an estimated $900 million in additional charges in Q4 related to consolidating our office facilities footprint that we expect to record in the fourth quarter of 2022. We anticipate our full year 2023 total expenses will be in the range of $96 billion to $101 billion. This includes an estimated $2 billion in charges related to consolidating our office facilities footprint.

The increase in Opex (OPerating EXpenses) guided for 2023 was mind-bending. It amounted to as much as $10 per share (pre-tax) in added Opex. Enough to wipe out the entire current EPS consensus. Only a couple of weeks later, Meta did announce an unexpected cost-cutting initiative, and with it new 2023 Opex guidance:

We have continued to refine our 2023 expense budget and now expect 2023 total expenses to be in the range of $94-100 billion, lowered from $96-101 billion previously. This includes the previously disclosed $2 billion in estimated charges related to consolidating our office facilities footprint. The updated range reflects our plan to add fewer employees in 2023 than we previously expected as we are significantly slowing our hiring trajectory through the beginning of 2023.

This lowered the Opex guidance midpoint, but only by a mere $1.5 billion. It’s not much if we consider that the new Opex guidance midpoint still stands $21 billion over the 2022 Opex guidance. On 2.25 billion shares outstanding, and considering a 20% tax rate, that factor alone would stand to decrease 2023 earnings by a net $7.50 per share. Since Meta is on track to print a $9.10 EPS or so for 2022, we can see that this cost problem is really very large.

Now, remember, the issue is that Meta’s consensus isn’t even discounting what will happen if a recession hits. If a recession hits, and Meta’s revenues shrink instead of expanding in 2023, that will be in the context of a huge increase in operating costs, much of which are already baked in (due to depreciation charges on already-made investments, wages on already-hired personnel).

It’s easy to see that this issue can overwhelm the current earnings consensus. Yet, the Metaverse gets most or all the press, and this large, negative, potential risk is mostly ignored — as if we’ll go straight into an economic recovery from the current quite-feeble economic headwinds.

Conclusion

Typically, if a recession was already baked into Meta’s consensus, we could be justified into “looking beyond the valley”. But as it stands, it’s quite obvious that Meta’s numbers looking forward mostly reflect several temporary pressures as well as the self-inflicted Metaverse wound.

What the consensus still doesn’t reflect at all, is the true possibility of a recession, and how cyclical advertising revenues, especially social advertising revenues, are.

Yet, this recession has a reasonably high probability of happening, considering that most of the impact from high interest rates is still to filter through the real economy (namely, most of the impact from housing and associated businesses). In this context, Meta’s current $111 share quote seems a lot less appetizing.

In my view and due to this, Meta is still not out of the woods. I’d be, at most, neutral on Meta right now.