Meta: Light At The End Of The Tunnel Or Oncoming Train?

Summary:

• Meta focuses on efficiency, aiming for accelerated revenue growth and cost reductions in 2023, while harnessing Generative AI to boost content and engagement.
• The future of TikTok plays a pivotal role in Meta’s success, with different outcomes impacting Meta’s growth prospects and market position.
• Meta’s valuation is justified given better financial discipline on one hand, and higher interest rate environment, weakening macroeconomic conditions, and intensifying competition on the other.

In our previous article, we discussed the favorable alignment of the stars for Meta Platforms (NASDAQ:META), highlighted by their strong Q1 performance and legal victories. Although we are pleased to see META stock’s year-to-date rally of over 70%, we are now moving to a neutral stance due to the optimism surrounding the company and what we believe to be a fully valued stock.

As we embark on 2023, Meta is preparing for potentially better days ahead, but its future is undoubtedly entwined with the fate of its rival, TikTok. Dubbing this the “Year of Efficiency,” Meta is sharpening its financial discipline, focusing on accelerated revenue growth and cost efficiencies. With key drivers like AI, Reels, and Click-to-Message ads, Meta is striving to overcome challenges posed by Apple’s privacy policy and TikTok competition. Our key thesis is that Meta’s ability to capitalize on these opportunities and navigate the complex landscape hinges on the future of TikTok. Let’s examine the factors at play and explore the potential outcomes for both Meta and TikTok.

Potentially Better Days Ahead

In our judgment, 2023 is poised to become the “Year of Efficiency,” with Meta developing a robust financial discipline for the long term. Meta’s shares have more than doubled since early November, fueled by bullish investors who see significant potential in the company’s accelerated revenue growth, continued cost efficiencies, and attractive valuation.

Several key drivers are contributing to the bullish sentiment surrounding Meta, and we expect these factors could propel the company’s revenue existing 2023 and throughout 2024, in-line with consensus forecasts (FactSet). These drivers include AI and product-driven improvements to the ad stack following the implementation of Apple’s App Tracking Transparency, increased engagement and monetization of Reels, strong growth in Click-to-Message ads, and the company’s ability to overcome the challenges posed by Apple’s privacy policy and TikTok competition in the first half of 2023.

We project that Meta’s Reels revenue and Click-to-Message revenue will drive growth, growing ~ 100% and 50% year-over-year in 2023, respectively. Excluding these two products, we estimate Meta’s core ad growth to be a modest 3% to 4% this year.

We anticipate that Meta will maintain cost discipline in the future. Through productivity enhancements and efficiencies, the company may achieve further expense improvements over the course of the year. The Street will welcome additional headcount reductions.

As Meta leverages its new data center architecture and discovers efficiencies within non-AI capital expenditures, we believe there is potential for capital expenditures to decrease. This potential reduction in capital spending could contribute to the company’s overall financial discipline, ultimately strengthening its position in the market.

Generative AI

Meta has the potential to become a frontrunner in the consumer internet sector, taking advantage of the forthcoming wave of Generative AI applications. While chatbots have gained considerable attention, Generative AI is poised to trigger a Cambrian explosion of content, such as video, images, and audio, reminiscent of YouTube and Netflix’s early years. This content influx could lead to a dramatic increase in usage and engagement. In comparison to VR/AR investments, which aim to transport users into entirely new environments, we contend that Generative AI better aligns with Meta’s core business on mobile and desktop platforms, possibly serving as Meta’s “second act” while the metaverse’s long-term development becomes the third act.

Meta operates four major apps, including Facebook and Instagram as broadcast networks and WhatsApp and Messenger as communication networks. With the exception of WhatsApp, engagement on these apps has experienced a slight decline in recent years due to dwindling user-generated content and negative network effects. Generative AI has the potential to unlock a plethora of curated content, reversing negative network effects and driving increased engagement. Furthermore, Generative AI can enhance Meta’s advertising business, as the company recovers from the impact of Apple’s App Tracking Transparency on its direct response advertising.

TikTok

The outcome of TikTok USA will have a significant impact on Meta.

After the Congressional testimony of TikTok’s CEO, we can highlight several important points. First, Congress appeared uneasy with Project Texas, which was designed to address data security concerns. Second, Congressional members continue to harbor skepticism, especially regarding national security and foreign influence. Lastly, despite TikTok’s content moderation policies being in line with industry standards, some members still questioned the company’s dedication to these commitments.

One possible solution could be the sale of TikTok’s data to a US company without transferring the algorithm. However, the acquiring company would face considerable challenges, as it would need to create a new algorithm for content and ad delivery. We believe Meta would greatly benefit in this scenario, with users and advertisers potentially migrating to Reels. Although this solution is plausible, it may not be the most likely outcome, as it presents drawbacks for all parties involved. The Chinese government would likely view a forced sale as a blow to their image, considering the mounting pressure on China’s tech industry from the US government and China’s public opposition to a forced sale. For the US government and the acquiring company, the loss of the algorithm means they wouldn’t obtain what makes TikTok unique. For US users, an algorithm change could lead to dissatisfaction, particularly against the Biden administration. As a result, we believe a sale is the least probable scenario.

A total ban would be the most advantageous outcome for Meta, but we think the likelihood of this scenario might be overstated, based on Meta’s stock performance and media discussions. Given the upcoming presidential election in 2024, which is anticipated to be a close race, Democrats may be cautious about alienating the 150 million US TikTok users and the 5 million advertisers on the platform.

We believe the most probable outcome is increased regulation of social media. If these regulations target TikTok and other foreign social media companies, Meta would benefit only marginally, as regulatory issues can be addressed by spending money. This would affect TikTok’s peak margins but not necessarily its growth rate. However, the worst-case scenario would be increased regulation on all social media platforms, raising Meta’s operating costs without providing any competitive advantage.

If TikTok avoids a complete ban, another potential outcome could be a surge in user engagement driven by its young audience’s rebellious response to perceived government control. The threat of banning the app might fuel a sense of defiance among its users, who may view the government’s actions as an attempt to restrict their freedom and self-expression. This counterintuitive reaction could result in increased usage and user loyalty, as young people rally around the platform to protect their preferred social media space from perceived government interference. In this scenario, Meta would suffer even greater share losses to TikTok.

In our opinion, the market might be overly optimistic about Meta’s potential to capitalize on TikTok’s regulatory hurdles.

Financials & Valuation

In light of the factors mentioned in the article, such as Apple’s data tracking changes, rising competition from TikTok, and overhiring, 2022 was a challenging year for Meta Platforms. For the first time, the company experienced a revenue decline of 1.1% to $116.6 billion. Earnings per share were hit even harder, dropping 37.6% to $8.59 in 2022.

In response to these challenges, CEO Mark Zuckerberg has shifted his focus towards efficiency for 2023, announcing significant layoffs and reductions in both operating and capital expenses. The consensus expectation is that sales will grow by 4.4% this year and then accelerate to 11.2% in 2024. EPS is projected to grow by 16.1% in 2023 and 24.6% in 2024, primarily driven by cost reductions and a rebound in top-line growth resulting from the factors previously discussed.

However, we believe that the company’s recovery hinges on the future of TikTok. Should TikTok face a ban, Meta is likely to significantly outperform consensus estimates. Conversely, if TikTok continues to grow unimpeded, Meta may struggle to achieve the projected recovery numbers. In our view, the consensus estimates provide a fair representation of the base case for owning Meta.

Following a large rally, Meta is currently trading in the middle of its 12-month forward price-to-earnings (P/E) ratio range relative to the S&P 500. The company’s P/E ratio is at a 13% premium compared to the S&P 500, which falls within its five-year range of a 50% premium to a 30% discount. On an absolute basis, Meta is trading at just below 20 times forward EPS, which is toward the lower end of its five-year range. However, we believe this valuation is justified considering the higher interest rate environment, weakening macroeconomic conditions, and intensifying competition.

Thesis Risks

We might be underestimating the government’s political will to ban TikTok. Considering President Biden’s advanced age, he may choose not to run for re-election, potentially allowing him to ban TikTok while minimizing the repercussions for the Democratic party. Additionally, the national security apparatus and Meta’s lobbying efforts could have a more significant impact on the ultimate decision to ban TikTok than we initially anticipated.

If the probability of an outright ban exceeds 50%, we would adjust our stance from being underweight to overweight on Meta’s stock. This shift would reflect the increased likelihood of Meta benefiting from a potential TikTok ban and gaining a stronger market position in the social media landscape.

Conclusion

In conclusion, Meta’s future hinges on its ability to navigate the complex landscape of competition, regulation, and innovation. While the company is taking significant strides towards efficiency and leveraging Generative AI, the future of TikTok remains a critical factor in Meta’s success. The market may be overly optimistic about Meta’s potential to capitalize on TikTok’s regulatory hurdles, and we believe the consensus estimates provide a fair representation of the base case for owning Meta. Given our view that Meta is fairly valued and the difficulty in predicting the binary outcome of the TikTok situation, we will watch carefully from the sidelines.

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Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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