- Meta’s revenue is slowing, costs are growing and cash is shrinking.
- The company’s stock is being supported by aggressive buybacks.
- A forensic analysis of cash flows indicates the company is stretching on its reported figures.
- Sell the stock before earnings estimates go down.
Introduction and company business model
Meta Platforms (NASDAQ:META) is one of the best known companies in the world, thanks to its ubiquitous platforms – Facebook, Instagram and WhatsApp. All are free to use, with the former two supported by advertising. The company is planning to roll out a subscription service for verified accounts. WhatsApp has made feeble attempts at monetization through payments and charging corporate users, but is otherwise a public service, one for which the company gets little credit. The company’s bold big bet is on the metaverse, an imaginary world where people don bulky contraptions on their head to virtually do what they would in real life. So far, the company has little to show for its efforts.
The company competes for users with other social media platforms like Snap (SNAP), Twitter and Pinterest (PINS). It competes with them for advertising dollars as well, along with Alphabet’s (GOOGL) Google search engine and YouTube service. The new kid on the block, TikTok, has dented the company’s business by siphoning away user attention and ad spend.
Meta Platforms financial overview
For the year ending December 31, 2022, the company reported $116.6 billion in revenue, down 1% YoY. Costs were up an astounding 23% YoY. Operating income was down 38% to a still healthy $28.9 billion (25% operating margin). After taxes, the company reported $23.2 billion of net income or $8.59 for each of its 2.7 billion shares. The company’s downward trajectory was worse in the fourth quarter, with revenue down 4% YoY and operating income down 49%, though this was affected by restructuring charges the company took.
Capital expenditures were $32 billion for the year and the company repurchased $28 billion of shares. It ended the year with cash of $47 billion and $9.9 billion of debt that it took on in 2022. Net cash was down $17.7 billion versus the prior year.
For the March quarter, the company guided to $26 to $28.5 billion in revenue, which would be flat from the prior year. It expects expenses for 2023 to be $89-$95 billion, up 1% to 8%. It expects capex of $30-$33 billion, flat YoY.
Forensic analysis of cash flows indicates Meta is stretching its reported profits
Against its reported $23.2 billion of net income, Meta reported a mere $7.3 billion of free cash flow, or less than one-third its net income. So free cash flow for 2022 was just $2.70 per share. We calculated free cash flow by starting with operating cash flow ($50.5 billion), deducting share-based compensation ($12 billion), purchases of equipment ($31.4 billion) and adding back proceeds from sale of equipment ($0.2 billion). We give the company the benefit of the doubt by not deducting acquisitions of businesses and intangible assets ($1.3 billion).
Note that we knock off stock compensation in calculating free cash flow as we believe this is a real expense. The company needs to spend this amount to buy back stock to keep the share count flat. The free cash flow we calculate would be equal to GAAP net income if a company’s capex is equal to its depreciation and there is no working capital inflow or outflow.
In investigating why free cash flow was different from net income, we found four major elements. The first was an add-back of impairment charges for leases and improvements of $2.2 billion that the company took as a restructuring charge in 2022. Some of this will represent a cash outflow in the future. The second was an add-back of abandonment charges for data center assets of $1.3 billion, again taken as a restructuring charge. The third was an add-back of accrued expenses and liabilities of $5.1 billion. Part of this represents severance charges that the company expensed in 2022 and will pay out in 2023. The biggest element by far, was capex of $31.4 billion vastly exceeding depreciation of $8.7 billion. That is a $22.7 billion difference! The company spent $18.7 billion in capex the prior year, and yet its depreciation went up to only $8.7 billion from $8 billion the prior year. This indicates to us that the company could be under-depreciating its assets and raises the company’s risk profile. It also faces drastically higher depreciation charges in the future to catch up with the excess capex spend.
As an additional check, we look at the property and equipment carried on the balance sheet. It was $79.5 billion in 2022 versus $57.8 billion the prior year. The $21.7 billion increase approximately matches the amount by which capex exceeded depreciation (there are usually small differences due to forex rates applied to international assets and accruals). A 38% increase in fixed assets could be overlooked if the company were growing at approximately that rate. However, given that the company is struggling to maintain its revenue flat, it calls into question why this line item is increasing so much.
Projected financial results
We believe that the company’s reported EPS is going to come in around $8 in 2023, significantly below the $9.50 consensus estimate. We arrive at this by assuming revenue will be flat YoY at $117 billion and expenses will be $91 billion, yielding operating income of $26 billion. Taxed at 19%, this would result in after-tax income of $21 billion. With continued buybacks of $27 billion, $12 billion of which would offset stock compensation, we expect $15 billion to go towards reducing the share count by 0.1 billion shares to 2.6 billion shares for the year. This would result in EPS of a little above $8. We are assuming that net interest expense will be close to zero.
In projecting free cash flow, we assume that operating expenses embed depreciation rising to $15 billion from $8.7 billion in 2022. We assume that capex will come in at the low end of the company’s guidance at $30 billion. Assuming zero working capital changes, this would put free cash flow $15 billion below net income at just $6 billion for the year. That would be a mere $2.30 per share.
If the economy weakens in the latter half of 2023, the company is likely to struggle to cut costs and grow revenue. The double-digit revenue growth expectation for 2024 is likely to be a gross overestimate, with flattish revenue a more reasonable outcome. In 2024, we would expect reported EPS to take another step down to the $7 level as rising depreciation seeps into the financial results. This would put EPS 40% below the current $11.33 expectation, and the third consecutive year of declining EPS. Whether the company’s free cash flow can match its net income will depend on if the company can cut capex to the $20 billion level.
META stock valuation and recommendation
With slowing growth and poor cash generation, not to forget rising interest rates. the likelihood of Meta garnering the premium valuation it used to is gone. We would apply a slightly higher than market multiple of 18x to value the company. Applied to 2024 EPS, this would amount to fair value for the shares of $126 for 25% downside from the current price. This represents more than 40x trailing free cash flow, so it rests on the assumption that the company’s performance, particularly on the capex front, will improve. To be fair, the company is likely to have about $10 per share of net cash at the end of next year, an amount we believe the company would like to hold.
We recommend that investors sell any existing positions in META stock before the company misses quarterly results and earnings estimates reset lower. Given the large gap between free cash flow and net income, we also believe that there is a non-trivial chance of the company facing an accounting investigation and restating its earnings. Intrepid investors may short the stock. It is easy to borrow and does not pay a dividend, so the cost of holding a short position is low. In fact, your broker may pay you a rebate linked to the Fed Funds rate, on the sale proceeds.
Seeking Alpha’s quantitative system assigns META a composite rating of 3.4, equating to a hold, with a D for growth, offset by an A+ for profitability. However, as we have shown, that profitability is overstated, not matched by cash generation and likely to fall. Wall Street analysts are more positive on the company with a rating of 4.1, equating to a buy, a rating most analysts have always had.
Risks to thesis
With a $450 billion market cap, Meta is unlikely to be a takeover or leveraged buy-out target. So the main risk here is that the company manages to perform much better than expected. Facebook and Instagram are pretty much saturated from a user and ad standpoint. So the company has to look at other avenues to improve profitability.
We see the following ways it could do so – in effect, we will provide a recipe for the company to succeed:
- Monetize unmonetized assets like WhatsApp. It is unlikely there can be much of an ad load put on WhatsApp. Nor are users likely to pay a high subscription fee. But it does have over two billion users, and even a few dollars a year of revenue off each would make a difference.
- Abandon the metaverse. It makes as little sense now as it did billions of dollars earlier. The amount the company claims it is spending on it is probably overstated in an attempt to get investors to ignore that expense amount, but it still comes to a pretty penny.
- Take a hard look at the capital budgeting process. It is likely that there is something wrong with the process right now that makes the company spend such a high amount. Return calculations are either not being done or being overstated. The approval process for new spend is probably lax.
- Link executive pay to free cash flow generation at the overall company and unit level.
Until there is tangible proof that the company is going to change, we recommend that investors sell their META stock, as the company depletes its cash balance and takes on debt to buy back its stock. Fundamentally, a company’s value is dependent on the free cash flow it generates, and on that count META falls short.
Disclosure: I/we have a beneficial short position in the shares of META either through stock ownership, options, or other derivatives. 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.