♾ Meta: Virtual insanity
Users are still here, but will they join Zuckerberg's metaverse?
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Meta Platforms (META), the artist formerly known as Facebook, reported its Q3 FY22 earnings report.
Today, we’ll cover the following:
Unless you have been living under a rock, you are probably familiar with Zuckerberg’s vision for the metaverse.
In 2020, Apple allowed users to block the IDFA (identifier for advertisers) at the app level. As a result, Meta has lost billions in ad monetization. Since then, the company has been in search of its second act. One that involves complete control of the ecosystem from the ground up.
Before we start, let’s discuss how Meta makes money.
Meta recently updated its business segmentation in two parts:
Family of Apps (FoA): Facebook, Instagram, Messenger, and Whatsapp.
Reality Labs (RL): Virtual reality hardware, Portal, and supporting software.
More than 98% of Meta’s revenue comes from advertising.
You get the revenue by multiplying two things:
The number of users.
The average revenue per user.
It gets a bit technical if we look at the detailed metrics.
Facebook metrics include only Facebook and Messenger:
Daily active users (DAUs).
Monthly active users (MAUs).
Average revenue per user (ARPU).
Family metrics include users who visited at least one of the apps in the Family segment:
Daily active people (DAPs).
Monthly active people (MAPs).
Average revenue per person (ARPP).
So if you open Instagram or Whatsapp, you are a “person.” But if you only open Facebook and Messenger, you are merely a “user.” 😄
Family metrics represent the company’s estimate of the number of unique people using at least one of the apps without double-counting.
I would expect management to eventually sunset Facebook metrics and have us focus solely on the entire ecosystem of apps instead.
Revenue has two main components:
Advertising: 98% of overall revenue.
Other revenue: < 2% of overall revenue. It includes the payment infrastructure and revenue from Reality Labs (Meta Quest, Portal hardware, and related software).
Overall revenue growth has declined steadily and turned negative in FY22.
Cost of revenue includes:
Data centers and technical infrastructure, network infrastructure, energy, and bandwidth costs.
Costs associated with partnerships, such as TAC (traffic acquisition costs).
Cost of products sold and related content costs for Reality Labs.
Operating expenses are primarily:
Research & Development: Engineering and technical teams responsible for developing new products or improving existing ones.
Sales & Marketing: Primarily marketing and promotional expenses, as well as professional services such as content reviewers.
Gross margin has been stable at around 80%.
Operating margin has steadily worsened due to two factors.
1) Dwindling profits from Family of Apps as growth stalls.
2) Expanding losses from Reality Labs with large R&D investments.
The core advertising business slows down while the company invests heavily in its Reality Labs initiative.
So, how problematic is this?
Let’s dive in!
1. Meta Q3 FY22
Family DAP grew +4% Y/Y to 2.93 billion (+0.05B Q/Q).
Family MAP grew +4% Y/Y to 3.71 billion (+0.06B Q/Q).
Facebook DAUs grew +3%Y/Y to 1.98 billion (+0.01B Q/Q).
Facebook MAUs grew +2%Y/Y to 2.96 billion (+0.03B Q/Q).
Ad impressions grew +17% Y/Y.
Average price per impression declined -18% Y/Y.
Here is a bird’s-eye view of the income statement.
Revenue declined -4% Y/Y to $27.7 billion ($310 million beat).
FoA revenue declined -4% Y/Y to $27.4 billion.
RL revenue declined -49% Y/Y to $0.3 billion.
Gross margin was 79% (-1pp Y/Y).
Operating margin was 20% (-15pp Y/Y, -9pp Q/Q).
FoA operating profit was $9.3 billion (34% margin, -12pp Y/Y).
RL operating loss was $3.7 billion (vs. a $2.6 billion loss in Q3 FY21).
EPS (non-GAAP) declined -49% Y/Y to $1.64 ($0.22 miss).
Operating cash flow was $9.7 billion (35% margin, -14pp Y/Y).
Free cash flow was $0.2 billion.
Cash, cash equivalent, and marketable securities: $41.8 billion.
Long-term debt: $24.6 billion.
Q4 FY22 Guidance:
Revenue from $30-$32.5 billion (vs. $32.2 billion expected). That’s -7% Y/Y, or flat on a constant currency basis.
Total expenses expected to be $85-$87 billion (vs. $87-$88 billion previously).
So what to make of all this?
User metrics were decent. Even the legacy Facebook app saw a slight uptick in users sequentially, and ad impressions grew by +17% across FoA. Engagement remains surprisingly strong despite the rise of TikTok and other platforms.
The macro environment is challenging for advertisers. So headwinds on monetization were not surprising, with softness in e-commerce, gaming, and financial services (also mentioned in my Google review, with YouTube declining by 2% Y/Y).
The strong dollar generated a 7pp headwind, making the growth number artificially muted. The growth in constant currency was +3% Y/Y and is a better representation of the business performance.
R&D expenses swelled +45% Y/Y due to hiring and technology development costs for Reality Labs, which were the main driver of the margin compression.
Q4 Guidance came in short of expectations with flat revenue Y/Y fx neutral.
Is the business sustainable?
Despite an aggressive bet on Reality Labs, Meta has maintained positive cash flow margins. But for how much longer?
Reviewing Meta’s trailing financials can be very misguiding. After all, operating cash flow just collapsed by 31% Y/Y.
Mark Zuckerberg can afford to push on his metaverse bet without putting the company's future at risk. However, in a challenging environment for the adtech industry, combined with a strong dollar and widening RL losses, the margin of safety could dwindle quickly.
Even if successful, Reality Labs could need years before the segment becomes cash-flow accretive.
Additionally, the legacy Facebook platform could face a double whammy:
Fewer impressions over time if user engagement erodes.
Less revenue per impression due to targeting headwinds.
There are many moving pieces, and the path forward is not as easy as the trailing financial metrics suggest.
2. Recent business highlights.
There are three primary areas of focus for management:
AI discovery: Meta wants to serve highly relevant ads to its users. The AI powering Reels (short videos) is one of the main priorities. Doing so requires further investments in infrastructure.
Messaging apps (Messenger, WhatsApp) are still under-monetized. Management sees tremendous potential for ads and paid messaging. A recent partnership with Salesforce allows businesses to chat directly with customers from Salesforce’s platform.
The metaverse: Zuckerberg is willing to lose $4 billion per quarter on the RL segment to build the future of work and play in digital worlds. The company signed a deal with Qualcomm to develop custom virtual reality chips for Quest devices, illustrating the commitment to improving the user experience. The Meta Quest Pro was well received despite its prohibitive $1,499 price. According to internal documents, over 50% of Meta Quest headsets are no longer in use six months after purchase. So while all these investments *could* pay off, RL remains a long shot.
3. Key quotes from the earnings call
CEO Mark Zuckerberg shared some engagement data on Reels:
There are now more than 140 billion Reels plays across Facebook and Instagram each day. That’s a 50% increase from 6 months ago. Reels is incremental to time spent on our apps. The trends look good here and we believe that we are gaining time spent share on competitors like TikTok.
About Reels monetization:
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.
Messaging apps are still under-monetized, particularly Whatsapp:
We started with click-to-messaging ads which lets businesses run ads on Facebook and Instagram that start a thread on Messenger, WhatsApp or Instagram Direct, so they can communicate with customers directly. And this is one of our fastest growing ads products with a $9 billion annual run-rate. And this revenue is mostly on click to Messenger today since we started there first, but click to WhatsApp just passed a $1.5 billion run rate and growing more than 80% year-over-year.
We expect hiring to slow dramatically going forward and to hold headcount roughly flat next year relative to current levels.
4. What to watch looking forward
We’ll have to watch operating expenses and free cash flow.
Will the metaverse investments be kept in check?
Can the company maintain positive free cash flow through this phase?
Will advertising headwinds continue for the foreseeable future?
Will family MAP maintain their slow growth or start declining?
Altimeter Capital owns more than 2 million META shares. Its CEO Brad Gerstner recently wrote an open letter urging Meta to:
Cut headcount expenses by 20%.
Reduce annual capex (currently $30B) by at least $5 billion.
Keep Metaverse / Reality Labs spending under $5 billion per year.
The goal is to become a “leaner, more productive, and more focused company.”
“Like many other companies in a zero rate world — Meta has drifted into the land of excess — too many people, too many ideas, too little urgency. […] Meta needs to get its mojo back.”
I’ll leave you with this tweet from Chris Bakke that made me chuckle.
That’s it for today!
Stay healthy and invest on!
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Disclosure: I am long META in the App Economy Portfolio. I share my META rating (BUY, SELL or HOLD) with App Economy Portfolio members here.
You wrote, "The strong dollar generated a 7pp headwind." Does pp mean percentage point? Thanks, and great article.
Your articles are amazing.