- November 15, 2022
- Posted by: Ramkumar
- Category: Mergers And Acquisitions
Will Meta Platforms Bounce Back
2022 is a challenging year for tech giants. All the tech companies have faced a double whammy of challenging macroeconomic conditions and a strong US dollar that impacted their sales and earnings growth. Thus, we are seeing announcements of massive layoffs from the tech giants. It started with Twitter when Elon musk wanted to wipe 75% of the headcount to optimize costs. Although we can attribute Musk’s decision to the premium he paid to acquire Twitter and his intent to recover the premium quickly; the biggest shock was the Meta platform’s announcement to sack 11% of its employees. I have valued Facebook since its IPO because of my interest in its business model. Facebook and Google disrupted the traditional advertising market with their online advertising model and then captured substantial value. Thus, it was among the few startups that were profitable from the beginning. At IPO, Facebook’s revenues were $3.7 billion, but its operating margin was 47.3%, making it a cash-generating machine. In a decade since the IPO, Facebook revenues soared to $118 billion in 2021 at a 40% operating margin, making it a dream stock for traders and investors. However, Facebook is not a stranger to controversies and challenges. In 2018, it got embroiled in the Cambridge Analytica scandal, where it compromised its users’ data for electoral purposes resulting in political backlash. Due to this scandal, the stock price plunged by 10%, causing concerns among its investors on the sustainability of Facebook’s business model. Facebook weathered this scandal by investing billions in tightening security measures for its users. Consequently, its revenues and margins grew to cause its stock prices to soar again. In this post, I provide insights on Meta’s current challenges and will Meta platforms bounce back.
Challenges in Business Model
Meta’s stock price decline is not because of the poor quarterly results. Although earnings results impact the stock price, these corrections are not permanent. In Meta’s case, there are concerns about the robustness of its business model. I believe there are three reasons investors are selling Meta stocks.
- Apple’s decision to bolster privacy for its users crippled Meta’s advertising revenues. The new iOS update enables users to decide if they can share their data with the companies for targeted ads. However, no user wants any company to use its data for monetization purposes, especially when the company does not share revenues with the users.
- Meta is losing market share to Tiktok, and with that, more advertisers are moving away from Meta’s platform to Tiktok.
- The macroeconomic headwinds have resulted in a decrease in the advertising budget, making the advertising industry cyclical and linked to economic growth.
- Meta’s failure to build a story on Metaverse’s business model and how it will generate revenues for the firm has resulted in investors losing confidence in its Metaverse business model. Currently, it is investing billions in Virtual reality and Metaverse with no sight of returns in the foreseeable future.
Valuing Meta Platforms
Before valuing Meta, we need to make the following changes in its accounting statements.
Accountants expense R&D expenses, though these are investments that give benefits over a longer term. For example, Meta has invested billions in R&D traditionally. In 2022, its R&D spend is $32 billion making it one of the top ten companies that spend on R&D. Further, its R&D expenses have increased yearly along with its revenues and earnings growth. Thus, it is evident that R&D investment is crucial to Meta’s value creation.
I have given the R&D investments done by Meta in the last ten years.
To estimate if the R&D investments add value, we need to add these R&D expenses to the balance sheet and deduct the amortization of R&D in that year in the income statement. Thus, we need to restate the operating income. Here, i assume that Meta’s R&D investment has a tenure of 3 years, meaning that i capitalize the R&D investments for three years.
When i capitalize R&D, Meta’s operating income increases from $35.5 billion to $49.25 billion. The net income also increases similarly to $42.5 billion when we capitalize R&D instead of Meta’s reported income of $28.8 billion.
I show the working of my R&D capitalization above. I have capitalized on R&D for three years. As a result, there is an adjustment to operating income of $13.7 billion which i have added to Meta’s reported operating income to derive the adjusted operating income.
When i capitalize R&D, Meta’s ROIC reduces from 39% to 34%, indicating that R&D investments do not add value to Meta platforms. A part of the reason is that the online advertising business is seeing higher competition resulting in lower growth and margins. Further, regulatory concerns over Meta’s privacy issues have forced it to increase R&D investments in security to address privacy concerns.
Another reason is its investment in Metaverse. Meta has reported its income and expenses in its earnings reports.
Reality labs, where most Metaverse investments happen, reported revenues of $2.3 billion and losses of $12.7 billion. While some of these expenses are operating expenses, a large portion is R&D expenses, and we need to capitalize on the same. If we adjust these inconsistencies, Meta’s operating income is better than its reported numbers.
I made the above adjustments and valued Meta platforms. Following are my assumptions:
- Meta’s growth has indeed flattened due to the maturity in the advertising spend, and its investments in Metaverse have yet to show growth. Nevertheless, meta has reported a 41.8% revenue growth in the last ten years. Though Meta will not report the same growth in the future, i assume its growth at 15% (sector growth) in the next five years before it settles to a risk-free rate.
- I assume Meta’s EBIT will sustain at 30% because accountants continue to expense Meta’s R&D investments. If i move a big part of these expenses to capital expenditures, its operating income improves.
- Meta’s investments in Metaverse have to show an impact in its improvement of operating income at a particular time, or else it will stop making any further investments. Thus, i assume its asset turnover will improve. Currently, its TTM Sale/Invested capital is 0.81, and i assume it will gradually improve to 1.25 (the average 10-year Sales/Invested Capital).
- Meta’s WACC is 9.2% at the prevailing 4.16% risk-free rate. It gets 43% revenues from North America, 22% from Europe, and 25% from Asia and the rest of the world. Thus, its weighted ERP is 4.51%. Meta derived 98% of its revenues from Advertising and 2% from VR Labs. I assume, in the future, Meta will increase its revenues to 20% from VR labs and 80% from Advertising, giving it an unlevered beta of 1.14.
Following is my valuation model for Meta.
In my valuation, Meta will grow at 10.3% for the next ten years at a 35% operating margin. Its marginal ROIC is 18%, much lower than the current ROIC of 30%.
With my assumptions, I value Meta’s Enterprise value at $268/share and its equity share at $279.4. Currently, Meta trades at $114.2/share, making it deeply undervalued. Moreover, at reported earnings, Meta trades at a P/E multiple of 10.9, and when we capitalize R&D, its P/E multiple is ~6x. Thus, Meta looks cheaper than other firms after capitalizing on its R&D expenses.
In my Meta valuation, 65% of its value comes from the terminal value calculation. Thus, i am unsure about my valuation and did a Monte Carlo simulation to derive different values for the firm.
Following are my value drivers for Meta valuation.
I used the following distributions:
- Truncated Normal Distributions for revenue growth
- Triangular distribution for operating margin
- Uniform distribution for Sales to Invested capital
My decision to select the distributions is on the following rationale.
When i do a bivariate analysis among the value drivers, i get the following:
Thus, the r-square is the highest between Revenue growth and equity value. Thus 79% of Meta’s value is linked to its revenue growth. Thus any changes in growth will impact its value considerably. Thus sales growth becomes a crucial value driver for Meta’s intrinsic value.
Thus, at the 25th percentile, Meta’s share price is $264/share indicating that Meta is deeply undervalued.
From a valuation standpoint, Meta is trading at a deep discount. However, I believe the reasons behind the fall in the stock are not from the valuation standpoint alone. Investors have developed a mistrust towards Facebook because it has not made any effort to explain its business model for generating revenues and earnings from Metaverse. Facebook’s strategy is to invest billions of dollars in Metaverse, but its plans to monetize the investments are opaque. For instance, if we buy VR glasses and spend 90% of our time in its Metaverse universe, Facebook has to either collect money from us as subscription revenues for us to access its VR universe or show us targeted ads. Facebook has not given that clarity to its investors.
Further, Facebook’s corporate governance is always under scanner due to its poor reputation for failing to protect user privacy. Its dual voting shares policy prevents investors from forcing a management change when founders do not heed investors’ demands, as its founder can subvert the board. Thus, investors who do not believe in Meta’s business model have decided to sell their shares rather than forcing a change in Meta’s strategy.
We have glorified the founders of tech companies, and some have even resorted to founder worship. Thus, investors have given their power to change management to these founders, thinking their management will drive shareholder returns. Tech companies have rewarded investors with super-normal returns, but those returns are under threat now. With tech giants ruthlessly laying off employees, they have no accountability as they are not answerable to the board or shareholders because the founders know they cannot get replaced.
Ironically, employees get fired when moonlighting as employers are concerned over the conflict of interest. Still, at the same time, we cannot hold the tech companies accountable for indiscriminate layoffs happening in the past few months.
The employer/employee relationships that were in friction earlier will worsen now with this negative news on layoffs.