Meta: After crossing the calamity, I revived with full health.

Hello everyone, I am Changqiao Dolphin!

This morning (April 27th Beijing time), Meta released its Q1 2023 financial report, which was another beautiful beat and mainly due to the recovery of advertising revenue growth in the current and next quarters. It can be said that with the management's shift in focus from VR to advertising, and under the macroeconomic background of no deep recession, Meta has completed its own downhill cycle and returned to the growth channel.

The core points of the financial report are as follows:

1. The beat is mainly on the revenue side. In Q1, Meta's total revenue was 28.65 billion, slightly above the upper end of the guidance of 28.5 billion. Market expectations were basically in line with the median of guidance, so Q1 revenue beat almost 4pct.

In addition, the revenue guidance for the next quarter is in the range of 30-33 billion, significantly higher than the consensus expectation of 29.5 billion. The implied growth rate of 30-33 billion is 4%-14.5%, which is an expectation of accelerated recovery, while the market is more linear extrapolation, so it appears to be more cautious.

Dolphin believes that behind such a recovery expectation, in addition to the normal repair of the original platform, there is also an implicit operating strategy that Reels is popular and will continue to expand monetization.

2. In the weak cycle, effective advertising is king. Unexpectedly, VR business revenue in Q1 was cut in half, so the main revenue beat came from advertising. Why can Meta's advertising exceed expectations against the trend of economic weakness? In fact, in the previous quarterly report, Dolphin had already given the answer: One is the relief of competition from TikTok and the additional advertising inventory brought by Reels, and the other is that effective advertising can actually gain more share due to high ROI when the economy is lying down.

3. Reels continues to drive traffic growth. In Q1, Meta's ecosystem users reached 3.81 billion, with daily active users reaching 3 billion, and user stickiness (DAU/MAU) continued to increase to 79.3% YoY. The main Facebook site in the United States grew faster, but the non-main site grew more fiercely, mainly from Instagram with Reels.

4. Profit improvement came from marketing cost reduction, and the effect of layoffs will be reflected in the next quarter. In Q1, Meta's overall operating profit margin returned to 25%, up 5pct MoM. VR losses increased, but the operating profit margin of App services based on advertising increased by 5.6pct MoM.

There were tens of thousands of layoffs in Q1, but the effect of layoffs has not been well reflected due to the compensation for severance expenses in the current period. Therefore, the profit improvement in Q1, in addition to a significant reduction in marketing expenses compared to Q4, mainly came from the reduction in marketing expenses. The actual operating profit margin after excluding one-time expenses has already returned to 29% , but there is still room for optimization compared with historical levels. The impact of severance compensation will continue to be felt in the second quarter, and in March of this year, Meta launched a third round of layoffs, which is expected to result in nearly $500 million in severance payments, to be gradually recognized in the last three quarters of this year.

As for the guidance for total spending and capital expenditures for this year, based on the adjustments made by Meta in March, this financial report has lowered its total spending budget again. As of now, it has been finalized at 860-900 billion for total spending and 300-330 billion for capital expenditures.

Free cash flow continues to recover. In the first quarter, it repurchased $9.22 billion worth of shares, with $41.7 billion left at the end of Q1. Due to the continuous improvement in operating performance, free cash flow continued to grow to $6.9 billion in the quarter, already recovering to 95% of last year's same period if the costs of severance compensation and business restructuring are added back.

As profits continue to be released normally, absolute cash flow is expected to further improve and return to previous highs.

As of the end of last year, Meta had $37.4 billion in cash and securities on its books, net of $9.9 billion in long-term interest-bearing debt, resulting in net cash of $27.5 billion.

Key metrics compared to expectations:

Dolphin's view:

Meta is a very typical case of a dilemma reversal, but the dilemma is more like one created by human factors, so the reversal comes faster after these factors are eliminated.

In Longbridge's summary of last quarter's performance prediction for Meta in the article "U.S. Stock Advertising: After TikTok, will ChatGPT stir up a new 'revolution'?" we were more optimistic than the market because we believe that Meta has the motivation to further reduce expenses under shareholder constraints and rational management decisions, and therefore a valuation of 550 billion is foreseeable. Coincidentally, soon after the publication, Meta announced further reductions in total spending guidance and the start of a new round of large-scale layoffs.

After this news, Meta once again launched a second wave of increase, with a market value reaching as high as 580 billion. Therefore, at the current valuation, the main expectation in the market is to reduce costs and increase efficiency.

Why is the better-than-expected performance in the first quarter not of low quality? Because the point of the better-than-expected performance this time is not in reducing costs and increasing efficiency, but in the growth of revenue, especially advertising revenue. The first quarter had the biggest gap in expected advertising revenue, and the market's expectation gap for total revenue guidance (median) for the second quarter is close to 7%, even after the unexpected underperformance of VR, which means the expectation gap for advertising recovery is only higher.

An interesting phenomenon is that the change in the gap between market growth expectations and management guidance implies a change in market confidence in Meta, which may better explain the post-market surge in Meta. In the prosperous year of 2021 and the first quarter of 2022, market expectations generally approached or were even higher than the upper limit of guidance, which represented the market's ample investment confidence in Meta at the time. The second quarter of 2022 was the period when market investment confidence was weakest, and consistent expectations approached the lower limit of guidance. However, expectations for the third and fourth quarters of 2022 were basically in line with the guidance median. In the first quarter of this year, market expectations were slightly above the guidance median.

It can be seen that although the reversal signal of Meta was strong before, investment confidence was confirmed season by season before being raised. This phenomenon becomes more evident when comparing the guidance and expectations of the current quarter with those of the next quarter.

This time, the management's second-quarter revenue guidance was significantly better than market expectations, with the lower end of guidance being higher than the consensus expected value. This kind of large difference in expectations has only been seen in the high-profile year of 2021 in recent years, so it surged by 12% after the market closed - not only because of the logic of Meta's return to growth and profit recovery, but also the further accumulation of investment confidence.

From the perspective of valuation, excluding 2020-2022, historical EV/EBITDA trade has revolved around 11x. Currently, the market's expected value of EBITDA in 2023 is about 56.1 billion. If the expected difference of 3% in the first quarter and the expected difference of revenue guidance in the second quarter (calculated by the median value of 6.8%) are used to further increase the consensus expected value of EBITDA by about 5%, the corresponding EV/EBITDA will be 9.2x~10.3x for the closing market value and after-market value, respectively. In other words, the surge after the market close has eaten away a lot of margin of safety.

The author believes that in the short term, there may be a possibility of continuing to rise due to the boost of investment confidence, as long as there are no other systematic risks. However, considering the uncertain macroeconomic outlook and the adverse effects of recession or interest rate expectations on advertising stocks, the short-term risk-return ratio corresponding to the after-market value is not particularly high. Just like yesterday's Google, it is more important to focus on the macro view at this time.

In the medium and long term, as the economic cycle returns upward, we also have confidence in Meta's valuation returning to above the median.

This article is an original research report by Dolphin Investment Research. Without permission, no reprint is allowed. After the financial report interpretation, the contents of the telephone conference will be provided immediately. Interested users can add the WeChat account "dolphinR123" to join the Dolphin Investment Research Circle and get the content of the telephone conference to exchange investment views.

The following is a detailed analysis of the financial report content.

1. Reels Accelerate, the Unstoppable Power of Short Videos

In the first quarter, Meta's revenue was 28.65 billion, a year-on-year increase of 2.6%, which was inline with market expectations. The biggest outperformance was in the advertising business, which accounted for the largest proportion. The VR business declined by 51% year-on-year in this quarter, which was not only due to the high base amount of the same period last year, but also a deeper drag factor of weakening user demand.

For 1Q23 expectations: The company set a range of 300-330 billion, with a corresponding change of a 4% decline to a 14.5% increase, of which the negative impact of high exchange rates was about 1%, and the company's guidance was significantly better than the market expectation of 295 billion.

1. IDFA and competition under control, Meta's effective advertising is back

The driving force behind advertising exceeding expectations is as mentioned by Dolphin in the previous quarterly report:

(1) On one hand, Reels is progressing well, helping to increase advertising inventory. In the face of economic weakness, advertisers prefer effective advertising, and advertising impressions in the first quarter increased by 27% compared to the same period last year.

(2) On the other hand, TikTok faces the risk of being banned, and when advertisers have tighter budgets, it is difficult for them to consider it. Recently, the speed of advertising growth has slowed down rapidly, reflected in the CPM of Meta’s downward slide slowing to a certain extent.

2. Fading demand + Shift in company focus to AI, VR is cold again

Although from the conference call of the first two quarters, we can see that Meta's management is cutting the VR budget, and more time was spent on discussing generative AI in the conference call of the last quarter, instead of the previously popular VR. It shows that the company's business focus has shifted somewhat.

However, the bleak VR revenue in the first quarter still exceeded market expectations. Behind the income being halved, apart from the company's short-term business changes, there is also industry environment deterioration led by diminishing user demand. IDC revised its forecast for VR headsets in March this year, especially for the past two years, with a significant downgrade.

Ultimately, VR still lacks sufficient content applications, which is a bottleneck that limits user penetration or, in other words, the breakthrough from early adopters' circles to the general public, as well as the fact that there is insufficient drive for user renewal under the absence of disruptive technology in hardware technology updates.

In summary, VR still lacks sufficient content applications, which is a bottleneck that limits user penetration or, in other words, the breakthrough from early adopters' circles to the general public.

2. Traffic is stable, stickiness is increasing In the first quarter, the total number of users in Meta's ecosystem exceeded 3.8 billion, with a daily active user count of 3.02 billion, and user stickiness (DAU/MAU) continued to reach new heights, boosted by short video app Reels.

Facebook's main site is also increasing, with a significant increase compared to the previous quarter. Since Reels was also launched on FB, Facebook has gone from almost no growth to net growth. Monthly active users worldwide increased by 25 million in the first quarter, with a daily increase of 37,000 users, and stickiness also improved.

Looking at specific regions, Asia-Pacific is the largest source of new users, followed by other regions outside Europe and America. Mature regions such as Europe and America also grew in the first quarter, with Europe in particular seeing year-over-year net growth after a continuous decline last year.

III. Effects of job cuts will be reflected next quarter

In the first quarter, costs and some expenses were optimized, with the overall operating profit margin increasing by 5.3% compared to the previous quarter, with cost optimization making the largest contribution. As expected, after the impact of one-time costs and revenue recovery on profitability, the gross profit margin in the first quarter returned to a relatively normal level seen in 2022 Q1.

In the first quarter, there were one-time expenses such as severance pay and business restructuring, so their effect has not been fully reflected yet. The company decreased its workforce by nearly 10,000 employees in this quarter, and in March, Meta announced its third round of 10,000 job cuts, so there is an estimated $500 million severance pay expense that still needs to be confirmed this year.

In this quarter, the main reduction was easily cut marketing expenses (down 8% YoY, with a sales expense ratio optimization of 3.6pct QoQ), which may be due to the reduction in promotion and marketing related to VR hardware.

To achieve an overall operating profit of 7.23 billion yuan under GAAP, a year-on-year decrease of 15%, and a significant slowdown compared with the previous quarter's 49% decline.

From the perspective of different businesses:

(1) The advertising business exceeded expectations, and the revenue rebounded quickly because Meta's advertising business is relatively mature and the rebound does not require synchronous cost and expenses.

(2) On the contrary, in the VR business, except for the depreciation and amortization of infrastructure costs, other costs vary with changes in hardware sales volume. However, R&D expenses are more fixed, so the loss rate will be more exaggerated under the decline in revenue.