Meta: Completely becoming an "AI fanatic," can high growth withstand high investment?

$Meta Platforms(META.US) released its Q3 2024 financial report after the market closed on October 30th, Eastern Time. Here are the key points:

1. A satisfactory report under high expectations: The Q3 performance was actually quite good, with strong revenue growth, especially on the profit side, which exceeded expectations significantly. There were concerns in the market about increased pressure on profit margins due to AI cost recognition. However, Meta's actual performance showed that Q3 operating profit rose to 42.7%, the highest point since the business headwinds of 2022.

With advertising experts giving Meta's Q3 performance consistently high positive feedback, market expectations have already been elevated. Compared to the latest expectations from investment banks, Meta's performance was essentially inline, with some indicators slightly missing. At high valuation levels, any small flaw can be magnified for discussion.

2. Capex to accelerate next quarter: Due to the favorable short-term advertising logic for Meta (Reels & Advantage+, competitive advantages in social media, etc.), the market is more concerned about the negative impact on profits from high investments rather than revenue growth expectations.

Q3 Capex was 9.2 billion, which was slightly lower than expected, but the full-year Capex guidance raised the lower limit, with the new range being 38-40 billion, implying that Q4 capital expenditures will surge to 13.5-15.5 billion (up 72%-98% year-on-year, 59%-70% quarter-on-quarter). This could be a positive for Nvidia, a pillar of the U.S. stock market.

Currently, the market expects Capex for 2025 to be around 45 billion, with slightly aggressive estimates reaching 50 billion, corresponding to an increase of about 15%-28%. If we extrapolate based on the short-term trends of Q3 and Q4, when the Q4 financial report provides guidance for the full year of 2025, the aforementioned market expectations for growth may not hold.

3. The "aftereffects" of high investment are beginning to show: Q3 total operating expenses accelerated by 12% within expectations. R&D expenses increased by 21% year-on-year, further reflecting the investment cycle brought about by high Capex and higher salaries for the AI team (the number of employees returned to positive growth in Q3).

The largest portion of this investment cycle is in infrastructure such as GPU servers. Correspondingly, the high growth of short-term depreciation and amortization expenses (Q3 growth accelerated to 40%) has begun to reflect the impact of high Capex.

4. Will profit pressure return to 2022 levels next year? Theoretically, with increased spending, profits will definitely be affected to some extent. However, from a short-term profit margin perspective, like Google yesterday, Q3 also saw a contrary rise

This is largely related to the current strong advertising phase. A rising profit margin also means that while there is high investment, Meta has hedged the pressure on profitability through stronger commercialization on the business side. In other words, the investment here is not like the blind investment in the RL department three years ago, but rather efficient investment in projects that can quickly realize monetization, such as AI advertising.

At the same time, Dolphin believes that as Meta invests in AI, it should also have advantages similar to Google, namely achieving resource reuse and cost optimization of basic technologies through AI, allowing the company to first taste the benefits of AI efficiency internally.

Therefore, under the premise of a stable macroeconomic environment in the United States, this round of capital expenditure expansion, while it may somewhat affect the trend of profit growth, will absolutely not repeat the nightmare of 2022. Moreover, Meta's investment in AI is clearly beneficial and not harmful (in contrast to Google, which faces the impact of AI replacing existing businesses). From a financial engineering perspective, after significantly updating high-end GPU servers, Meta can also alleviate the explicit pressure on financial profits by extending the depreciation period based on actual usage. This operation has been implemented by Google and Microsoft in the past two years.

5. The phase of advertising boom has passed: In the third quarter, advertising grew by 18.6%, which is already quite impressive given the high base (only slowing down by 3 percentage points quarter-on-quarter), but some markets have directly raised expectations to a 20% year-on-year growth.

The company's guidance for total revenue in Q4 is 15% to 20%. Currently, market expectations, including relatively optimistic ones, are all around the median of the guidance range. Although the growth trend is still very strong when viewed in isolation, it can only be said to be basically in line with expectations, whereas in the past, Meta often significantly exceeded expectations for this metric.

So will Meta's subsequent revenue growth gradually slow down? Dolphin believes the possibility is not low.

This wave of Meta's strength is mainly attributed to three points, listed in chronological order: the competitive advantage from TikTok being banned, Advantage+ compensating for the impact of Apple's IDFA on ROI, and Reels accelerating user penetration and commercialization. Of course, last year there was also a temporary boost from Chinese cross-border e-commerce platforms like Temu and Shein (which contributed 10% of total revenue last year).

However, the last point of the aforementioned 3+1 benefits has already begun to show signs of loosening (in September, the advertising scale of T&S two companies on Meta shrank significantly). The logic behind these changes has been discussed in detail in Dolphin's last quarterly report. As for the first three points, aside from Reels possibly having further upward space driven by price increases, the influence of the other two benefits will gradually weaken under the pressure of a high base.

On the other hand, from the perspective of the relationship between advertising volume and price, the growth in the third quarter relied more on the increase in unit price, reflecting the current strength of the U.S. economy and Meta's relative competitive advantage. However, Meta's CPM is uniquely high among peers, and the continuous rise in unit price will somewhat weaken advertisers' ROI, causing some advertisers with lower tolerance to turn to other platforms that offer better cost-performance ratios or are still experiencing rapid growth in traffic

6. VR is expected to benefit from new product sales during the shopping season: Revenue from VR-related Reality Labs in the third quarter was $270 million, a year-on-year increase of 29%. The growth rate remains stable due to a low base, but it still reflects a typical off-season performance.

Currently, VR still relies on new products to stimulate demand. At the end of September, the Meta Connect conference announced the release of the cheaper new Quest 3S VR headset, which is expected to boost sales during the shopping season in the fourth quarter.

7. Cash usage and shareholder returns: At the end of the third quarter, Meta had a total of $70.9 billion in cash and short-term investments, with a net cash of $42.1 billion after deducting long-term debt. This quarter's free cash flow was $15.5 billion, with $8.9 billion used for share buybacks and $1.3 billion for dividends, estimating an annualized shareholder return yield of 3%.

8. Performance indicators overview

Dolphin's Viewpoint

At the current historically high valuation position (25x Forward P/E), the market has some ambivalence towards Meta.

On one hand, the driving force of AI on advertising is clearly visible, and the help of AI in improving internal efficiency has also shown more concrete results in the past six months. This expectation gap in logical deduction has gradually been corrected in the rise of Meta leading tech stocks this year.

On the other hand, with the implied nearly doubled capital expenditure growth in 4Q24, the market's concerns about excessive investment weakening profits have resurfaced. If Meta provides a stronger-than-expected guidance for advertising revenue, then the potential impact of increased investment on profits can still be justified by the logic that "the benefits outweigh the drawbacks."

However, Meta's guidance this time is rather conventional, so under the backdrop of high valuation, profit concerns have been further amplified. It is advisable to pay attention to the management's explanations during the conference call and whether there are any changes in the guidance for 2025 profits.

Nevertheless, compared to investment issues, Dolphin believes that under Meta's efficiency-focused strategy, there may not be too much to worry about. Whether through structural adjustments in personnel or through financial techniques to extend depreciation periods (Meta's server depreciation period is already lower than peers, and high-end GPU servers indeed have a longer actual usage life), active adjustments can be made opportunistically in the coming year.

What we are more concerned about is whether there is a significant risk of revenue slowdown. As mentioned earlier, the dividend factors that have driven Meta's strong growth in the past 1-2 years are expected to gradually weaken in the fourth quarter of this year and next year, so what will be the new growth engine? The monetization power of Reels is one, but what else? Threads? Meta AI?

If revenue growth falls back to around 15% next year, or even 10-15%, and the likelihood of profit margins significantly increasing due to investment growth is also low, then how can a valuation of 25x or even higher be supported? **

Although we do not doubt Meta's significant competitive advantage compared to its peers in the medium to long term from a fundamental perspective, the "original sin" lies in the overly optimistic and consistent short-term expectations. Additionally, Trump's presidency seems to cause some disturbances in short-term trading sentiment, so from the perspective of risk-reward ratio, it may be more appropriate to wait for a better position.

The following is a detailed interpretation

1. Revenue: Withstood high expectation pressure

In the third quarter, Meta's revenue was $40.6 billion, a year-on-year increase of 19%, showing a certain normal slowdown due to the higher base. The main contributor to the better-than-expected results was the advertising business, which accounts for 98%, while VR remains in the off-season. The next quarter is expected to benefit from the shopping season and the popularity of new products, boosting revenue.

Q4 Guidance:

(1) Total revenue in line with expectations

Meta's management expects total revenue for Q4 2024 to be in the range of $45 billion to $48 billion, corresponding to a year-on-year growth of 15% to 20%. Currently, market expectations, including relatively optimistic ones, are clustered around the midpoint of this guidance range. Although the growth trend looks very strong when viewed in isolation, it can only be said to be basically in line with expectations, as in the past, Meta has often significantly exceeded this indicator.

If Meta continues to adopt its traditionally conservative and low-key style in this guidance, then the implied revenue outlook for the next quarter is close to the upper end of the range, which would still represent a very good year-on-year growth performance. The main reason is that although Q4 is the shopping season, this year's shopping season has nearly a week less than last year. Historically, the length of the time period has an impact on current performance.

Looking at specific business segments:

1. Advertising Business: Driven mainly by price growth

For the advertising business, I have consistently preferred to break down the current volume and price growth trends to better understand the current macro environment and competition.

(1) In the third quarter, the growth rate of advertising impressions continued to slow to 7%, but the user base is still expanding (the total daily active users in the ecosystem grew by 4.7% year-on-year), resulting in only a slight 2% increase in average impressions per user.

Logically, Reels is currently in a period of rapid ad filling . Is the sudden slowdown in impressions due to Reels reaching a saturation point, or is Meta intentionally tightening the faucet (ad inventory) to maintain high CPM within the platform, thereby optimizing its own profit ROI? This is something to watch for in the earnings call.

Starting from Q1 2024, Facebook will no longer disclose the monthly active users of its main site and ecosystem. Dolphin 君 mainly refers to the app download data and user duration data tracked by third-party platforms (Sensor Tower) to observe trends.

a. From the download data, both major platforms, FB and IG, are experiencing a slowdown in growth.

b. User duration remains temporarily stable

In the third quarter, IG's user duration is still growing, while FB barely maintains its level. Therefore, combining indicates that as the proportion of Reels short video content increases, IG's user stickiness is also rising (single user duration growth).

(2) Acceleration in advertising unit price growth

We previously mentioned that the advertising unit price is related to whether the economy is in an upward cycle and whether the platform's competitive advantage is improving, but this is under the condition of stable traffic on the Meta platform.

In the past year, although Reels has contributed new advertising inventory since its launch, the pricing has been relatively low within the ecosystem due to ROI issues. As the proportion of AI video content recommendations increases (reaching 50% in Q1 2024), the accuracy and conversion rate of ads have also improved to some extent, naturally providing motivation for raising Reels' pricing.

Moreover, the macro environment remained strong in the third quarter, so most peer platforms also saw an increase in pricing (YouTube has been shifting traffic to Shorts, dragging down the overall composite CPM pricing).

In the third quarter, Meta's overall CPM growth rate reached 11% (vs 10% in Q2 2024), further accelerating compared to the previous quarter. Third-party platforms indicate that early in the third quarter, pricing was affected by the transition from peak season to off-season, showing a decline. However, in the latter half of the month, with stable consumption, advertising in vertical fields such as retail, financial services, fast-moving consumer goods, and tourism either remained strong or rebounded, along with the increase in Reels' ROI leading to higher CPM pricing, collectively driving the overall CPM back to growth and setting a new high.

In the future, as long as the economy does not show significant weakness, the overall CPM can still rely on Reels to narrow the monetization gap with modules like Feeds and Stories.

However, Meta's current CPM is uniquely high among its peers, and the average APP service revenue per user has consistently remained high. Is traffic monetization being overdrawn? The continuous increase in unit price may weaken advertisers' ROI to some extent, causing some advertisers with lower tolerance to turn to other more cost-effective or rapidly growing emerging platforms.

2. VR: The off-season has come again, let's see Q4

The hot sales of Ray-Ban in the third quarter do not seem to have brought much surprise in terms of revenue, and the low base did not yield growth dividends, remaining stable at around 29%, similar to the previous quarter. Dolphin believes that the inability to drive growth is mainly due to the demand for AR glasses not being comparable to that of VR headsets.

Currently, VR still relies on new products for stimulation. At the end of September, the Meta Connect conference announced a cheaper new Quest 3S VR headset priced at $299 (Quest 3 is $499), which is expected to boost sales during the shopping season in Q4.

Combining IDC data and revenue calculations, it is expected that the sales of the Quest series in Q4 will likely match the levels of 4Q23. (All are estimates by Dolphin, for trend reference only)

II. Capital expenditure continues to accelerate, will there be significant profit pressure next year?

In the third quarter, although the growth rate of operating expenses accelerated, it did not bring much drag on profits. Q3 operating profit actually increased to 42.7%, the highest point since the business headwinds of 2022.

Although the capital expenditure in the third quarter was 9.2 billion, which is lower than market expectations, the full-year Capex guidance for this quarter has instead raised the lower limit, with the new range being 38-40 billion, implying that capital expenditure in Q4 is expected to surge significantly (+72% to 98%).

Currently, the market expects Capex for 2025 to be around 45 billion, with slightly more aggressive estimates reaching 50 billion, corresponding to an increase of about 15% to 28%. If we extrapolate the short-term trends from Q3 and Q4, by the time the Q4 financial report provides guidance for the full year of 2025, the aforementioned market expectations for growth may not hold.

Dolphin believes that the inverse change in short-term operating profit margins and capital expenditures may stem from two reasons:

The first is the impact of the confirmation window period, where the funds invested in the current period have not yet been expensed. The second is that the company has improved operational efficiency through other means, such as consolidating office spaces, reusing basic resources, and replacing traditional technologies with AI tools.

However, if we look solely at the directly related expenditure indicators, we can still visibly see some impacts from the investment cycle. For example:

1) Depreciation and Amortization Expenses

In the third quarter, depreciation and amortization expenses increased by 40% year-on-year, showing a certain acceleration compared to the second quarter. The confirmed increase in depreciation may not yet include the significant impact of the new investment cycle that has been ramped up since the second quarter. If Meta does not adjust the depreciation cycle going forward, then based on the growth momentum of capital expenditure in Q4 2024, even with the aforementioned other efficiency improvement methods to offset the impact, the profit side in 2025 will still face some pressure.

2) Employee Compensation Expenses

In the third quarter, the employee count was 72,404, with a net increase of 1,600 people quarter-on-quarter, returning to positive growth year-on-year. After more than a year of workforce reduction and efficiency improvements, the benefits of layoffs at Meta have now ended due to AI investments.

Last quarter, the company had already taken precautions regarding this change, and Dolphin expects this trend to continue into 2025. However, since management has repeatedly emphasized their structural adjustments and reorganizations, the net increase in employees will not be that high, likely reflecting more in the higher compensation for AI developers, which will drive overall R&D costs.

As for other expenses, the overall situation remains stable:

a. Management expenses continue to decline

This year, Meta has relatively fewer lawsuits, so management expenses, which include legal fees, have been shrinking at a double-digit growth rate. However, next year, the European Union is expected to strengthen its scrutiny of whether Meta's compliance with DSA regulations is adequate, and further fines against Meta cannot be ruled out. Nevertheless, this is not a typical operating item and is sporadic. For cash-rich giants, as long as the penalties are not severely punitive, they can somewhat ignore short-term legal disturbances and focus more on core business operations.

b. Sales expenses are expected to recover growth

Although sales expenses in the third quarter still declined, the rate of decline has significantly slowed. With many new products coming out this year and next, marketing expenditures are expected to gradually recover with slight growth.

c. Gross margin remains stable

The gross margin in the third quarter remained stable at 81.8%. Although there are seasonal fluctuations, there is currently no obvious drag from AI cost recognition.

Ultimately, the operating profit margin for Meta in the third quarter was 42.7%. According to the segmentation of advertising and VR businesses, as expected by the company's management, VR losses are still expanding. To significantly reduce losses, a blockbuster product is needed.

However, in the short to medium term, due to unresolved issues regarding whether the technology is disruptive and the lack of demand, there are currently no promising hardware prospects. Nevertheless, the market has long been accustomed to the nature of Reality Labs' business. As long as Mark Zuckerberg does not make excessive investments and losses do not significantly worsen, there will not be too many demands on the VR business during this strong period of advertising growth driven by AI.

Dolphin Investment Research "Meta" historical articles:

Earnings season (past year)

August 1, 2024 conference call: Meta: What drives Q3 advertising high growth? (2Q24 minutes)

August 1, 2024 earnings report commentary: Mag 7 thunderous, can the "clean stream" Meta really hold up?

April 25, 2024 conference call: "Meta: Plans to invest in AI for many years, will not overly concern about short-term profitability (1Q24 earnings call minutes)

April 25, 2024 Financial Report Review: Meta: The Nightmare of Plummeting Again? More Frightening than Thrilling

February 2, 2024 Conference Call: Meta: Advertising Remains Strong and Stable, Continuing Investment to Strive for the Next Generation Computing Platform (4Q23 Conference Call Summary)

February 2, 2024 Financial Report Review: “Surge” Meta: Explosive Growth in China, Mark Zuckerberg Generously “Gives a Big Gift”

October 26, 2023 Conference Call:" Meta: Chinese Advertisers Contribute Significantly (3Q23 Performance Conference Call Summary)

October 26, 2023 Financial Report Review: Meta: Advertising Strongly Returns, Why Doesn’t the Market Buy It?》

July 27, 2023 Conference Call:" Meta: Focused on AI Empowerment, Not Just Commercialization (2Q23 Performance Conference Call Summary)

July 27, 2023 Financial Report Review:" TikTok Loses Power, Meta Completely Reborn"

April 27, 2023 Conference Call: “Efficiency Year” Achieves Good Results, Reels Showcases Its Strength (Meta 1Q23 Conference Call Summary)"

April 27, 2023 Financial Report Review: Meta: Trials Completed, Fully Revived

February 2, 2023 Conference Call: “Efficiency” is always on his lips, and Zuckerberg has learned to be “obedient” (Meta 4Q22 Earnings Call Summary)

February 2, 2023 Earnings Report Review: Good news stacked like Buffs, is Meta making a glamorous turnaround?

October 27, 2022 Conference Call: Under questioning and “siege,” Zuckerberg still insists on betting on the metaverse (Meta 3Q22 Conference Call Summary)