Headstrong Meta still gambles on "Metaverse" despite suffering heavy losses from bleeding

Hey everyone, I'm Dolphin Analyst!

This morning (October 27th, Beijing time), Meta released its Q3 2022 financial report. After the Snap and Google disasters, the market was nervous about Meta's performance. The final report showed that, like Google, Meta fell short on profits. However, the reason for the 18% drop in share price was not only due to the lack of profits for the quarter, but also due to the market's strong dissatisfaction with Meta's expansion plan for next year.

On one hand, investment banks expect Meta's cost expectations to be too conservative, while on the other hand, shareholders have publicly urged Zuckerberg to lay off employees in the past two days. The market should have had a more optimistic expectation for the optimization of operating expenses. If we look into possible areas for incremental spending, Dolphin believes that, aside from the metaverse that Zuckerberg is focusing on, the improvement of Reels' competitiveness in Instagram is likely to be the key area for spending, followed by continuing to improve technology to mitigate the impact of Apple's IDFA policy.

However, regardless of the reason, the expectation of continued erosion of profits is not something the market wants to see.

Returning to this financial report, the key points are summarized as follows:

Overall revenue meets expectations, VR is weak, and guidance for the next quarter is slightly weaker. Meta's total revenue for Q3 was relatively normal and within the guidance range, a 4.5% YoY decrease that exceeded expectations but was similar to what investment banks had expected. Advertising performance was slightly surprising. After the Snap and Google catastrophes, the market was concerned about Meta, but the actual situation was not much worse. However, VR, which received significant investment, was somewhat weak, with a YoY decline of -49% in Q3, much lower than the market's expectation. The newly released Quest Pro is priced too high and is not expected to contribute much to revenue growth in Q4.

Management's revenue guidance for the next quarter is in the range of 300-325 billion, slightly weaker than the market's unanimous expectation of 323 billion, but this guidance is still acceptable, especially after the huge disparity in expectations from the previous quarter.

Traffic is steadily expanding, but advertiser demand continues to decline. Except for Europe, the number of active users in other regions is steadily increasing. Under the entire ecosystem, Meta's global monthly active users reached 3.7 billion. At the same time, Meta is also further releasing advertising inventory by showing more ads to users to resist the acceleration of declining ad unit prices.

The decline in ad unit prices is not only influenced by the macroeconomy but also closely related to the platform's competitiveness. Additionally, Reels' monetization ability is weak, which also pulls down the overall level.

The effects of layoffs have yet to be seen, and high costs weaken profits while next year's expansionary spending will exceed market expectations. Despite the news of Meta's hiring freeze and layoffs, the total number of employees in Q3 increased by nearly 4,000 compared to the previous quarter. Under these circumstances, costs cannot be optimized, which is why shareholders called for Zuckerberg to lay off 20% of the workforce the day before yesterday. Under pressure on revenue, operating expenses are growing rapidly, leading to a near 9% decline in the operating profit margin in Q3. Management proposed that the total number of employees will no longer increase by 2023, but the operating expenses budget for next year, ranging from 960 billion to 1010 billion, still significantly exceeds market expectations (around 900 billion), which reflects that the original cost optimization expectations have basically failed. The company stated that it is expected that the VR business will have significant losses by 2023, but it still wants to accelerate investments to achieve its long-term operational profitability targets. The continuous feeding of investment into the "gold-swallowing beast" cloud-based virtual universe business is also the main reason for the market's dissatisfaction, leading to a significant drop in stocks after-hours.
The company spent $6.55 billion in share repurchases during the quarter, with a remaining quota of $17.78 billion. As of the end of the third quarter, the company had a total of $41.8 billion in cash and cash equivalents, restricted cash, and marketable securities. The current free cash flow is only 173 million, compared to 9.5 billion and 4.5 billion for the same period last year and the previous quarter, respectively. The significant deterioration in cash flow is due not only to the decrease in profit but also to the significant increase in capital expenditures for purchasing properties and equipment.

5. Comparison between Key Indicators and Expectations

Dolphin Analyst's Opinion

Since the beginning of this year, when macro and competitive pressures caused Meta's revenue to collapse one after another, the market's expectations for Meta have been limited to shrinking expenses to maintain profitability and withstand the economic downturn cycle. Since the second quarter, Meta has repeatedly been rumored to be carrying out large-scale layoffs and closing offices in some regions, making the market highly expectant for cost optimization for next year.

However, it seems that the management's ideas are not the same. Although it guarantees that the scale of employees will no longer expand, it still persists in increasing its investment in VR business. Zuckerberg's dream of the metaverse involves investment cycles ranging from 5-10 years, and this "entrepreneurial investment" will be deemed to enhance valuation at the time of economic upswings, which is rewarded with icing on the cake, but during economic downturns, such investment is considered to harm shareholder interests and is punished twice as much.

A few days ago, the CEO of Meta's shareholder, Altimeter Capital, could no longer resist publicly urging Zuckerberg not to overthink, but to quickly implement large-scale layoffs. We do not know if management will consider adjusting its investment spending plan. But until clear indications of contraction are made, it will be difficult for the market to change its attitude towards Meta.

Moreover, what Dolphin Analyst is more worried about is that in addition to Zuckerberg's obsession with the metaverse, he believes that Meta's choice to increase investment in the headwind may also include the budget required to respond to competition on social platforms (such as short videos). If this is the case, the management's continuous emphasis on the threat of competition should continue to raise investors' vigilance regarding the escalation of industry competition. After all, this is Meta's foundation. If the foundation becomes loose, all that remains is a crash. We recommend paying attention to the management's views on the current competitive situation and the progress of short video Reels during the conference call. Dolphin Analyst will share the summary of the conference call with Dolphin users through the Longbridge App. Interested users are welcome to add WeChat ID "dolphinR123" to join the Dolphin research group and get the summary as soon as possible.

Detailed analysis of this financial report

Traffic expansion exceeding expectations, monetization efficiency continues to decline

In the third quarter, Meta's platform users returned to growth compared to the previous quarter, and compared to the same period last year, except for the European region, where Russian services were temporarily suspended, overall performance continuted to slightly expand, exceeding market expectations.

As of the end of the third quarter, the monthly active users of Meta's complete ecosystem reached 3.71 billion, of which Facebook accounted for 2.957 billion, and the user stickiness (DAU/MAU) continued to climb after hitting a low point in the fourth quarter of last year.

From the perspective of ARPU (advertising revenue per single user), Europe and America, where the main source of revenue comes from, continue to see a decline in user monetization value due to economic pressure, especially in the macroscopically weaker European region. Increasing pressure on the Asia-Pacific region is too low in absolute value to provide much support to total revenue. This also directly affects Meta's revenue, and profitability continues to weaken due to relatively fixed costs of traffic operation and personnel expenditures, which are difficult to optimize quickly in the short term.

Advertising: Lower-than-expected guidance, short-term pressure on Reels commercialization

In the third quarter, Meta's advertising revenue was $27.2 billion, a year-on-year decrease of 3.7%. Excluding the impact of exchange rate changes, the growth rate is around 2%. In addition to exchange rates, macroeconomics, competition, Apple's IDFA, and the high base effect of the same period last year are the main factors dragging down growth. However, this quarter's revenue is within the company's guidance and slightly higher than the market's consensus expectations.

In terms of regions, the European region is more affected by the macro environment due to the impact of war, and advertising revenue is accelerating its decline. In the core North American region, after the first decline last quarter, the decline was somewhat eased this quarter, but the horizontal comparison was still weaker than that of its peers in the industry. This part of the revenue is not affected by exchange rates, so it is more related to Meta's own product competitiveness and the corresponding customer marketing shrinkage ( Meta has a large number of SME small business advertisers). Meanwhile, SMBs are more sensitive to economic downturns and cut spending more quickly.

Meta's traffic in North America continues to expand, but the steadily decreasing prices indicate a tightening demand from advertisers as well as the threat of competition faced by Meta itself. According to Dolphin Analyst's calculations, the rate of change in Meta's advertising unit price in each region accelerated sharply downwards this quarter, particularly in emerging markets, indicating a rapid weakening of demand from advertisers.

"Another key factor is that the commercialization of Reels itself is not high, which has a downward impact on the average price level. Considering the user interaction of Reels occupying 20% of Ins duration disclosed by management in the last quarter, a telephone conference summary will be available later."

Whether it is macroeconomic or competitive pressures, if Meta wants to resist the decline in revenue, it needs to release more advertising inventory to alleviate pressure. In the third quarter, advertising impressions increased by 17% year on year, and according to Dolphin's estimates, the number of ads shown to individual users increased by 15% year-on-year.

As almost 98% of Meta's revenue comes from advertising, the outlook for advertising revenue can be compared with the company's guidance for overall revenue changes.

"The fourth-quarter revenue guidance is in the range of 30-32.5 billion, corresponding to a decline of 3.5% to 10.8%. Although the central guidance is below market expectations."

"This guidance is not good," following the implementation of Apple's IDFA privacy policy in the fourth quarter, the high base effect will gradually weaken. However, the implied growth range in the guidance is basically the same as that in the third quarter, which has a high base effect, indicating that the actual growth in the fourth quarter can only be worse than that in the third quarter. However, after the significant underperformance of last quarter's guidance forecast, it can be reluctantly accepted this time.

At the same time, such conservative guidance data "also indirectly indicates that the commercialization of Reels was not significant in the third quarter and is unlikely to help counterbalance some of the resistance to overall revenue."

"3. VR/AR: economic downturn, waning novelty consumption, and rising prices add more pressure." Third-quarter VR/AR business revenue plummeted to 285 million yuan, and Dolphin Analyst estimates that Quest 2 sales for the season will be only about 1 million units. In the previous quarter's financial report, Dolphin Analyst expressed concerns, stating that hardware price increases will definitely have an impact on front-end sales in the phase of declining consumer demand and lack of new milestone VR content.

As Oculus is still the absolute leader in the VR headset market, its downturn represents the overall market downturn. According to IDC's latest forecast data (2022.10.5), it is expected that global VR headset sales will reach 10.8 million units for the 2022 full year, which is slightly lower than the August forecast of 12 million units and below last year's sales.

Although Oculus released new products as scheduled in October, it did not expect that the Quest Pro priced at US$1,499 would be a bit expensive in the current environment. It is expected that sales will be average, with more consumer and enterprise users who are keen on new technologies.

In a recent public discussion between Zuckerberg and Microsoft CEO Nadella, they mentioned that a Quest 3 priced at $300 to $400 will be launched in the next two years. This performance report also mentioned that the cost growth in 2023 includes the hardware cost of the new Quest which will be launched later.

Dolphin Analyst believes that in the early stage of popularizing emerging hardware, prices that are more suitable for the public's consumer level can quickly drive penetration when the content is not rich enough. And more user penetration will stimulate the development power of content providers.

The real big thunderbolt is that the profit continues to weaken beyond expectations, and there is no sign of convergence in next year's expenditure guidance.

The company's operating profit for the third quarter was only 5.66 billion yuan, a year-on-year decrease of 46%, and the quality of earnings also significantly weakened, with a profit margin dropping from 29% in the second quarter to 20%, below market expectations (~22%).

The management's outlook for spending in 2023 is the main criticism from the market. Although the company mentioned that the employee size will remain the same by the end of 2023, resources will be internally adjusted to focus on growth projects, the market wants to see a reduction in the number of employees, which will optimize overall operating expenses. In the past two years, Meta has been aggressively recruiting, with a focus on hiring people for Reality Labs at high salaries. However, it will take a long time for VR business to pay off, and the economic downturn has only further delayed its monetization. The short- to medium-term return on investment for the VR business is too low, and the return cycle is getting longer. Nevertheless, Meta's management continues to expand investment, which is the most unpopular decision with investors.

Apart from short-term expenditure, such as office integration, the main sources of incremental operating cost are employee compensation. Meanwhile, the growth in costs is primarily driven by increased investment in infrastructure such as servers and data centers, and new Oculus products, needed to cater to the rising Reels traffic. Under pressure from reduced revenue, the growth of such costs poses a risk of continuing margin erosion.