Charlie Martin
14 February 2022
Paradise Divide Capital
charlie@paradisedividecapital.com
Introduction
In October 2021, I wrote up well over 3,000 words on my bull thesis for Meta (formerly known as Facebook). In it, I wanted to first address, and dispel, many of the bear theses that had been postured for Meta, namely antitrust, regulation, and the IDFA, and second I wanted to lay out my bull thesis, which included valuation, network effects associated with social media, their advertisement platform, and expansion into e-commerce and payment. In hindsight, I thought that the repealing of the IDFA was not going to be a big issue, because it didn’t manifest itself in 3Q ‘21 earnings, but the effects of Apple’s decision to prevent across app tracking did show up in the 4Q ‘21 earnings release, and it was extraordinarily present in the 1Q ‘22 forecast. Other than that, I remain bullish on Meta, evidenced by increasing my stake in Meta 6 times since I published my last piece on Meta. Meta’s 4Q ‘21 earnings release was by far the largest earnings disappointment of a large-cap technology company in history. The next day, Meta’s stock fell over 25%, which resulted in the single biggest 1-day loss of market capitalization in history. In this substack, I will try to address more niche issues concerning Meta including their 4Q ‘21 earnings, revisiting how I will go about valuing the company, competition, and terminal margins.
4Q ‘21 Earnings
To start, Meta’s reported quarterly revenue of 33.6 billion and quarterly net income of 10.28 billion. This represented a 20% YoY revenue growth and an (8%) YoY net income decline. Meta’s operating margins decreased from 46% to 37%. Meta’s DAP (family daily active people) increased 8% YoY and their MAP (monthly) increased 9% YoY. Over the last 5 years, Meta has had a revenue CAGR of 38%, so a growth of 20% represents a decline in the pace of growth. Meta reported that they bought back $19.18 billion of stock in 4Q ‘21, which represented a decrease in share count of 4.6% QoQ and 5.6% YoY. 4Q ‘21 represented the first time in the history of Meta that there was a significant decrease in the amount of shares outstanding, a trend that I hope will continue. Meta still has $38.79 billion of approved buyback left.
In 4Q ‘21, Meta started to break down their revenue into FoA (Family of Apps) and RL (Reality Labs), which gave the first glimpse to investors just how much Meta was spending on their metaverse plan. In 4Q ‘21, Meta generated $32.79 billion of revenue from FoA and $0.87 billion from RL. FoA generated $15.8 of net income and RL generated ($3.3 billion) of net income. Investment in RL by Meta has proved to be a large headwind since 3Q ‘21 earnings, and the 4Q ‘21 earnings, which separated RL into its own segment, have only enforced RL as a short-term headwind.
The part of Meta’s 4Q ‘21 earnings that was the main factor for the sharp decrease in market capitalization was their 1Q ‘22 earnings guide. Meta guided $27-29 billion of revenue growth, which would represent 3-11% revenue growth YoY. This is sharply lower than Meta’s 5 year trailing revenue CAGR of 38%, and even though analysts have long predicted a slow in growth to the 15-20% range for Meta, the guide to 3-11% was not expected. Meta’s CFO David Wehner attributed this low 1Q ‘22 earnings guide to competition for user attention by TikTok, Apple’s implementation of their new IDFA policy, Reels not being able to monetize at the rate of Posts and Stories, and larger macroeconomic issues such as supply chain disruption and inflation which are impacting advertisers budgets.
To start, I will go over what I think are some of the highlights of the earnings report, namely trailing topline revenue growth and increased rate of share buybacks. On a trailing basis, Meta was able to grow revenue 37% on a yearly basis from 4Q ‘20 to 4Q ‘21. This is mainly attributable to coming out of the Covid-19 pandemic, which put a strain on millions of small businesses and companies that used and spent money on advertising on Facebook and Instagram. Increased optimization of advertising on stories, increased user engagement, and increased time spent by users on Meta’s FoA accounts for the rest of the growth of Meta’s revenue. Meta’s pace of share buybacks was the other positive part of 4Q ‘21; in 3Q ‘21 Meta repurchased $14.37 billion worth of stock, and in 4Q, Meta repurchased $19.18 billion of stock, representing 33.4% QoQ growth of the share buyback. Historically, Meta’s share buyback has been primarily to compensate employees without diluting the rest of the shareholders, but in 4Q there was a meaningful decrease in share count of 4.6% from the previous quarter. Meta paid an average of $327 per share they repurchased in 4Q ‘21. Meta still has $38.78 billion approved, and available, for share repurchases. Given the dramatic drop in Meta’s share price, on February 14th, 2022 it is $217 a share, I would hope that Meta has only increased the rate at which they are buying back stock. Decreasing share count through buying back shares is the best way to meaningfully return capital to shareholders, as it increases an individual shareholder’s ownership stake in the company. It is important that Meta uses their capital right now to repurchase shares given the decrease in the share price.
The first poor part of Meta’s earnings is the decrease in their operating margins. In the period from 4Q ‘20 to 4Q ‘21, Meta’s operating margins decreased from 46% to 37%, which resulted in a (8%) decrease in net income and a (5%) decrease in EPS. This decrease in Meta’s operating margins are directly related to increased spending on RL, which Meta spent >$10 billion on in 2022. In 4Q ‘21, RL had $0.87 billion of revenue and ($3.304 billion) of net income. Meta’s spend on RL increased 53.9% from FY ‘20 to FY ‘21. The market reacted negatively to this sacrifice of short term operating margins in order to build the metaverse, which Meta says could become their main business segment, if successful. I am not as short-term oriented as the broader market is on Meta. However, I think that RL can’t become >$10-20 billion cash burn per year, and if unsuccessful, Meta needs to return to operating margins that are >50%. Operating margins can’t go <30%, and if they do, it would signal that Meta is being irresponsible with their spending.
Meta’s guide for 1Q ‘22 was the other concerning part about their 4Q ‘21 earnings release. I went through much of their guide in a previous paragraph, so I’ll just try to provide my opinion here on the importance of the headwinds that Meta faces going into 1Q ‘22. The first headwind that Meta outlined was ability to monetize Reels at the same rate that they monetize Stories and Posts. I see this as only a near term headwind; Meta was able to successfully make the transition, in terms of monetization of their platform, from the internet to mobile, from Facebook to Instagram, and from Feed to Stories. I have no reason to believe that they won’t be able to make the transition to monetizing Reels effectively, as well. The competition between Reels and TikTok is extraordinarily important, but it is something that I will address later in this Substack. The next headwind addressed in Meta’s 1Q ‘22 guide was the impact of Apple’s IDFA on their ability to optimize their advertisement targeting. I see this only as a short-term headwind, only because I have conviction in Mark Zuckerberg’s ability to figure out a way to target ads just as effectively without cross-app tracking. Whether that is better algorithms or an increase in the amount of data points collected on a user, in my opinion, cross-app tracking is not necessary to effectively target ads. The final headwind that was spelled out in Meta’s 1Q ‘22 guide was macroeconomic issues such as supply chain disruptions and inflation. These headwinds are affecting each company, and this too is only a short-term headwind for Meta because over time supply chain bottlenecks will be smoothed out and interest rates will increase, which will decrease the rate of high inflation going on now.
A Different Approach to Valuing Meta
In my last write-up on Meta, I used a variety of different multiples and comps to justify my stance that Meta is undervalued. In my last write-up, I used EV/EBITDA as one of my valuation multiples, but I don’t think that an EBITDA calculation for Meta is helpful. This is because of the large depreciation costs that are associated with Meta’s business model. Since depreciation is intrinsic to Meta in ways that interest, taxes, and amortization aren’t, I will instead use cash flow yield as a way to value Meta. Cash flow yield has the advantage of including both depreciation and amortization, which are real costs that shouldn’t be overlooked. For Meta, they had $8 billion of depreciation and amortization in FY ‘21.
At close on February 14, 2022, Meta had a free cash flow yield of 6.4%, a number which offers an attractive risk/reward proposition, considering this is depressed due to a decrease in operating margins. Even with the massive spending on RL, which is currently depressing cash flow by >$10 billion per year, the cash flow yield is attractive. If we make the assumption that the metaverse project is worth zero to Meta’s market capitalization, and they stop spending any money on RL tomorrow and assume all that extra cash goes to the bottom line, Meta’s cash flow yield goes from 6.4% to 8.1% on a trailing twelve month basis.
Since Meta is a large conglomerate, which has many different business lines inside their FoA, I think that it is necessary to break them down into individual components to properly value Meta. Meta’s FoA includes Facebook, Instagram, WhatsApp, Messenger, and more. Meta’s RL mainly consists of bets surrounding their Oculus VR headset. Other R&D associated with RL is kept largely secretive.
Instagram (Valuation)
In FY ‘21, Instagram contributed roughly $47.62 billion of revenue to Meta, which represents a nearly 100% increase in revenue from FY ‘20. I think that it is safe to assume that you can underwrite the 3-year revenue CAGR of Instagram to be ~30%. If we assume that Instagram has the same gross margins as the larger FoA does, which is ~85%, we can conclude that Instagram does gross income of $40.48 billion, and if we extrapolate that to the operating margins of Meta’s FoA, we can assume that stand-alone Instagram does $23.11 billion of net income.
With a 30% 3-year revenue CAGR and the high gross and operating margins, I think that Instagram could conservatively trade at 27x earnings or a 3.7% free cash yield. That would value Instagram at $623 billion. Using comps of Pinterest, Snap, Twitter, and Tencent, that multiple could easily expand to 40-50x earnings given the strength and speed of both revenue and earnings that Instagram has. Assigning even a 35x earnings multiple to Instagram would make its market capitalization ~$200 billion more than Meta as a whole or or $808.85 billion.
Facebook (Valuation)
In FY ‘21, Facebook contributed to the vast majority of the other part of Meta’s advertising revenue. That would equate to $67.31 billion in revenue. Although the Facebook app and Facebook.com contribute more to Meta’s overall FoA revenue than Instagram, the pace of growth of Facebook is much slower than Instagram, thus giving it a lower earnings multiple. Applying the same gross and operating margins to Facebook, it does $57.21 billion in gross income and $32.3 billion in operating income. The same earnings multiple that Instagram I gave Instagram in the previous paragraph can’t be applied to Facebook because of the slower pace of growth. I think that it is safe to assume that the slowest rate of Facebook’s 3-year revenue CAGR would be at GDP, which would be at ~4%, and on a global scale, I would be comfortable underwriting 7% annualized revenue growth over the next three years.
Taking that all into consideration, I think that a 12x earnings multiple is extraordinarily conservative and a 16x is fair. That would equate to a free cash yield of 8.33% and 6.25%, respectively. A 12x earnings multiple would imply a market capitalization for independent Facebook of $387.6 billion, and a 16x earnings multiple would imply a market capitalization of $516.8 billion. In my estimation, a conservative estimate for the combined value of Facebook and Instagram would be $1,010.6 billion, and I believe that a fair valuation of combined Facebook and Instagram would be $1,325.65 billion. That would imply an upside of 70.6% and 123.8%, respectively, to the current market capitalization of Meta as a whole.
Advertising Business Model
The business model for monetizing both Instagram and Facebook is relatively simple, which is why I won’t go in depth on it like I will for WhatsApp. Essentially, an advertiser comes to Meta with their advertisement and what type of person they want to target their advertisement to. Through Meta’s extensive algorithm and extensive amount of data they have on their users, they are able to target that advertisement to exactly the right person. This ad targeting is important because normally advertisers don’t purchase ads on a per-ad basis or to target a fixed amount of people; advertisers generally allow Meta to keep pushing their ads to more and more users based on the return-on-investment that an advertisement generates. That is based on conversions of an advertisement appearing on a person's page to that person buying the product and a person's engagement with the advertisement, which includes going to the advertisers website, time spent looking at the advertisement, and liking, commenting, and sharing the advertisement. Both Facebook and Instagram have other ways of making money such as Facebook Marketplace, Instagram Shop, and Facebook Pay, but those account for a fraction of Facebook and Instagram’s revenue and the business model of those are easy to understand, so it doesn’t make sense to dive deeper into that.
WhatsApp (Valuation)
The other parts of Meta are harder to assign an earnings multiple to, considering that they are either currently not being monetized efficiently or they are losing money from research and development costs.
WhatsApp is integral to communication outside of the United States, and I believe that successful monetization of WhatsApp can provide a significant tailwind for Meta. WhatsApp has 2.0 billion MAUs (monthly active users) and there are over 100 billion messages on the platform every day. WhatsApp is much more global than Facebook and Instagram, with only 7.5% of 2021 downloads were from the United States. WhatsApp is used in over 180 countries and is the most popular messaging platform in 86% of those 180 countries. The majority of WhatsApp users have Android devices as compared to iOS devices. Since WhatsApp doesn’t produce advertising revenue like Facebook and Instagram do, an earnings or even revenue multiple isn’t applicable to properly value WhatsApp. When Meta acquired WhatsApp on February 19, 2014 for $19 billion, WhatsApp had 465 million MAUs, and today, WhatsApp has 2.0 billion MAUs. Meta paid about $40.86 per WhatsApp user, and if we extrapolate that to today’s 2.0 billion users, WhatsApp would have a valuation of $81.7 billion.
Since WhatsApp is free to all users and there are no third-party advertisements being run on WhatsApp, Meta has had to turn to other strategies to make WhatsApp a net-positive subsidiary of Meta. One strategy that Meta has employed is to use WhatsApp data to better target advertisements to users on Facebook and Instagram. A common misconception is that this data is coming from the actual message that a person might send on WhatsApp; in 2016, end-to-end encryption of messages was installed on WhatsApp, meaning that Meta could not access the contents of a WhatsApp user if they wanted to. Instead, they acquire data based on the different people and businesses a person might interact with when using WhatsApp. The two ways that WhatsApp is monetizing its platform is through WhatsApp for Business and WhatsApp Pay.
The WhatsApp Business App helps businesses efficiently and effectively communicate with their customers on a large scale. Netflix, Uber, and Wish are among a series of large companies that have used the WhatsApp Business API to communicate with their customers. WhatsApp makes money based on “slow replies,” which means that it is free for companies and customers to message back and forth, but if a customer were to respond to a message and the company did not respond within 24 hours, the company would be charged a fee. This establishes an incentive structure for companies and consumers to use WhatsApp because of its free use. If a company were to use iMessage or an Android equivalent, they would have to use an independent API, such as Twilio, to be able to foster such interactions. Using iMessage has embedded telecommunications costs that using WhatsApp doesn’t, which reduces margins for businesses. The “slow reply” structure makes use of WhatsApp sticky for companies. Because companies are incentivized by staying on the platform and messaging through the platform through the “slow reply” structure, it becomes costly for a company to abandon WhatsApp messaging.
WhatsApp Pay, or Novi at is now called, makes money transfer and payment easy for users of all income levels. Since WhatsApp Pay is embedded in WhatsApp, a user's network of contacts is already established and there is a decreased risk of fraud or sending money to the wrong person. WhatsApp makes payment accessible for everyone through their UPI (Unified Payments Interface), which makes it so that transactions can occur without bank numbers or IFSC codes of recipients. WhatsApp pay started in India and Brazil, but it has since expanded to all other countries. WhatsApp charges a fee of 3.99% of the value of the transaction done through WhatsApp.
Although the exact number of revenue for WhatsApp is unknown, it is estimated that WhatsApp generates ~$4 of revenue per user on a yearly basis. That would equate to ~$8 billion of yearly revenue for WhatsApp, and applying the same operating margins used for Instagram and Facebook, it is safe to assume that WhatsApp does $3.84 billion in net income. Using a conservative free cash yield of 4.5%, or an earnings multiple of 22.2x, WhatsApp is valued at ~$85 billion, which is similar to the $40 per user valuation estimate mentioned earlier. Considering the stickiness, growth rate, and how entrenched WhatsApp is in the foreign communication sector, it should have an earnings multiple of 30x earnings multiple, or a free cash yield of 3.3%, which is more realistic to comps. That would imply a valuation of ~$115 billion for WhatsApp.
Reality Labs (Valuation)
Valuing Reality Labs (RL) will be tougher than my previous valuation estimates that I had for WhatsApp, Instagram, and Facebook. However, it will be made slightly easier because of the 4Q ‘21 breakdown of Meta’s revenue into RL and FoA. Right now, it is clear that the market believes that RL is a net-negative for Meta because of the amount of cash that the project is currently burning. As mentioned earlier, RL is currently a net-loser of >$10 billion per year for Meta. This part of my analysis is concerned with the valuation of RL, not the pivot, expansion, and spend concerning the metaverse--I will address that later in this article.
In FY ‘21, RL did $2.27 billion in revenue, which represents a 100% increase from FY’20. Over the two years of reporting history of RL, it has a revenue CAGR of 113%. I believe that over the next 3 years, RL can have a revenue CAGR of 60%, and I believe that over the next 7 years that RL can sustain a cumulative revenue CAGR of 40%. That would mean that in FY ‘24, RL would do $9.31 billion of revenue, and in FY ‘28, RL would do $23.91 billion of revenue.
I think that it is not fair to value RL using comps for a variety of reasons. First, most companies that are creating products, technology, and software for the metaverse are in private or haven’t been created yet. The companies that are private are not mature enough to use as comps because they are raising their Seed, Series A, or Series B funding rounds. The public companies that are associated with the metaverse or are spending large amounts of money on expansion don’t operate in the same sphere of the metaverse that Meta operates in and wants to expand to. For example, a company like Unity Software would be considered a “metaverse company,” but they make software for applications in the metaverse, whereas Meta makes software for the metaverse, as well as physical hardware, the Oculus Quest VR headset, UI for the metaverse, and nearly all parts of the metaverse experience. Other public companies such as Roblox, Autodesk, and Nvidia aren’t good comps because they are not “pure-play” metaverse companies in the same sense that RL is a pure play metaverse segment of Meta.
In RL’s bull case scenario, I believe that it won’t be profitable until at least FY ‘26, and in its bear case scenario, it will never be profitable. Assuming a 50% 5-year forward revenue CAGR, in FY ‘26, RL will do $17.26 billion in revenue, which would mean that if annual spending stayed constant at $10 billion, Meta would produce $7.26 billion in net income. I think that RL spending will track the growth of RL; in our bull case scenario, I think that spending on RL would increase past $10 billion annually because of the success of RL.
In the worst case scenario, I think that RL growth slows from a trailing two-year revenue CAGR of 113% to a forward two-year revenue CAGR of 20% or lower. In this scenario, I think that it will be evident to Mark Zuckerberg, Meta’s board of directors, and shareholders that a $10 billion annual cash burn is not beneficial, and RL will receive less and less investment. It is hard to envision a scenario where Meta’s management would be so blind to the RL failing and continue to burn cash on this project for >5-7 years. In my opinion, the worst case scenario for RL would be a 3-year cash burn of $30 billion, with no significant success of the metaverse. While this is certainly a possibility, I don’t think this is likely considering the consumer adoption and utility of Meta’s Oculus headset and interface.
The other important tailwind that Meat’s RL project has is access to capital. As opposed to a smaller public company doing work on metaverse products or private companies, RL has access to a >$10 billion annual budget to build out their vision of the metaverse. No other company doing work on building products for the metaverse has this advantage of this level of quick and easy access to capital. And, since Meta’s credit is investment grade, if they need to raise capital in the form of a bond offering, they could raise at a low credit spread.
I don’t think that it is possible to put a dollar value on the value of RL because in the best case scenario, RL could be worth trillions of dollars to Meta, but at the same time, I am fully aware of the downside risk that RL poses to Meta. Currently, however, the market is clearly taking the position that investment in RL is pointless and the metaverse project will fail. I think that the risk/reward proposition for RL is more attractive than what the market currently believes. I think that at maturity, RL can have 60% gross margins and 25% operating margins. These are lower than Meta’s FoA because the Oculus Quest has significant hardware costs. Those margins combined with a 5-year revenue CAGR of 50% and RL’s access to capital, I think that an independent RL could trade at 15-20x FY ‘21 price/sales. This would imply a valuation of between $34.11-45.48 billion for RL.
The race to build products of the metaverse, in my mind, is eerily similar to the fight to acquire market share in the food delivery space. When GrubHub IPO’d in 2014, they were focused on the profitability of the business. At the same time, DoorDash was burning hundreds of millions, if not billions, of cash per year. While GrubHub was touting its margins and profitability, DoorDash knew that they could temporarily burn cash to manically take market share in the food delivery business from GrubHub. Today, DoorDash has nearly 55% of the market share of the food delivery space in the United States compared to GrubHub’s 16% market share, and DoorDash is valued at 5x what GrubHub was valued at when they merged with Just Eat Takeaway.com in 2021.
While it is uncertain whether the race to build out products for the metaverse will be similar to the race to acquire market share in the food delivery business, I think that it serves as an important lesson: the company with greater access to capital has a greater chance of becoming dominant.
The Sum of the Parts
Individually adding up all the market capitalization contributions of Meta’s subsidiaries (Instagram, Facebook, WhatsApp, and RL), I would have a total valuation of Meta of $1485.8 billion. That would imply a price of $529 per share, or a 147% upside to Meta’s current share price. I think that might be slightly aggressive considering the RL spend is detracting from the earnings of Instagram, Facebook, and WhatsApp, an aspect that is not taken into consideration in my share price estimate. I think that detraction should account for a $100 billion decrease in Meta’s market capitalization, which would revise my share price estimate to $492 per share, or a 130% upside.
Competition (TikTok)
In the 4Q ‘21 conference call, Mark Zuckerberg mentioned TikTok numerous times as a competitor for user attention. TikTok has a few advantages to Instagram and Facebook at the moment: they were designed as an exclusively mobile application and their user base is mostly kids, teens, and young adults. In order to effectively compete with TikTok, Meta rolled out Reels on both Facebook and Instagram. Reels works in almost an identical manner to how TikTok works.
On TikTok there are two pages: the “Following” page and the “For You” page. The vast majority of user time and attention is spent on the For You page, where user engagement with posts determines what is shown to the user. TikTok’s algorithm works in a way that maximizes appealing content to the user. When a user first downloads TikTok, the algorithm will show the user an array of different content to learn what type of content the user engages with the most. For our hypothetical, let’s imagine that our fictional user engages the most with dance videos. A user's engagement is measured through a user's time spent on a video as a percentage of the time of the whole video, likes, comments, shares, and many other more niche engagement factors. The more that a user engages with a video, the more that TikTok’s algorithm will show similar videos to the user.
TikTok’s For You page is endless, meaning that no matter how many videos a user watches or scrolls through, there will always be more videos to watch on the For You page. This coupled with a highly effective and refined algorithm makes TikTok a highly addictive platform. TikTok has engineered their platform to maximize dopamine release in similar ways to Instagram and Facebook, but the difference between Meta’s FoA and TikTok, is that the structure of TikTok’s video structure maximizes time spent by a user on the platform. Reels is essentially a copy of TikTok inside of Instagram and Facebook. Reels uses the equivalent of a For You page, where their algorithm uses the same engagement factors as TikTok to optimize content shown to users. The feed on Reels is also endless in the same way that TikTok’s For You page is endless.
In my opinion, Reels will never be TikTok, and frankly, I don’t think that Meta should aim for Reels to become TikTok. The reason for this is two-fold: quality of content between Meta’s FoA and TikTok and the higher level of network effects built into Meta’s FoA as compared to TikTok. Before I go into the analysis of these two factors, which I think are both tailwinds for Meta, I want to appreciate the impressive rise of TikTok. Whether this rise was due to the pandemic or some other factor, TikTok has become much larger than the dance app that it once was. I believe that TikTok has staying power and will continue to be successful for years to come.
The quality of content posted on Meta’s FoA, Instagram and Facebook in this case, is much different than the quality of the content posted on TikTok. On Instagram and Facebook, people care significantly about the quality of their posts, even on Stories, whereas on TikTok, people care much less about the quality of the posts. On Instagram and Facebook, users might curate their feed or timeline to look aesthetically pleasing, and since TikTok is centered around videos, it is much tougher to have users care about the aesthetic of their page. If a user of Facebook or Instagram posts a Reel, that shows up on their page in the same way that a Post would show up on a user’s page, thus making users care much more about the quality of a Reel they would post. Since users care more about the quality of the Reel they would post, that leads users to post less often.
Instagram encountered a similar thing when they introduced Stories in an attempt to match the growing popularity of Snapchat in August 2016. In the period from the inception of Snapchat in 2011 to 2016, their stories were the most compelling part of the app, along with communication with a user's friends. The original idea, and use case, for Snapchat was every user was going to have a “story” for the day, which would showcase through videos and pictures what they did during that day, and for the first 5 years of Snapchat’s life, this was how Snapchat was used. After Instagram and Facebook Stories were created, and after the novelty of a user posting their day on story and seeing all their friends stories wore off, the main use case from Snapchat transitioned to communication. I, personally, use Snapchat everyday as a way to communicate with friends, but I haven’t posted a Snapchat story in over 2 years. The quality of content posted on Instagram stories turned out to be much better than the quality of Snapchat stories, and most people eventually started making their Instagram story a more curated version of their Snapchat story.
I think that Reels will be successful if they follow the same playbook that Instagram stories used. A small fraction of the content posted on TikTok is entertaining or even worth a user’s time, but the portion that is funny, entertaining, or informative keeps the user swiping through all the poor quality content. If Reels is able to provide more utility to the user, they will be able to compete seriously with TikTok in the short videos space.
The other advantage that Instagram and Facebook have over TikTok is the large, pre-established networks that exist. A user’s experience on TikTok is almost no different if they follow all their friends or they have an anonymous account that follows no one. The opposite is true of Facebook and Instagram; the platform is most effective and useful when a user follows their friends and their interests. Having this network not only establishes and maintains relationships and connections, it creates a moat for the business and stickiness for the user. I talked at length about “networks as a moat” in my last write up, so I’ll try to briefly summarize my thesis here: Facebook and Instagram are staying popular because a user’s network is so established, and the effort to try to build that extensive network on another social media platform is not worth it. That provides a moat for Instagram and Facebook over other social networks. A user of Instagram and Facebook is also “sticky” because of the network they have built. If a user’s following and friends are using Instagram or Facebook to post, share, and message, it is hard for that user to take themselves out of that network and not see what their friends or following are posting. Because of this, users of Facebook and Instagram are sticky, which means they are not likely to leave the network.
As I explained earlier, the same is not true of TikTok, which provides an advantage for Reels over TikTok. TikTok does not have the same moat around its business that Instagram and Facebook do, and because of the lack of an entrenched network, the users of TikTok are not as sticky as the users of Instagram and Facebook. If the execution of Reels goes well, it can be both a platform where users can post higher quality versions of “TikToks,” and enjoy good content produced by both people inside and outside their network.
The final point that I want to make on competition between Meta’s FoA and TikTok, is I think that TikTok isn’t as much of a competitive threat to Instagram and Facebook as it is to other social media platforms like YouTube and Twitch. I believe that because Instagram and Facebook are, with the exception of Reels, visual first platforms. Use of TikTok requires both visual and auditory engagement with the content, which is more similar to how users interact with YouTube and Twitch. In practice, Instagram and Facebook are more accessible most of the time because there is no auditory barrier to engage with content. Speaking from personal experience, since I started using TikTok around 2 years ago, my time spent on Instagram has not decreased, but my time spent on YouTube has decreased. YouTube and TikTok are competing for a different type of user attention than Instagram and Facebook are competing for.
Terminal Margins
I talked a lot about gross and operating margins in my valuation estimates for Instagram, Facebook, WhatsApp, and RL, so I’ll try to keep this brief. I think that it is safe to assume that the software parts of Meta can have 85-90% gross margins and 45-50% operating margins in their mature state. This has to do with the relatively small cost of an additional user. This is how SaaS businesses operate and why SaaS businesses are typically the most expensive businesses, on a price/sales multiple, in the market. As far as RL goes, I think that it should have 60% gross margins and 25% operating margins at maturity, which I believe won’t come for at least 5-7 years. Meta’s ability to maximize terminal margins will drive shareholder value over the long term, and thus Meta will be able to return more and more capital to shareholders through share buybacks. I expect that margins will be depressed until either RL reaches maturity or it fails, but I don’t think that Mark Zuckerberg will suppress shareholder value over an extended period of time in hopes that his vision of the metaverse will play out.
Conclusion
Meta is PDC’s largest position at >22% of the total portfolio. My conviction on Meta has only increased as its share price has fallen. My opinion on Meta is clearly in contrast to the current prevailing opinion, evidenced by a 40% drawdown from Meta’s ATH. But, having an orthogonal opinion to the market is the only way to produce alpha. Thank you so much for reading this! I know this was a long one (well over 6000 words and 12 pages), so I hope it was worth it to read. If you have any questions, feel free to reach out to me at charlie@paradisedividecapital.com or my phone number: 720-737-0668. Just as a disclaimer, none of this is investment advice or a solicitation to purchase Meta’s equity (NASDAQ: FB) and this is for educational purposes only. Below, I am going to link some of the sources that I found particularly useful when writing this. Again, thanks so much for reading! <3
Sources:
“Meta Reports Fourth Quarter and Full Year 2021 Results.” Meta, investor.fb.com/investor-news/press-release-details/2022/Meta-Reports-Fourth-Quarter-and-Full-Year-2021-Results/default.aspx. Accessed 17 Feb. 2022.
“TIKR: Institutional-Grade Investing for Individuals.” TIKR Terminal, app.tikr.com/stock/about?cid=20765463&tid=126910337&ref=ebrjz1
Accessed 17 Feb. 2022.
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Way to go, Metamate! I'm a buyer at any price below $300!