Meta Platforms Inc.'s (META, Financial) first-quarter earnings report last week triggered a drastic market reaction, with shares plummeting 10.50% by the end of Thursday's trading session, resulting in a staggering $130 billion loss in market capitalization. This decline sharply contrasted with the over 20% surge seen after the previous earnings release, marking the largest single-day market cap gain ever recorded.
Interestingly, the sell-off was not prompted by an earnings miss. The social media giant actually surpassed the earnings per share consensus by a robust 9% and revenue by $240 million. The primary concerns seemed to stem from guidance, which was perceived as somewhat conservative, along with management's plan to significantly increase investments in artificial intelligence.
Earnings review
Meta continues to stand out as a pivotal player in the tech and advertising landscape. With an estimated 3.2 billion global users engaging daily across its platforms, the company's reach is truly astounding.
What's even more notable is the company's consistent growth in user numbers, which expanded by a remarkable 7% year over year. This growth was fueled by gains across Meta's diverse suite of platforms, highlighting its ongoing relevance and expansion in the digital space.
During the first quarter, Meta also achieved notable growth in user engagement, resulting in a 20% increase in ad impressions. This advancement is visually captured in the accompanying graph, illustrating a steady year-over-year uptrend in average revenue per user.
This dual achievement signifies Meta's success in expanding both its user base and the value derived from each user, demonstrating an impressive growth trajectory for the company.
In the short term, Meta anticipates a decline in free cash flows due to aggressive capital spending, particularly in AI development. The company projects full-year expenses of $96 billion to $99 billion and capital expenditures of $35 billion to $40 billion, with a $5 billion increase at the lower end of the guidance range. The heightened investment in AI initiatives is expected to result in lower free cash flow margins.
Despite the near-term impact on cash flows, I do not view these AI investments as a reason for the market's negative reaction. Instead, I believe these strategic investments could unlock new revenue opportunities over the long term, contributing to Meta's growth trajectory.
Additionally, the company's revenue guidance for the year disappointed investors, with projected top-line figures of $36.50 billion to $39 billion. While this guidance suggests up to 22% year-over-year revenue growth, some investors may have had higher expectations, leading to the market's reaction with a 16% drop in shares.
A great opportunity
Meta has stood out as one of the top performers among the Magnificent Seven, trailing only behind Nvidia Corp. (NVDA, Financial). Despite concerns over its valuation climbing too swiftly, I believe these worries are more a reflection of human psychology than the underlying business fundamentals. Any potential losses in tomorrow's trading are likely to be short-lived, especially once the somewhat tangential effects of the Federal Reserve's prolonged stance on interest rates become clearer.
Meta's competitive edge is resilient against higher interest rates, and its valuation reflects expectations of sustained competitiveness over decades. The decision to ramp up capital expenditures during a period of exceptional growth is, in my view, a strategic move by management rather than a signal to sell this exceptional stock.
There are numerous reasons to anticipate that Meta will continue surpassing expectations and delivering value to shareholders. The company is entering the AI race more competitively, facing off against giants like Microsoft Corp. (MSFT, Financial). However, what sets Meta apart, even compared to Nvidia, is its exceptional margins, making it a standout among the Magnificent Seven.
Meta has entered the competition with ChatGPT by launching its Llama3 large language model, signaling its commitment to AI innovation and positioning itself among the major beneficiaries of the trend. The future of the technology remains uncertain, but Meta is aggressively pursuing a leading role in this evolving landscape.
Throughout 2023, Meta implemented significant cost-cutting measures, marking it as the "year of efficiency," a move that resonated well with both the markets and shareholders.
The company's substantial capital expenditure into augmented reality and the Metaverse is expected to leverage its existing AI capabilities. By integrating open-source aspects of its AI stack, Meta aims to develop new functionalities as technology advances.
Meta's strong economic foothold in the U.S. is another key positive factor. Given its concentration in digital advertising, the company's performance is closely aligned with overall economic activity.
Moreover, unlike previous economic expansions, businesses are currently deleveraging on a net basis, creating a favorable environment for Meta's operations and growth prospects.
Valuation
Following the latest sell-off, META has become very attractive, and there is plenty of upside if we look at a simple discounted cash flow model.
Assuming Meta can keep growing at around 15% per year and maintain its current margins, then this model implies 46% undervaluation.
Risks
Meta's financial stability is heavily reliant on digital advertising spending. Any reduction in this spending, particularly due to economic weakness, could negatively impact the stock. However, amidst the ongoing AI competition, the company faces significant risks, including potential major product setbacks similar to Google's recent experience with Gemini. Despite these challenges, I believe macroeconomic risks, especially given Meta's cost-cutting efforts and AI's potential to enhance its core product rapidly, pose the greatest concerns.
Additionally, various economic risks could disrupt the market, including:
- Fed policy errors.
- Escalation of the banking crisis.
- Return of inflation.
- Commercial real estate market collapse.
- Private asset write-downs.
- Increased political uncertainty during an election year.
Rising interest rates or extended higher rates could dampen the performance of high-multiple stocks. Nevertheless, Meta appears less vulnerable to this given the strength of its customer base and the potential for improved product economics through AI integration.
Conclusion
Meta's first fiscal quarter earnings sheet revealed a strong performance, indicating the enduring nature of the digital advertising rebound that began in 2023. The company retains significant advertising relevance for marketers and managed to accelerate its top-line growth. Notably, it was a standout quarter for Meta in terms of free cash flow, with margins exceeding 34%.
I believe the market has reacted excessively to Meta's expansion into AI, which should not be seen as a negative. Although the price-earnings ratio is less than 20, indicating it is not entirely cheap, the company's growing revenues, earnings and free cash flow justify this valuation for the largest U.S.-based social media company.
