AAPL - Meta's Q2 Double Miss: Everything You Need To Know

• Meta has reported its quarterly earnings and missed on both lines. That's bad.
• But at the same time, the company continues to add new users, despite tough comparables and an unfavorable macro environment.
• The valuation is well below average, and if the current investments pay off, investors could be handsomely rewarded.

Article Thesis

Meta Platforms, Inc. ( META ) reported weaker-than-expected Q2 quarterly results , missing estimates on both lines. Business growth wasn't encouraging. That being said, there were also some positives in the report, and the valuation is pretty low while the balance sheet remains strong. For someone with a longer-term horizon, Meta looks interesting, as its Metaverse investments will hopefully pay off increasingly in the future.

The Headline Numbers

The following screenshot highlights both the headline numbers that Meta reported, as well as the market's initial, pretty negative reaction:

The earnings miss, around 4%, wasn't too dramatic, although lower-than-expected profits naturally aren't positive. Revenue was down compared to the previous year's quarter, although only slightly. The market sent shares lower by 5% initially, although trading is volatile and this will likely change to some degree.

The Good, Bad, And Ugly

As one of the largest tech companies in the world, Meta Platforms is seen as a growth stock by many. For a growth stock, a -1% revenue growth (decline) rate is pretty bad. We have to look somewhat deeper, however, as there are a couple of important additional factors to consider. First, Meta was hurt by a strong U.S. dollar during the period. When the dollar rises, the revenues that are generated outside of the U.S. are worth less once denominated in USD.

The dollar strengthened quite a lot against currencies such as the euro, yen, etc. Since Meta is widely exposed to non-U.S. markets -- the company has billions of users while the US only has 330 million people -- there was a meaningful negative impact on Meta's reported results stemming from forex movements. That doesn't change the headline numbers, but investors will likely be happy to hear that underlying revenue growth in constant currency rates was likely significantly higher. This information wasn't broken out in the earnings release, but the company stated that they are seeing a 6% headwind to revenues in the current quarter (Q3). If the impact was similar in the second quarter, which seems like a reasonable assumption to me, then organic revenue growth was in the 5% range. That's still not an especially great growth rate for a tech company, but it is not too bad, either, considering Meta's inexpensive valuation.

Meta's underlying business growth wasn't great, but not terrible, either. During the quarter, daily active users totaled 1.97 billion, which was up 3% year over year. One year ago, the pandemic was still a big issue -- many people remained at home, and going out and traveling wasn't overly common. This has changed, as people have been going out more this year. This means that they spend less time at home looking into their phones or tablets, which reduces the likelihood of them checking into their social media accounts very often. The macro-environment thus worked against Meta when it comes to the company's daily active user ("DAU") count. And yet, DAUs were up year over year, which is a positive sign, I believe. The DAU growth rate wasn't great, but it was positive, despite a tough comparison. It does not look like other social networks are eating Meta's lunch -- instead, Meta remains king in the social media space.

Meta's profits declined year-over-year, which can mainly be attributed to a steep increase in costs. A large portion of Meta's staff works from the U.S., thus costs are mostly in USD. When the USD strengthens, there's a major headwind for revenues, but costs do not decline much. At the same time, Meta has been investing heavily to build out its Metaverse business, which isn't profitable yet. Management, including Meta's CEO and visionary founder Mark Zuckerberg, see the Metaverse business as a huge long-term growth driver, but it will take several years until this new business has the required scale to become profitable and start contributing to Meta's bottom line. For now, the Metaverse business is burning money, and that hurts Meta's profitability today and in the near term.

In the above table, we see what happens when operating leverage is working against a company. Meta's revenue was down marginally, but expenses were up. This resulted in a steep hit for Meta's profits, as operating income and net income were down by 32% and 36%, respectively. An earnings decline was forecasted, thus this was not a dramatic surprise, but analysts had predicted a net income decline of around 32% instead of the 36% decline we have seen. When a growth company is experiencing a major profit pullback, that's bad news. Ideally, one would like to see profits grow more than revenue, not see profits decline a lot more than revenue.

That being said, Meta remains extremely profitable. The company generated a net margin of 23%, despite an increase in its tax rate, which is still pretty strong. That is almost on par with Apple's ( AAPL ) net profit margin of 26% over the last year. Since a large portion of the additional expenses, which were the driving factor for the profit decline can be seen as an investment in future revenue streams, the near-term profit decline should also not be overblown. Meta has, for example, increased its R&D spending by 43% year over year, or by $2.6 billion in absolute terms. If they had not done so, Meta's earnings per share would have declined by just 10% instead of 32%, which would have been way less drastic.

In the past, Meta's R&D efforts have paid off, as the company has managed to grow its business at a compelling pace over the years, e.g., by adding new products such as reels on Instagram. With the same leadership in place that has brought this success in the past, and with that leadership believing that the current investments will pay off in the future, I'm cautiously optimistic that the current profit decline will indeed only be temporary and that the company will benefit from stronger business growth in the future. Investors who are more skeptical about the vision of Mark Zuckerberg and the rest of the leadership team may see this differently, though. There is, after all, no guarantee that these investments are the correct choice and that this strategy will pay off.

Meta also has made some changes to its hiring in the recent past. Slowing down R&D is not a great idea if one is excited about new products or markets, but expenses in areas such as administration can be brought down, which will have a positive impact on profitability without hurting the company's longer-term business growth outlook too much. Meta seems to be willing to do exactly that -- the company has lowered its full-year expense outlook from $87-$92 billion to $85-$88 billion, which pencils out to a $3 billion reduction versus previous estimates. In other words, Meta plans to be more efficient than previously thought, which is a good thing for shareholders. Still, 2022 will be a down year versus 2021, as expenses will be up versus the previous year even factoring in the reduced expense guidance.

An Inexpensive Valuation And Nice Cash Returns

If Meta were to earn ~$2.50 for every quarter, it would be trading at around 17x net profits. That's not a low valuation for a company without top-line growth. But one can also argue that it isn't an overly high valuation for a company with an excellent track record that is currently investing heavily to build out its next multi-billion dollar business. After all, Mark Zuckerberg believes that the Metaverse business will become as big as the core social media business over time, as reported here on Seeking Alpha. Investors that have trust in Mark Zuckerberg's vision might thus be looking at a company that doubles in size in the coming 5-10 years, even without growth from the core business (which seems like a conservative assumption to me). In that case, a 17x earnings multiple during a time when profits are artificially depressed does not seem especially expensive.

We can also look at Meta's valuation in a different way. Today, based on current EBITDA estimates for this year, Meta is valued at less than 7x forward EBITDA:

That is less than 40% of the historic valuation norm. If Meta ever gets back on growth track and the market decides that the historic valuation norm wasn't too wrong, then Meta could climb by around 160% from the current level -- that's the upside to its 3-year and 5-year median enterprise value to EBITDA multiple. If it happens (which isn't guaranteed), it won't happen quickly. The market will likely want to see how the Metaverse business is developing, what expense trends will look like, and so on. But even if that were to happen over 5 years, it would make for an attractive annual return. In fact, even a 160% increase over 10 years would be far from bad, as this would pencil out to annual returns of ~10%.

Investors with a longer-term time horizon could thus benefit quite a lot from the way-below-average valuation Meta is trading at today. Meta seems to agree, as it keeps buying back shares at a meaningful pace -- a little more than $5 billion in Q2, or more than $20 billion annualized. That makes for a buyback pace of roughly 5%, which is way better than Apple's famed buyback pace (~3%-4% historically, less in the last two years).

Takeaway

Not everything is working in Meta's favor right now. Large forex exposure is a headwind right now, and due to a steep expense increase, the company missed earnings estimates. That being said, I do not believe that the company is on its deathbed. The company remains extremely profitable, has a fortress balance sheet with cash of $40 billion, and if management is right about the potential in the Metaverse, then the current valuation could be quite low.

Investing in Meta is, to some degree, a bet on the company's ongoing success in growing its business. One could argue that this means that investing in Meta means that one is betting on Mark Zuckerberg and his vision. In the past, that worked well, so I personally am happy to do so -- but there's no guarantee that the Metaverse investments will pay off.

Due to high expenses/investments, Meta's profitability is depressed right now. But even based on these depressed profits, shares are not expensive and do trade at a hefty discount compared to the historic valuation. I am willing to own Meta in these times while waiting for the investments to pay off. The fact that the company is buying back shares rapidly at the same time is encouraging, I believe. I welcome all readers to share their opinion about Meta's results and outlook in the comment section!

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