Meta's Q4 guidance that knocked the stock lower is not a reason to sell

Published Wed, Oct 25 20238:21 PM EDT

Meta Platforms (META) reported strong third-quarter results thanks to a rebound in advertising sales and continued cost discipline in CEO Mark Zuckerberg's "year of efficiency. However, warnings of a volatile start to ad spending in the fourth quarter that coincided with the war in the Middle East caused shares to give up their initial after-hours gains and trade lower. Revenue for the three months ended Sept. 30 climbed 23% year-over-year to $34.15 billion, beating analysts' forecasts of $33.56 billion, according to LSEG, formerly known as Refinitiv. Earnings per share grew 168% year-over-year to $4.39, exceeding Wall Street's estimates of $3.63. META YTD mountain Meta Platforms YTD While dropping more than 3% in extended trading following its 4% regular session decline, Meta has still surged nearly 150% year to year. The stock is, by far, our second-best performer in 2023 behind only Nvidia (NVDA), which has skyrocketed more than 185%. Bottom line There wasn't anything wrong about Meta's quarter, as once again, the company's year of efficiency paid dividends to profitability. Additionally, it appears that Meta has finally overcome some of the significant revenue headwinds of the past two years--lower monetization rates due to Apple's privacy changes and the transition to Reels. The stock traded higher most of the evening, clawing back some of the losses from Wednesday's broader market selloff. But the turn happened late on the call when management was asked more about fourth-quarter revenue guidance. By the looks of it, Meta was likely being ultra-conservative with its outlook, acknowledging the fact that there's a lot of uncertainty out there. But in the worst case where sales do in fact trend toward the mid to lower end of its range, we would expect the company to pull back on spending to better align revenue growth with expense growth. Can they please stop bleeding money on Reality Labs? But here's the unfortunate truth of the matter. We're in a tough market at the moment, where the mega caps are in give-up mode. It doesn't matter what good is happening at the company – all the focus is on the negatives of what they say, causing investors to rush out the stocks and lock in profits in what has been the best group to own all year. However, we are cognizant that until the market checks off some of the five factors that need to happen for stocks to improve , Jim Cramer explained Wednesday evening on "Mad Money," the market could be in for some more pain. Despite these market headwinds, we remain positive on the improvements Meta has made in the past year. It may still be too early to buy the dip on Meta. But with the stock trading at a very reasonable price-to-earnings multiple of about 18 times forward 12-month estimates, we also think it would be wrong to sell the stock down here. Quarterly commentary Consistent with Meta's prior quarter, strong platform engagement, improved monetization rates, and year-of-efficiency gains are how this roughly $750-billion-market-cap social media giant was able to achieve revenue growth of 23% in the third quarter while nearly doubling its operating margins from the year-ago period. Starting with engagement, Meta estimates that in Q3 3.96 billion people used one of Meta's Family of Apps daily, up from more than 3.8 billion in the second quarter. The Family of Apps includes Facebook, Instagram, WhatsApp, and Messenger. On a more granular basis, the number of daily and monthly active users of Facebook both beat expectations. One reason why overall engagement continues to improve, including in the U.S. and Canada, which is arguably Meta's most important combined market due to its high average revenue per user (ARPU) monetization rates, is the success of video content and Reels — Meta's answer to Chinese-owned short-form video powerhouse TikTok. Meta estimates that the product enhancements it has made to Reels have driven a more than 40% increase in the time spent on Instagram since launch. Artificial intelligence is a driver, with management pointing to the success of AI-recommended content from unconnected accounts as an incremental source of engagement growth. "This year alone, we've seen a 7% increase in time spent on Facebook and a 6% increase on Instagram as a result of recommendation improvements," Zuckerberg said on the post-earnings call. The second key driver of the quarter was improved monetization. Again, Reels comes into play here, with the company saying that it has reached a level where monetization is neutral to overall revenue, marking a successful transition for the company. Next year, it will be a tailwind to revenue. The implementation of AI tools is also helping advertisers run more effective campaigns. "Our AI tools for advertisers are also driving results with Advantage Plus shopping campaigns reaching a $10 billion run rate and more than half of our advertisers using our Advantage Plus creative tools to optimize images and text in their ads creative," Zuckerberg said. Following the success of Reels, Zuckerberg has his eyes set on business messaging as the company's next big opportunity. Meta may be having a lot of success in its Family of Apps business, but that doesn't mean the company has lost focus in the metaverse — for better or for worse. The company remains committed to investing in Reality Labs, even if that comes with more meaningful operating losses next year. We would prefer a more measured approach to spending in this money-losing operation, especially since we are big fans of what fellow Club name Apple (AAPL) has going for it with next year's launch of the Vision Pro mixed reality headset. To be sure, Meta offers a line of quality Quest headsets at much cheaper prices than the Vision Pro's hefty starting price of $3,500. Even the high-end Quest Pro AR and VR headset is priced at $999, less than a third of the Vision Pro's starting price. However, the losses have become much more tolerable thanks to the resurgence of the company's overall profitability. It also helps that Meta is back to its old ways of generating a ton of cash. Meta generated more than $13 billion worth of free cash flow in the quarter, bringing its total through the first three quarters of the year to $31.505 billion. For perspective, the company generated $18.4 billion of free cash flow in all of 2022. Lastly, Meta picked up the pace on share buybacks in the quarter, repurchasing $3.7 billion worth of stock. That left the company with $37.22 billion remaining available. Meta repurchased $9.22 billion worth of stock in the first quarter and only $793 million in the second quarter. Outlook Turning to the fourth quarter, Meta said it expects revenue to grow about 13.5% to 24% year over year in the range of $36.5 billion to $40 billion, reflecting a midpoint of $38.25 billion which is a little light of the $38.8 billion consensus. This outlook assumes a 2% tailwind from foreign currency. This was a wider-than-usual range, with the CFO pointing to volatility in ad spending at the start of the quarter due to the war in the Middle East. On the expense side, Meta lowered its full-year 2023 outlook to the range of $87 billion to $89 billion from $88 billion to $91 billion. This new midpoint of $88 billion was below forecasts of $89.6 billion, which in this case is good since we're talking about money being spent by the company. Looking out to 2024, management provided a preliminary outlook on expenses. The company anticipates total expenses to be in the range of $94 billion to $99 billion, reflecting a midpoint of $96.5 billion. Although this midpoint is roughly in line with estimates of $96.38 billion, we think it's a sigh of relief to see this number below $100 billion. The company reiterated the same three factors for total expense growth it explained last quarter. They are (1) higher infrastructure-related costs, (2) growth in payroll expenses, and a (3) meaningful increase in Reality Labs operating losses. On capital expenditures, Meta anticipates spending will be in the range of $30 billion to $35, slightly below estimates of $33.83 billion, as it increases investment in servers (both in AI and traditional) and data centers. 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Visitors stand in front of the Meta logo during a launch event at the corporate offices of Meta in Berlin on June 6, 2023.

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