This investment thesis also appears on the SumZero platform.
Few companies have so successfully combined growth with profitability as Meta Platforms (META: 596.25/share). A company born out of the miracle of the Internet Revolution, it is charting a path toward leadership in the AI Revolution. However, those investments have come under scrutiny as investors start to worry if Big Tech can earn a meaningful return on them. While the stock price has not quite taken a beating this year, it has not delivered the heady returns that investors have grown accustomed. This has presented investors with an opportunity to buy a firm that earns an “Attractive” rating according to my stock rating methodology. An accompanying spreadsheet with my accounting adjustments and valuation model is available.
The Advertising Cycle Is Turning
Adapting from economic structuralism, one should see Meta as a social media monopoly at the meso level and an advertising company at the macro level, where it exists in an oligopoly in which its chief competitor is Alphabet. The first port-of-call when analysing Meta should, therefore, be its advertising cycle. In my article, “Meta Platforms: Its Economics and Valuation”, I explained that,
The price of Meta’s ads is subject to the same laws of supply and demand that I recently showed govern S&P 500 returns. Ad impressions take the place of supply, and the price-per-ad that advertisers are willing to pay for user attention, is demand. Ceteris paribus, as ad impressions rise, price-per-ads decline, and vice versa. The chart below, inspired by Thompson, shows just this relationship, with year-over-year changes in ad impressions usually inversely correlated with average price per ad.
An updated version of that chart is here below:
I went on to say that,
The best time for advertisers to invest in advertising on Meta is when the supply of ad impressions is rising as, all things being equal, this pushes average price per ad down, which has the effect of improving advertising returns and making Meta more attractive to advertisers viz. its competitors, as was the case in 2022. With average price per ad growing in the last three quarters, Meta is vulnerable to more cost effective competition, because prospective advertising returns are lower. Nevertheless, the advertising business remains very strong.
Since Q2’ 2024, when I wrote that article, the supply of ad impressions has increased, softening the rate of increase in the average price per ad rising since 4Q 2023. Prospective advertising returns are not at 2022 levels, but the weakening of Meta’s competitive position in its core business has been slowed, and this hurts competitors.
Costs Discipline is Working
Since 2023, Meta’s annual report has featured a section titled, “Investment Philosophy”, which is really a declaration about their desire to embrace “cost discipline” and to continue to build things. Meta’s push to compete in artificial intelligence has led to an increase in the firm’s costs and expenses, but cost discipline does seem to be working. While costs and expenses have indeed grown, as a share of revenue, they have declined from an all-time-high of 71.2% in 2022 to 57.6% in 2024, below the historic average of 59.4%. As a result, Meta’s net operating profit after tax (NOPAT) margins, which had fallen to an historic low of 29.4% in 2022, are now at 43.2%, above the average NOPAT margin of 40.2%.
Meta’s Industrialisation
Where once software ate the world, today, AI is eating the world, with Big Tech promising to spend some $300 billion in 2025 on AI infrastructure. In an article on digital firms, “Uncertainty, Information and Digital Firms: a Framework for Understanding Meta Platforms and its Peers”, I noted that,
The impact of the internet on the economy has been to decouple matter from information and expand the production possibility frontier. New markets, industries and economic sectors have emerged and continue to emerge, as capital and entrepreneurial planning have launched toward technological infrastructure. Firms have and continue to develop new ways of capturing value, and new forms of economic transactions have emerged and continue to emerge. The possibilities flung open by the internet have also created new forms of firms, firm-types which enjoy increasing returns -the tendency of what is advantaged to gain further advantage and what is disadvantaged to to be further disadvantaged-, and which are compelled to enhance consumer welfare. The Internet Revolution is the most consequential economic transformation of the world since Johannes Guttenberg developed modern movable type printing in 1440.
Key to this was that, thanks to the decoupling of matter from information, digital firms could produce with zero marginal costs, creating a tendency toward oligopolistic and monopolistic market structures. That easy consensus is changing. AI requires investments in infrastructure that are changing the nature of digital firms in a process of industrialization, or, better yet, materialisation. The company’s 2024 capital intensity, as measured by capex/revenue, at 23.9%, is higher than the historic average of 19.2%, and has been rising for the last two years. Since 2022, it has never fallen below 20%. There are only three other years in which capex/revenue has been over 20%: 2012, 2018 and 2019. However, although Meta’s maintenance capex, which I computed using Venkat Pedireddy’s methodology, has shot up from $2 billion in 2015 to $11.5 billion in 2024, as a share of revenue, the cumulative capacity cost ratio of Meta’s infrastructure has declined from 0.11 to 0.07. Quite simply, the economic cost of Meta’s physical investments has declined as this giant firm has continued to grow at astonishing rates. This is important because some analysts have worried that these infrastructure investments could hurt profitability. So far, Meta has continued to be exceptional. The reason seems to be that its existence as a digital firm prior to the AI Revolution, allows it to grow and be profitable at such astonishing rates that it can take on such investments without hurting itself.
Profitability is a Feature
Since 2011, Meta has compounded revenue by 33.9% a year and NOPAT by 37.4% a year. The company’s 5-year compound annual growth rate (CAGR) for revenue is 18.4%. By way of comparison, according to Credit Suisse’s The Base Rate Book, the mean 5-year sales CAGR between 1950 and 2015 was 6.9%, and for firms with annual sales of over $50 billion, it was just 1%. Meta’s 5-year NOPAT CAGR is an astonishing 23.9%. Few companies can match Meta’s growth and profitability at this scale, indeed, its numbers make many small firms look decrepit. Between 2011 and 2024, its average return on invested capital (ROIC) is 31.7%, with the current ROIC being 38.7%. As with NOPAT, Meta has improved its ROIC in each of the last three years. Only four other years have ROIC-levels higher than 2024, and its NOPAT is the highest in its history.
It Matters that Meta is Founder-Led
Mark Zuckerberg remains at the helm of Meta and this is key to its extraordinary success. Not only does it tie management to shareholder interests, it also ensures that, unlike Apple, and Google, for example, Meta is led by someone with the credibility to make big changes to the company. Although the metaverse was value-destroying, Zuckerberg’s credibility allowed him to try something that Tim Cook or Sundar Pichai cannot. Zuckerberg would likely argue that AI will ultimately make the metaverse possible, and indeed, revenues for the Reality Labs division have doubled in the last three years, and if that does in fact happen, it will be because Meta has a builder at the helm with a desire to stake his place in history.
Meta is Reasonably Priced
With a stock price of $596 Meta has a price-to-economic-book-value (PEBV) of 1.98, implying that its NOPAT has a growth limit of 98% from its 2024 level, despite its stellar and exceptional returns. I used my reverse discounted cash flow (DCF) model to tease out the expectations implied by the firm’s current share price.
In the first scenario, I quantified the expectations implied by the current price:
- NOPAT margin remains at the present level of 39.3%.
- Revenue grows at 16.9% in 2025, 13.7% in 2026, 12.5% in 2027 and by 14.4% thereafter, in line with consensus estimates.
In this scenario, Meta compounds NOPAT by an average of 7% a year till 2036, where shareholder value equals the current price.
If, on the other hand,
- NOPAT margins falls to its 3-year average of 33.3%
- While revenue grows at its 5-year CAGR of 18.4%
Meta can compound NOPAT by 8.8% a year, down from its 5-year CAGR of 23.9%, and the stock is worth $800 per share today, a 34% upside to the present price.
While Meta is more richly priced than one would like, Warren Buffett’s observation that, “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price”, seems apt at this point.
Impact of Footnotes Adjustments and Forensic Accounting
Here below are details of adjustments made to Meta’s 2024 10-K:
Income Statement: I made $7.6 billion in adjustments to calculate NOPAT, with the net effect of adding $5 billion in non-operating expenses. The adjustments are equal to 12% of Meta’s GAAP net income.
Balance Sheet: I made $167.7 billion in adjustments to calculate invested capital with a net decrease of $75.9 billion. One of the largest of these adjustments was $37 billion in operating, variable and not-yet commenced leases, an adjustment which, on its own, is worth 13.5% of reported assets.
Valuation: I made $161.4 billion in adjustments with a net effect of decreasing shareholder value by $225.5 million. The largest of these adjustments was $80.5 billion in adjusted total debt, representing nearly 5.2% of Meta’s market cap.