Nightmare of a sharp drop again? The scare is greater than the horror.

Hello everyone, I am Dolphin.

Meta released its first quarter financial report for 2024 this morning (April 25th, Beijing time). The biggest issue in the first quarter report is the lower revenue guidance for Q2 and the higher expenditure guidance, which compresses profits at both ends, weakening the market's expectation for the company's continuous improvement in profitability.

The post-market stock price fluctuation is more based on the previous quarter's high advertising prosperity, coupled with the current market's full recognition of Meta's advantages, so the overall valuation is not considered low. The "expectation gap" caused by the first quarter report makes it difficult to avoid a dual adjustment of Meta's EPS and valuation by the market.

Key points of the financial report:

1. Another guidance thunder: Weak revenue + increased expenditure, whose responsibility is heavier?

Meta's first quarter performance was good, confirming the high advertising prosperity in Q1, but the guidance hid some thunder. On one hand, the company's revenue guidance for the second quarter did not exceed market expectations as much as in the previous quarter, with a median of 37.8 billion compared to the market's expected 38.3 billion. On the other hand, Meta also raised the guidance range for annual operating expenses and capital expenditures, stating that the increased spending will mainly be used in AI, and revealed that Capex will continue to grow in 2025.

This seems a bit unfair. Firstly, Meta's capital expenditures are among the highest among the major giants, but do not match the actual scale of realized income. Secondly, the company just raised the expenditure guidance in the previous quarter, and during the conference call, Mark Zuckerberg also emphasized that the computing power is sufficient. Raising the budget again just three months later seems to indicate relatively casual or extravagant budget management.

So, which point does the market care more about, weak revenue or increased expenditure?

Dolphin believes that although the continuously increasing expenditure is unpleasant, the market should be more concerned about the weak revenue guidance for the second quarter. The current period is a critical period for the AI technology revolution and a time when the giants are setting the stage, which naturally implies a new round of investment cycle. Moreover, the tolerance and credibility of the market for investing in AI on the Meta platform and the optimization of advertising business have already been confirmed in the first two quarters, and the latest release of Llama-3 has received good user feedback. Therefore, compared to the metaverse two years ago, the market's tolerance and credibility for investing in AI are obviously higher.

However, it is difficult to ignore the weak revenue guidance. It is worth paying attention to the management's explanation during the conference call, whether it is related to the several hours of downtime of some platforms under Meta at the end of March, the significantly expensive advertising prices, and the reduction of marketing budgets for cross-border e-commerce and game developers in China. The market's growth expectations for Meta in 2024 are not low, exceeding 17%, and if the growth in the second quarter is only 14%-22%, the pressure for growth in the second half of the year will be even greater due to the high base.

2. User disclosure adjustment: Overall growth is stable

Another change in this financial report is that only the overall daily active users (DAU) of the platform ecosystem, totaling 3.24 billion, was disclosed, with a year-on-year growth of 7%, exceeding market expectations. The daily and monthly active users of the platform in different regions and the Facebook main site itself were not disclosed this quarter.

However, Meta supplemented the disclosure of the change in advertising volume and price trends by region. From this, we can roughly judge the daily active user situation in different regions - strong growth in the Asia-Pacific region, followed by North America, and Europe is the weakest. However, it is difficult to separate the user numbers of the Facebook main site itself.

3. VR: Decline in the popularity of new products

Without the consumption atmosphere of the shopping peak season and the novelty of new products, the popularity of Quest 3 has significantly declined. The VR segment's revenue in the first quarter was 440 million, lower than the market's expected 496 million. At the same time, the operating loss rate has expanded again, but it did not cause substantial negative impact as the market's expectations were sufficient.

Recently, Meta has opened the VR operating system Horizon OS, but it may not be so quick to see the effect on terminal volume. It might be better to observe for a while.

4. Advertising volume and price drive: Steady increase in unit price brings more marginal impact

From the perspective of the relationship between advertising volume and price, the driving force behind the strong advertising in the first quarter is mainly the increase in display volume, with a year-on-year growth of 20%. However, in terms of marginal changes, the continuous increase in advertising unit price has a greater impact on accelerating the growth rate of advertising revenue.

The growth rate of advertising unit price in the first quarter increased from 2% in the previous quarter to 6%, which is related to the strong macro environment and Meta's own competitiveness. In addition, it also implies an increase in the advertising ROI of Reels, a corresponding increase in advertising prices, and a reduction in the overall drag on the group.

5. Profit: Highest gross profit margin, accelerated expansion of employees

Under the dividend period of AI video recommendation to improve user stickiness and drive platform ROI, Meta's gross profit margin further increased to 81.8% on a quarter-on-quarter basis, which is also a record high level for Q1 in previous years.

However, in terms of operating expenses, Q1 returned to growth, resulting in an operating profit margin of 37.9%, slightly lower than market expectations. Although the 5% growth rate of operating expenses is not considered high, the net addition of 2012 employees in Q1 accelerated compared to the previous quarter, so it is expected that expenses will continue to grow in the next half of the year. The efficiency improvement cycle brought about by the previous round of layoffs is coming to an end, with only a small room for optimization in sales expenses.

Dolphin's View

The biggest problem with the first quarter report is that while the Q2 revenue guidance is slightly lower than expected, the company has also raised the guidance range for total spending and capital expenditures for the full year of 2024, creating a situation similar to two years ago where profit expectations were squeezed from both ends, inevitably leading to significant stock price fluctuations.

Although it is inevitable in the short term to adjust the full-year EPS and valuation (post-market capitalization corresponds to PE 20x/18x for 2024/2025, assuming a 10% downward adjustment in profit expectations for 2024 after the financial report, corresponding to a PE of 22x for 2024), objectively speaking, Dolphin believes that there may be an overreaction in the short term, and it is definitely not suitable to extrapolate the trend from two years ago.

In fact, the current situation and the beginning of the second half of 2022 are quite different. On the one hand, the increased Opex and Capex promised by the management are mainly used for AI, and the logic of AI-driven business growth has already been demonstrated. It is also possible that in 2025, it will further drive revenue growth rather than the expected decline. On the other hand, the competition deterioration problem that hurt logic last time, at least for Meta at present, does not exist, and instead, the recent TikTok ban/divestment issue has been repeatedly discussed.

Therefore, we believe that the "pressure" beyond expectations on profits in the short term is not the core issue. After squeezing out the valuation premium, changes in the macroeconomic environment and competitive landscape are the key factors affecting the mid-term valuation.

As a giant in advertising, the "expectation gap" issue for Meta's financial report also serves as a warning for Google, which is set to release its financial report tomorrow—while adjusting advertising revenue expectations, capital expenditures are also expanding. However, Google also has a cloud business. Since the completion of the Next conference in early April, the market's growth expectations for the cloud business have increased compared to the beginning of the year due to the company's positive outlook on AI empowering Google Cloud, which may help offset some of the potential gap caused by the "expectation gap" in advertising revenue.

Detailed interpretation is as follows:

I. Another Guidance Thunder: Weak Revenue + Increased Spending

In the first quarter, Meta's revenue was 36.5 billion, a year-on-year increase of 27%, although the base has become higher, the quarter-on-quarter growth is still accelerating. The main area that exceeded expectations is the advertising business, which accounts for 98%, while VR revenue fell short of expectations due to the declining popularity of the Quest 3 new product.

However, there are two hidden thunderbolts in the guidance:

(1) Weak Revenue

Meta's management expects a total revenue range of 365-390 billion for Q2 2024, corresponding to a year-on-year growth of 14%-22%, with the median slightly lower than market expectations. Although Meta's guidance style tends to be conservative and low-key, the upper end of the guidance range only barely matches the current market expectations, which is a stark contrast to the performance of the previous quarter.

At the end of March and early April, both Instagram and WhatsApp, under Meta, experienced nearly 2 hours of downtime, which may have also affected advertising conversion in the second quarter. At the same time, compared to higher and still growing ad prices among peers, some advertisers may consider weighing actual ROI. The combination of these two factors may also have a significant impact on short-term Q2 revenue growth.

1. The quantity and price of advertisements are rising simultaneously.

Factors driving the changes in the quantity and price of advertisements, as well as their subsequent sustainability:

The advertising display volume continues to grow rapidly by 20%, in addition to the expansion of user scale (the total daily active DAP of the ecosystem increased by 7% year-on-year), the average display volume per user has also increased.

Due to the lack of disclosure of the monthly active users of the Facebook main site and ecosystem in this quarter, we can only rely on third-party data platforms to see that, whether it is Facebook or Instagram, user growth in the North American region is limited, mainly coming from international regions. Instagram still leads the growth, with a 4% year-on-year increase in international daily active users driving an 8% increase in total usage time, while Facebook's user base is declining year-on-year.

As a direct competitor, tracking TikTok's performance can observe changes in the competitive landscape. In the first quarter, TikTok and Meta encountered the same problem - a year-on-year decline in North American users, relying solely on international users for growth. And due to the repeated issues of shutdown and divestment, TikTok's user loss in the North American region is even more severe.

(2) Advertising unit price accelerated by 6%

As we mentioned before, the advertising unit price is related to whether the economy is in an upward cycle and whether the platform's competitive advantage has improved, but this is under the condition of steady traffic on the Meta platform.

In the past year, although Reels has contributed new advertising inventory, due to ROI issues, the pricing within the ecosystem has been relatively low. However, with the increase in the proportion of AI video content recommendations (reaching 50% in 1Q24), the accuracy and conversion rate of advertising have also improved to a certain extent. Coupled with macro strength, the overall pricing in the industry has also remained high (there was a decline at the beginning of the year, but it gradually recovered in February and March), so the advertising unit price growth rate in the first quarter of Meta reached 6% (vs 2% in 4Q23).

2. Decline in the Popularity of New VR Products

In the first quarter, VR revenue returned to a calm state, with a year-on-year growth of 30% on a low base, mainly due to the quick decline in the popularity of the Quest 3 new product.

Based on IDC data and reverse calculation of income, Dolphin estimates that the overall sales of Oculus in the fourth quarter will be over 1 million units, a significant decrease compared to the previous quarter. (All values are estimated by Dolphin and are for reference only)

Last quarter, driven by the strong sales of Quest 3, Meta's market share also rebounded to 62.2%. IDC estimates that the shipment volume of VR/AR headsets will reach 9.7 million units this year, a year-on-year increase of 17%. It is also expected to see a rebound driven by Apple's Visionpro, but the total shipment volume is still lower than that of 2021.

Dolphin believes that the purchase threshold for Apple's Visionpro is not low, so there is no need to be too optimistic for the time being. Meta recently opened up Horizon OS, and it is worth paying attention to the actual feedback. Considering the development cycle of high-quality applications and the hardware penetration rate, Dolphin still recommends observing in the short term.

Expenditure is on the rise, and the net expansion of employees is accelerating.

Meta has been reducing costs and increasing efficiency for a year, until the end of 2023, marking the end of a phase. In 2023, Meta has reduced nearly 20,000 employees throughout the year, but in the fourth quarter, there was a net increase of 1,132 employees. In the first quarter, the number of employees reached 69,329, with a net increase of 2,012 compared to the previous quarter, indicating an acceleration in expansion and signaling the end of the dividend from the efficiency improvement of this round of layoffs.

Although the increase in employee costs is not yet evident from the first-quarter expenses, if this expansion trend continues, it is expected that expenses will increase significantly in the second half of the year. The company has also correspondingly raised its total expenditure (cost + expenses) guidance for this year, from the original 94-99 billion to 96-99 billion.

Looking back at the gross profit margin, as expected by Dolphin Jun, Meta's gross profit margin has significantly increased by 3 percentage points year-on-year, reaching 82%, which has basically recovered compared to the previous difficulties. In the short term, with the repeated increase in AI investment, it is expected that further improvement will be somewhat challenging.

However, Dolphin Jun also believes that this is only a temporary recovery phase. In the medium to long term, after passing through the mismatch period of AI investment and output, considering that AI can continue to optimize advertising ROI, expand monetization efficiency, help reduce internal company costs, and reduce losses in the RL segment, there is still room for improvement in the gross profit margin.

In the end of the first quarter, Meta's operating profit margin was 38%. Although the gross profit margin continued to improve, operating expenses began to increase, leading to a weakening of the profit margin on a quarter-on-quarter basis. Looking at the two major business segments of advertising and the metaverse, the metaverse is still in a high level of loss, and management expects that the operating loss of Reality Labs will continue to increase. However, the VR business accounts for a small proportion, and management has repeatedly emphasized that the market's expectations for losses are relatively well-informed.