‘Meta is becoming a structurally lower margin business,’ analyst says

Arete Research Partner & Senior Analyst Rocco Strauss joins Yahoo Finance Live to discuss his decision to remain bearish on Meta despite Wall Street’s bullish tone, the technology company’s cost-cutting plans, and the overall outlook for Meta.

Video Transcript

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BRAD SMITH: Shares of Meta are up over 80% year to date, as big tech bounces back. But our next guest says that he's taking the opposite stance to Wall Street on the tech giant. Arete Research Partner and Senior Analyst Rocco Strauss joins us now.

Rocco, great to have you here with us. Help us break down your thesis and why, perhaps, some of the bullish sentiment around a more cost-conscious Meta might be overblown?

ROCCO STRAUSS: Yeah, I think you have to split this into the cost side and, obviously, the top line expectations here. I think the cost side is somewhat understood by the market, given that Meta has already lowered its opex by roughly 3 billion or so at midpoint. So I see limited downside surprise potential to this and would flag a handful of reasons why EPS expectations actually have gotten a bit ahead of themselves.

So first, Meta is becoming a structurally lower margin business with real decrease in its share on time spend, especially about the creative cost that you have against that. Second, Meta seems to offer more discounts. And that's according to our checks with advertisers, especially to attract more experimental budgets onto Reels. Though on the cost side, that's not favorable.

Third, the hardware share, mainly driven by Oculus, is rising. And that's a lower margin business. And we have, on top of that, seen some large discounts already for these VR kits.

Fourth, you see Microsoft and now even Amazon, Twitter, and a few others accelerating their AI investments and partnerships. Meta certainly has to double down on this during or within 2023 as well.

And then lastly, the ongoing ID issues referring to Android's SDK runtime, which is somewhat similar to what Apple did with ATT last year, the prevention of fingerprinting workarounds, and others could further deter proper attribution in 2023. And that certainly would weigh on pricing and requires more investments into measurement. That's the cost side.

RACHELLE AKUFFO: And so, Rocco, I want to break some of that down because you mentioned, obviously, better engagement there. There was a lot of hubbub about, with the TikTok ban, who would be the biggest beneficiaries. But it seems like investors got a little bit ahead of themselves. What's the scenario you see there regarding what happens with TikTok and how that might impact what happens with Meta's growth?

ROCCO STRAUSS: Yeah, I mean, it's really the question. Are we seeing an outright ban of TikTok? And that certainly could, on a runway basis, depending on when that ban actually happens, add some $4 to $5 billion or so to top line in this year. But it could also be that we are going to see some kind of divestiture, or someone is actually acquiring the Western world TikTok assets. And that certainly would have little to maybe even a negative impact, given that more budgets could actually move to TikTok in a more brand-safe environment than under the current owner.

BRAD SMITH: Has the bottom in terms of some of the digital marketing revenue sentiment-- has that bottomed out?

ROCCO STRAUSS: I think it's two key things that we should look on here. I mean, ad checks somehow point to some stabilization and first quarter of '23 versus fourth quarter of last year. Though let's think for a quick second about how inflation is actually driving this. I mean, core inflation only peaked in March of '22. Though there is some support still in January and February of this year, while that will fade from second quarter onwards. That's the first thing I would flag.

And then secondly, the Street is projecting a huge reacceleration of top line growth in second half of 2023, mainly citing lower comps. I would raise a key question here. And that is, what is putting the consumer in better shape in second half of '23 versus the second half of '22, given we see intensifying macro challenges with the looming credit crunch, sticky inflation, record level of credit card debt?

You have rising mortgage rates. You have increasing unemployment likely in the second half of this year. And that should put a lot more pressure on ad budgets in the second half of '23, where the Street sees some 10% growth for Meta, while we actually project a decline.

RACHELLE AKUFFO: So then, I mean, a lot of this is-- we saw a lot of optimism when Meta first announced this year of efficiency. We saw multiple rounds of job cuts, more expected on the way as well, and really also pivoting away from some of the less profitable aspects of the business. But do you think investors then aren't focusing on the right things when they're focusing on this year of efficiency?

ROCCO STRAUSS: I guess the question is, are you looking at 2023, or are you looking already beyond what could may happen in 2024? I think '23 is a lot more challenging than what consensus estimates currently project. And certainly, we shouldn't turn a blind eye, as you point out, on the disruption that could be caused by these layoffs.

I mean, while Meta certainly wouldn't cut headcount by, now, 21,000 people in total, as sales were actually soaring or if the company would assume a huge reacceleration in second half of '23. And then maybe if we look a bit left and right here as well, right, I mean, Snap had a lot of issues around its App Store business, driven by Apple's privacy changes. Pinterest suffered from a lack of innovation, also the dependence on brand spend, while Meta is still, even today, a supply-constrained platform, though the key or bench of advertisers has been thinned out over the last some quarters, which you see reflected in lower CPMs across the board.

And while the e-commerce budgets that are sitting within Facebook and are likely driving some 40%, 45% of the total mix are driven by SMEs and DTCs and just fading was falling discretionary budgets, we are just seeing that starting, given that most consumers have actually burned through their COVID savings. And that will certainly have an impact into the second half of this year as well.

BRAD SMITH: OK. And so going forward from here for Meta, the larger question is, for some of the advertisers that may have left a platform like Twitter, even though we're not going to necessarily get quarterly or real cadenced reports from a company in Twitter, the, of course, common knowledge at this point in time is that they have struggled at least to hold on to advertisers at the same scale. Does any of that flow on over to a company in Meta and some of their subsidiaries?

ROCCO STRAUSS: Yeah, I mean, if you put Twitter in relation, obviously, to Meta, it's significantly smaller. So even if you assume half of their ad budgets would flow onto the platform, it would almost not be meaningful for Meta.

And then also the question is, where do these budgets actually flow? I mean, Twitter largely was more B2B advertising. And that probably is better-suited certainly on platforms like LinkedIn and maybe a few other platforms.

RACHELLE AKUFFO: So then if you had to give your estimation of where Meta is going to fare versus some of its counterparts here, facing the same macroeconomic conditions-- but as you mentioned there, more-- some issues, at least for Meta, on the retail side, how should a better position itself?

ROCCO STRAUSS: It's tough, right? And I mean, certainly, these larger ad-funded internet names have never gone through a recession so far. You can look back to '08, '09, '10 and what you have seen in terms of like the-- like how growth rates have behaved on Google at that time. And that shows you that you had a huge deceleration in growth in '09.

And these companies here are not immune of these cyclical downturns that we're actually running through. So there isn't really a lot that Meta can do. I think they're already early on with all the headcount reductions that you have, as they are kind of seeing what's coming towards them in the second half of this year.

So it is the right thing to focus on the cost side while still investing in the right products to actually move out of this in a stronger position.

BRAD SMITH: Hey, Rocco, just very briefly while we have you, has Meta gotten past some of the iOS privacy changes and the headwind, or at least kind of the knock on how much they were able to index data, how much data they were able-- they were even able to kind of advertise based on?

ROCCO STRAUSS: Yeah, I mean, Apple has already opened somewhat especially around attribution, which was the main issue for Meta and also some of the others here. But as I've already flagged a bit earlier, we should also not underestimate what's happening on Android that is moving somewhat slower but is going in the same direction as Apple is.

And also, Apple and Android both are trying to prevent these fingerprinting workarounds of these privacy changes that we had seen. And that certainly could cause trouble to everyone in this market. Though, with a large first party data set, as Meta has, they're slightly better positioned than many of their peers, especially like TikTok or Snap. And they could benefit from that after you had some period of turmoil, if you want.

RACHELLE AKUFFO: Certainly interesting there, flagging some of those highlights there. A big thank-you there to Rocco Strauss, Arete Research Partner, Senior Analyst. Thank you so much.

ROCCO STRAUSS: Thank you.