Liz Truss is officially the shortest-serving Prime Minister in the history of the United Kingdom. Bond markets panicked at her aggressive, unfunded tax-cutting plan at a time of rampant inflation. Interest rates spiked, the pound fell, and Truss’ own political party turned on her, causing her to resign just 45 days after taking office.
While it’s easy to call Truss’ short tenure a failure, I also see reasons for optimism in this series of events. It demonstrated the most important feature of democratic capitalism: the ability to self-correct. With UK inflation approaching double digits, cutting taxes without a corresponding reduction in spending would have been reckless. The bond market rendered its verdict immediately, and the political system followed close behind. A market democracy can’t prevent humans from making mistakes, but it provides the means to fix them.
Contrast that with China. Just as Truss was resigning, Xi Jinping secured a precedent-defying third term as general secretary of the Chinese Communist Party. By all accounts, Xi has surrounded himself with loyalists who are unlikely to question his policies. China’s authoritarian system can be more efficient than a market democracy in many ways: often to bad ends (censoring the Internet, forcibly detaining minority groups), but occasionally for good (rapidly building hospitals or nuclear power plants). The problem with one-person rule is that when mistakes are inevitably made, they are much harder to correct.
I’ve made plenty of bad investments over my 15-year career, but I can’t remember any as frustrating as Meta Platforms META, formerly known as Facebook. After falling more than 20% on the day of its third-quarter earnings release, Meta’s stock is now down 73% from its Sept. 2021 high (as of the close on Nov. 9). The stock is trading right around where it was in late-2015. That’s seven years with nothing to show for it.
Well, not quite nothing. Relative to the 2015 base, Meta’s 2022 revenue is expected to be up about 550%, representing a compound annual growth rate of more than 30%. Earnings per share are expected to be up more than eight-fold, good for 35% compound annual growth. The reason the stock has performed so poorly is that Meta’s valuation multiples have collapsed. The price/earnings ratio went from 78 to less than 10. The enterprise value/sales ratio went from 15 to 2.
Is meta being disrupted?
The first thing to determine is whether Meta’s core products are still relevant and popular. Management now refers to this segment as the “Family of Apps”: Facebook, Instagram, Messenger, and WhatsApp. There’s a common narrative that “no one uses Facebook anymore” and that “Meta is being disrupted by TikTok.” If you believe that, we don’t really need to do any more research—a cheap price/earnings ratio is meaningless if a company’s earnings aren’t sustainable.
I believe Meta’s core business is healthier than it might appear on the surface. The company reported having 2.9 billion daily active users and 3.7 billion monthly active users across all its apps in the third quarter. More than a third of the global population logs into one of Meta’s apps daily, and almost half logs in every month. Aside from Google, Meta controls some of the most popular products in history.
Better yet, Meta’s user base is still growing. The company added around 120 million daily active users in the past year. For context, that’s about a third of a Snapchat or half of a Twitter—added in just one year to a base that was already more than eight times larger than those companies. Even the much-maligned Facebook brand is growing, adding 54 million daily active users in the last year, including 1 million in the U.S. and Canada (Facebook’s most mature market, where the company has also gotten the most negative media attention). Meta can’t grow its user base forever—they’ll eventually run out of people—but there’s little data to support the anecdotal conclusion that “no one uses Facebook anymore.”
Admittedly, Meta’s revenue and (especially) its margins haven’t been as healthy as its user numbers in recent quarters. Part of the problem is difficult prior-year comparisons from the pandemic, when people were stuck at home with nothing better to do than scroll social media and shop online. For the four quarters beginning in Q4 2020, Meta’s year-over-year revenue growth averaged almost 43%, a major acceleration from the 25% revenue growth recorded in Q4 2019 (before the pandemic). Year-over-year revenue growth decelerated significantly as soon as the company started to lap those numbers, culminating in the 4% revenue decline in the most recent quarter (2% growth excluding foreign exchange headwinds). Most forms of online entertainment have exhibited a similar pattern, including streaming video, online games, and other social networks.
Privacy changes by Apple, which started rolling out toward the middle of last year, have exacerbated Meta’s recent growth problems. Apple’s iOS now requires apps to show a scary-sounding prompt if they want permission to track users across services. (Apple uses much friendlier language about “personalized ads” for its own services, which seems like a blatant abuse of power.) Not surprisingly, most users decline to provide this permission, making it much harder for companies like Meta to both target their ads and measure their effectiveness. Meta estimated the Apple changes would cost it around $10 billion in annual revenue, or a greater than 8% growth headwind.
Meta’s year-over-year comparisons should get much easier in 2023, but there’s a bigger existential threat: competition. Meta has been confronting fears that it was a fad (“Remember MySpace?”) ever since it was founded in 2004. The company has done an admirable job fighting off past competitors, either by acquiring them (Instagram) or aggressively copying them (Snapchat). However, none of these past threats compare to the scale of TikTok, which has taken the world by storm over the past several years.
Meta CEO Mark Zuckerberg showed incredible foresight when he agreed to buy Instagram for $1 billion in 2012. Most people thought Zuckerberg was making a mistake, or at least massively overpaying—at the time, Instagram only had 13 employees, 30 million users, and zero revenue. But Zuckerberg had a keen insight, memorialized in a series of emails (which subsequently became public as part of an antitrust investigation):
There are network effects around social products and a finite number of different social mechanics to invent. Once someone wins at a specific mechanic, it’s difficult for others to supplant them without doing something different…One way of looking at this is that what we’re really buying is time. Even if some new competitors spring up, buying [Instagram]..now will give us a year or more to integrate their dynamics before anyone can get close to their scale again. Within that time, if we incorporate the social mechanics they were using, those new products won’t get much traction since we’ll already have their mechanics deployed at scale.Source: The Verge
I think of Zuckerberg’s “social mechanics” as existing along three dimensions:
- The nature of the content: text, images, video, and interactive.
- The format: short-form vs. long-form and ephemeral vs. permanent.
- The sharing mechanism: one-to-one vs. one-to-many, and sharing with connections vs. strangers.
This framework can be used to describe the existing social networks, and perhaps even predict what comes next. It also shows that Zuckerberg was mostly right: Once a given niche is filled, it’s hard for a new entrant to displace the entrenched network. For example, Twitter is mostly about short-form, permanent text shared with strangers in a one-to-many format. YouTube has a similar sharing mechanism but for long-form videos. Snapchat’s “snaps” are ephemeral images shared one-to-one with connections, while its “stories” are ephemeral images shared one-to-many. TikTok’s brilliance was in finding an unoccupied (and remarkably engaging) niche: short-form video shared one-to-many with strangers.
Meta’s strength has always been in combining these categories while leveraging the largest user base in the industry. Facebook has text, images, and video, both long-form and short-form. Content can be shared one-to-one through messages, or one-to-many through posts. Users can adjust their privacy settings to share only with close friends, all connections, or with anyone. Instagram was historically focused on permanent images shared one-to-many through posts, but it has integrated ephemeral images with its own “stories” feature and has a rapidly growing short-form-video-shared-with-strangers product through Reels.
The downside to so much variety is that it results in a cluttered user interface. But the upside is that it gives users many more reasons to check Meta’s apps, and then to stay engaged with them. A user might log into Instagram to see baby pictures of their niece, but then get sucked into watching a story posted by a celebrity, scroll through a handful of Reels, and then end up forwarding a funny clip to an old college friend through a direct message. No other company has been able to replicate this diversity of content while combining interest-based followers with real-world connections.
Furthermore, Meta doesn’t just compete with other social networks. There are only 24 hours in the day: the real competition is for our time. People can scroll through TikTok instead of scrolling through Facebook, but they can also watch a movie on Netflix, or a game on ESPN, or walk their dog, or play Scrabble with their brother-in-law. From this broader perspective, you could argue that Snapchat’s existence was a net positive for Meta: Snapchat invented the “stories” format, which Facebook and Instagram copied, which encouraged their users to share more, which made the platforms even more engaging, which created more surface area to show ads. Snapchat is a competitor to Meta, but it also gave Meta a new weapon in its fight against the thousands of other competitors for our time. Will TikTok’s long-term impact be similar, by incentivizing the creation of Reels?
The metaverse and margins
In my breakdown of “social mechanics” above, the next great untapped opportunity seems clear: interactive. The niches for text, images, and video are pretty well filled out. Entrepreneurs can try new gimmicks to differentiate themselves in these categories—like BeReal’s attempt to get users to share ephemeral photos simultaneously—but building a new product with long-term staying power will be very difficult. By comparison, interactive and immersive online experiences—the so-called “metaverse”—are at an early stage of development.
If you ask 10 people what the metaverse is, you’re likely to get three different answers and seven blank stares. I think the most interesting example is Roblox: a virtual world and videogame platform with 59 million daily active users (and closer to 250 million monthly active users). Roblox is free to play and features millions of user-created “experiences,” a robust digital economy, and persistent user identity in the form of avatars. It is available across a range of devices—from PCs to smartphones to Xbox—and it generally prioritizes accessibility over performance. For example, the graphics are relatively simple, allowing for an enjoyable experience even with an old smartphone on a slow network. I’m intrigued by Roblox’s limitless potential, but I’ll save that discussion for another day.
Meta—which changed its name a year ago to emphasize this opportunity—has taken a more expansive view of the metaverse. The company is building a Roblox-like experience called Horizon Worlds, which is struggling to gain traction (monthly active users appear to be less than 0.1% of Roblox’s level). But its main focus has been virtual reality, accessed through Quest headsets.
There are many reasons to be skeptical about Meta’s efforts. I’ll group them into three categories: (1) Will there be broad demand for virtual reality experiences? (2) Can Meta make a high-quality experience from a technical perspective? And (3) Will they earn an attractive return on their investment?
On the first point, I’m probably more optimistic than most observers. The killer feature of virtual reality is its ability to create a sense of presence: to trick the user’s brain into thinking they’re in a different place. VR may not be able to replicate the senses of touch, taste, or smell anytime soon, but a high-quality device can already get impressively close with sight and sound.
There are infinite potential use cases for a virtual sense of presence. Imagine watching any sports event or concert from the front row—but from the comfort of your couch, without having to pay $25 for parking or $10 for a beer. The experience won’t be as good as actually being there, but it should be far more engrossing than watching on TV. How about visiting with relatives who live on the other side of the world? It’s not the same as flying to meet them, but wouldn’t it be better than FaceTime if you could feel like you were in their virtual living room? Virtual reality could also take the place of physical objects. When I’m working on my laptop while traveling, I always miss having my two oversized computer monitors. It would be nice to put on a pair of glasses and feel like my home office came with me.
On the other hand, VR’s degree of immersion has a downside: it completely takes you away from your actual surroundings. It’s the opposite of Facebook and Instagram, which can distract you for five minutes while waiting in line at the grocery store. Most people probably feel like they don’t have the time or space to spend hours in a virtual environment. That may be helped by the development of augmented reality, which incorporates elements of your real-world surroundings. Imagine that your living room is the front row of a concert venue, but if you walk into your kitchen, it looks the same as always.
The second question is whether Meta (or any company) can make a high-quality VR experience. Here too, I’m relatively optimistic. I’ve tried out Meta’s Quest 2 headset, and while it’s far from perfect, the path forward seems clear: Higher-resolution displays, smaller and longer-lasting batteries (or perhaps a separate battery pack that could be worn elsewhere), more sensors to capture the user’s facial expressions and body movements, and so on. There’s some social awkwardness to be overcome, but that’s true of a lot of new technology. Meta doesn’t have any intrinsic advantage in developing VR technology—especially not compared to other big tech companies like Apple or Google—so they’re trying to get an edge by being early and spending more money than anyone else.
However, money often isn’t enough, and sometimes it can even be counterproductive. I think this has been a problem for Alphabet’s “other bets” segment, which so far has failed to yield real commercial products. There can be a big difference in motivation between a 20-year-old college dropout who has bet everything on a startup, versus a 35-year-old career programmer making $300,000 a year and eating catered lunches. Ironically, Meta’s chances of success might be higher if the metaverse effort were an independent company forced to stand on its own two feet, instead of relying on endless cash flows from Family of Apps. That would force the company to focus on areas with real near-term potential in terms of consumer adoption and monetization.
That brings me to the last and most uncertain question: Will Meta earn an attractive return on its investment? Investors may be willing to tolerate an eccentric CEO’s passion project, but Meta shareholders are panicking because of just how much money the company is devoting to its metaverse initiative. Meta is on pace to lose more than $13 billion in its “Reality Labs” segment this year, and management has warned that losses will grow significantly in 2023! Reality Labs has been a nearly 30% drag on Meta’s total operating income this year. Without this headwind, Meta’s price/earnings ratio would be below 7. Investors cheered when Meta recently announced plans to lay off 13% of its workforce.
Zuckerberg’s approach to monetization seems to be “get people to use it, and we’ll figure out the business model later.” Some possibilities include selling VR hardware for a profit (which will be difficult if they want to achieve broad adoption) or selling virtual goods in proprietary experiences like Horizon Worlds (though I’m skeptical that Meta is going to get enough people to care). Probably the most viable business model is taking a percentage of revenue from third-party services that use Meta’s platform, similar to the fees Apple and Google charge for their app stores on iOS and Android. But this kind of revenue faces regulatory pressure, is contrary to Meta’s stated intent of building an open platform, and it’s hard to see it being large enough to justify Meta’s investment. Bottom line, “we’ll figure it out later” worked out well for monetization on Facebook and Instagram, but I have serious doubts about whether Meta can pull it off with Reality Labs.
Mark Zuckerberg: King of meta
I opened this post by talking about Liz Truss and Xi Jinping. For better or worse, Meta is not a democracy. Mark Zuckerberg has majority voting control, and if he does something minority shareholders don’t like, there’s nothing we can do about it. Frankly, if Zuckerberg didn’t have his voting control, he probably would have been fired by now. On the other hand, if Zuckerberg is right about the metaverse, 10 years from now we may be glad he was in a position to ignore all the naysayers. I just hope he has enough sense to throw in the towel if it becomes obvious that Reality Labs is a losing bet—don’t take the core business down with it!
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