META Bear case
A bull steelmans the bear case.
Disclaimer: This post is not financial advice, and is not a solicitation to purchase or sell any securities. For more info, please review the disclaimer.
After Q2 earnings, Meta dropped 8.5% the next day. While many bulls insisted that the market was overreacting and that results were actually good, I have to admit that the results were weaker than I expected, and many market participants summed up the negative sentiment surrounding Meta.
With Meta currently my biggest position, I want to take some time to articulate the Meta bear case to help clarify it for myself and to make sure that I understand the other side of the trade as well as possible.
I’ve separated the concerns into three categories: the specific quarter, the general AI / Capex trade, and then legal / other.
Quarter:
META revenues were just in line with consensus. We aren’t seeing accelerating growth, despite the accelerating spend in capital expenditures so far.
META expenses increased, 55% y/y . This led to reduced operating income y/y and was especially driven by a 67% increase in research and development costs. This expense is largely for unproven products and the company’s AI push rather than the core business.
Concerningly META COGS was also up more than revenue suggesting that incremental margins may be worse as META and the Meta ads system becomes more compute intensive.
AI / Capex:
Meta is shifting from the business model you’re familiar with: a social media platform with strong network effects, to an attempt to compete with leading AI labs and hyperscalers, committing hundreds of billions of dollars.
Meta’s existing business seems to be in the pile of software that is easy to recreate with the help of new AI tools. While the social network has some core network effects, LLMs may revolutionize how we interact with technology and where we go to for entertainment. If AI creates personalized entertainment will people spend as much time on Facebook and Instagram?
Part of the significant CapEx with uncertain future returns funds META entering other business lines with very established, well-funded, and fast-growing incumbents like Anthropic and OpenAI, as well as Open Source models like Kimi on the AI model development side, and then hyperscalers like Amazon, Google, and Microsoft. Despite Meta’s claims of potential optionality, they are yet to show revenue from any other uses for their compute, and enterprise sales is not a core competency.
In addition to all these factors above, Reality Labs continue to lose $10-20B /year. Meta spends aggressively on capex without providing much clarity to shareholders and without caring what they think. A bet on Meta is ultimately a bet on Zuckerberg at the helm and spending as he sees fit.
Capex actually understates the amount that Meta is committing to these projects. If you look at the growth in Meta’s off-balance-sheet purchase commitments and lease obligations, you can see a massive ramp-up over the past two years for future capex and performance obligations.
Legal / Other:
Future litigation is pending, and while the specific damages are uncertain, the cost is very likely to be material according to the company’s own admission. This leads to significant headline risk in the short term and uncertainty, as well as the potential for truly massive judgments against Meta. If you extrapolate the recent Meta and YouTube lawsuit about addictive product design to 10% of the U.S. user base, $4.2M/person * 18.2M affected users for a $76T judgment which dwarfs any possible enterprise value. judgments just in the U.S. To compound this, Meta reported litigation and severance expenses that caused the company to miss earnings estimates this quarter as well.
If you read Meta’s legal proceedings it’s almost 10 pages long!
Overall, I think META’s core network effects remain strong, and you want a technology-obsessed founder at the helm of a cash geyser with strong potential adjacent businesses tied to their world-class distribution. The price you pay vs the current normalized operating income and growth, even adjusted for reasonable litigation settlements is very attractive.
For balance I’ll conclude with a couple of bullish tweets:
