Meta Platforms: Don't Fear the Cost of AI (NASDAQ: META)

Meta platforms (Nasdaq: Meta) declined after the Q1'24 earnings report where the company predicted a new round of spending on AI. The stock missed the 2022 lows below $100 on the back of efforts to control costs and The beginning of a year of performance. mine Investment Thesis The stock is bullish after the decline, as the social media company invests in the future and has a high probability of a TikTok ban.

AI spending cycle

Meta fell after earnings due to the social media company's suggestion of another investment cycle for Generative AI. The company handily beat Q1 analysts' estimates due to increased video ad demand, but the market was also disappointed with Q2 guidance.

Due to timing issues, Meta reported impressive growth of 27% in Q1. The company was unlikely to repeat this growth rate at its scale and forecast. Going forward growth was to drop below 20%.

Meta guided for Q2'24 revenue of just $36.5 to $39.0 billion, short of estimates of $38.3 billion. Midpoint targets are a rounding error for a company approaching $150 billion in annual sales.

The big market fear is that Meta is entering another investment phase, this time for AI. After all, the company predicts spending more on Reality Labs after losing just $3.8 billion in Q1. With modest quarterly sales of just $440 million, these investments have little to no upside in paying out shareholders.

The stock sank, but management didn't actually guide spending materially higher in the current year. Total spending is forecast at $96 to $99 billion, with only $2 billion on the low end. Some of these higher costs are also associated with legal costs, costs that most companies would exclude from the guidance.

A major increase in expenditure is capital expenditure. These costs are increasing by ~$4 billion over the original target in 2024. Many of these data center costs will pass through depreciation charges over time.

The fear of the unknown is a big jump in costs in 2025. Investors should not be surprised by higher spending going forward, as growth of up to 20% supports higher spending levels.

However, the main problem with Meta is the obsession with reporting the total cost, despite knowing that the market wants the difference between the 2 buckets. By nature, total expenses will increase with revenues higher than just COGS, and revenues will increase from $36 billion in Q1 to an estimated $45 billion in Q4.

AI shouldn't be afraid of spending cycles, as Meta is ultimately building Meta AI assistants. One area to watch is that LLMs continue to become dramatically more expensive, with large tech companies spending dramatically more to build each new generative AI tool.

Meta forecasts capex spending of at least $35 billion this year, after spending $6.7 billion in Q1 alone. The company will average $10 billion per quarter through the remainder of 2024. Google ( GOOG ) ( GOOG ) and Microsoft ( MSFT ) have increased spending with Q1'23 levels doubling. All of these AI companies were spending only $5 billion per quarter through 2021, even with increased online demand following the Covid boost.

While these companies have generally increased capex spending, much of the spending has been in line with rising revenue. Meta actually cut spending as a percentage of revenue in 2023, but recent spending trends suggest that 2024 level will change the investment landscape again with a midpoint capex of $37.5 billion. That is 24% of revenues.

Despite lower revenue levels compared to other major AI companies, Meta is able to aggressively invest in investments for the future due to higher gross margins.

Normalized EPS model

Meta reported that EPS increased during Q1, with operating margins nearly doubling Q1'23 levels at 38%. Despite spending aggressively on Metaverse, Meta still generated EPS of $4.71. In addition, one can potentially incur several billion in one-time expenses, such as legal fees, to achieve a higher quarterly EPS metric.

Naturally, the bigger concern is that Meta now spends the next two years investing so aggressively in creative AI that analysts have significantly lowered EPS targets for future years. Analysts seem to have started reducing EPS targets beyond 2024.

CEO Mark Zuckerberg is a big believer in personalized AI, where AI assistants are able to do things for users and turn into agents. The company mentioned the following AI opportunities:

• AI assistants
• Creator AIs
• Business AIs
• Internal coding and development of AIs

The big question is the level of investment, whether AI will keep pace with spending like the MetaMetaverse, where losses are running at a rate of $15 billion a year. The key here is that our investment thesis accelerated in 2022 when stocks took a beating and the meta planned to cut Realty Labs' big losses.

The company will see $5+ EPS accretion from offsetting losses in this category. Now, Meta AI appears to be on the way to compounding MetaLabs' losses by investing in assistants and agents.

Consensus estimates have the social media company generating around $23 in EPS in 2025. An investor still has the option of looking at the stock in terms of adding back Realty Labs' big losses to generate $27-28 EPS.

The stock here is incredibly cheap, although the meta faces some volatility as the market is not appreciating the decline in earnings growth due to investment. Stripping out Realty Labs' losses, the stock trades at just 16 times normalized EPS of $28.

Gene Munster, analyst at Deepwater Asset Management prediction The TikTok ban could lead to Meta winning 50% of US revenue, which equates to a 5% overall revenue increase of just $7 to $8 billion. TikTok US revenue is estimated at $16 billion for 2023, so the impact on growth in 2024 may not be much.

Meta ended the quarter with a large net cash balance of ~$40 billion, with positive free cash flow of $12.5 billion in Q1 alone. The company even spent $14.6 billion on share repurchases while paying a $1.3 billion dividend last quarter for a total return of nearly $16 billion in capital.

take away

The key takeaway for investors is that the decline in meta-platforms after Q1'24 results makes the stock very attractive again. Even just assuming all the extra costs are never lost, the stock is cheap for the growth rate. Once it is assumed that Metaverse is eventually monetized or spun off, a normalized EPS of $28 makes the stock very cheap.

Investors should use cost fears to snap up Meta shares during 2024. The company is investing aggressively in both AI and Metaverse and the company should eventually see a payoff that will lead to next decade of growth.