The recent Metaverse hype once again reminded investors of this costly lesson: the hotter the investment concept, the cooler our heads have to be. In March 2021, Roblox (RBLX) became the first Metaverse stock to go public. The two year old The company with no operating income went public on the New York Stock Exchange with a market cap of ~$40B and a share price of ~$80. The share price quickly rose to nearly $135 and the market cap nearly doubled to $80 billion by November 2021. Like many past hypes, this one doesn’t end too well (so far, at least). As you can see from the chart below, share prices collapsed from the $135 peak to the current level of around $40. Just 30% of its peak price (which would require a 237% rally to get back there – if that ever happens) and about half of its IPO price (which would require a 100% rally to break even) .
I mention the Roblox episode to remind us that the same lesson applies to other Metaverse stocks and meta platforms (NASDAQ:META) is no exception. About 6 months after Roblox went public, Zuckerberg announced that Facebook would be rebranded to META along with the “All in Metaverse” strategy. With the development of the global mobile internet, an innovation as fundamental as Metaverse raises high hopes, inspires investor imagination for the future, and also offers tremendous potential for returns for shareholders.
And so the goal of this article is to examine the Metaverse future at leisure. I’m a longtime bull on the Metaverse future and also on META. Next you will see that while the future is bright, you need to consider whether the schedule fits your goal and risk profile.
Because to finish first, you have to finish first.
Metaverse: bright future but long schedule
According to the following McKinsey report, the impact of the metaverse is projected to generate up to $5 trillion in value by 2030. The Metaverse future is just too big for companies and investors to ignore. More specifically, the game market impact will be $108-125 billion, the advertising market impact will be $144-206 billion, and the virtual learning market impact is expected to be $180-270 billion . Most of the impact will come from the e-commerce sector and will range in magnitude from $2 trillion to $2.6 trillion.
In my view, however, the metaverse (like every other earth-shattering technological innovation before it) will be a long journey that may take years or more. The construction of the Metaverse ecosystem cannot be completed by any company alone, but requires the industry to jointly build the infrastructure step by step. Each step, such as computer technology, development of algorithms, production of VR content, will take years and zigzag.
A large part of my career has involved high-tech R&D and consulting. And a fascinating topic is always the so-called 10/10 rule, as detailed in my previous article on Tesla:
We may have a feeling that technological innovation is accelerating, and there’s some truth to that feeling — in terms of the NUMBER of new technologies emerging each year (or even quarter). But if you look a little closer, you’ll find that PACE has followed most of the innovations and still follows the 10/10 rule: 10 years to build and another 10 years to find a mass audience. And here we are talking about innovations that are “obviously” earth-shattering (that is, in hindsight) like cell phones, PCs, the internet, GPS, etc.
I see no reason why the Metaverse innovation should disregard the 10/10 rule. Prospective investors should therefore carefully review their investment timelines and objectives. Rather than hoping for a sudden breakthrough, I recommend investors focus more on business fundamentals and see if they have the resources to play the long game. And the good news is that META has a cash cow business to bridge the transition, as detailed below.
Cash burn rates and CAPEX
Given the timeframe in which virtual reality can make a meaningful contribution and the need for sustained high capital investments, cash burn rates need to be carefully monitored. META used to be a cash cow, as you can see in the chart below. Its position in cash and cash equivalents grew from under $40 billion to a peak of more than $64.2 billion in 2018 and 2020. Its current position in cash and equivalents is $40.5 billion due to recent operational headwinds and heavy capital investments. Thus, in less than 2 years, it deployed nearly $24 billion in cash. And after such a large investment, Reality Labs currently contributes less than 2% to its revenues.
Going forward, to fuel its growth, META must continue to spend aggressively on both growth CAPEX and OPEX (operating expenses), as summarized in the chart below. The top panel of the chart shows the META CAPEX spend over the past 3 years on a quarterly basis. CAPEX spend held steady at or below $4 billion through 2021, then increased to $7.57 billion last quarter. Compared to its operating cash flow of $12.2 billion last quarter (see middle panel), it still generates a healthy amount of free cash flow (about $4.63 billion). Also, as you can see, the trend is worrying. CAPEX spending is trending up while operating income is falling.
The silver lining might be that META doesn’t have to overspend on maintenance investments, as you can see at the bottom of the chart. If we approximate its maintenance capital expenditure with depreciation, then its maintenance capital expenditure over the last 3 years averages only about $1.8 billion per quarter, which is only 40% of the average CAPEX spend over the last 3 years. Last quarter’s number was about $2 billion, which was only about ¼ of CAPEX spend over the same period. As a result, a large portion of CAPEX spending is growth spending.
The bad news, however, is that as a SaaS software company, it has to spend heavily on OPEX, as you can see in the chart below. The company has continuously spent billions of dollars developing new software research. Total operating expenses have been around $15 billion for the last few quarters since 2022, up almost 50% from a year ago. And research and development costs have also risen rapidly. It has more than doubled from $4 billion in 2020 to the current level of $8.7 billion.
Balance sheet status and valuation
Currently, META has about $40.5 billion in cash on its ledger, which translates to $4.7 per share. It also has some debt (totaling $16.6 billion), but the debt is lower than cash. As a result, it has a net cash position of $23.8 billion, a pretty sizeable one. In other words, at its current market cap ($401 billion), about 5.9% of META’s market is cash only.
If we subtract the money from the stock price, its PE multiple would get even lower. For META, its FY1-PE is around 15.3x based on SA data at the time of this writing. And it would only be 14.4x after excluding its cash position.
Plus, as you can see in the chart below, META’s record is pretty strong compared to other similar competitors like Google and Netflix. Leverage is at a very conservative 13.2%, on par with Google’s (11.3%). Likewise the debt ratio (only 10.7%). Finally, note that the debt to free cash flow ratio is also very conservative. All three have conservative debt-to-free cash flow ratios, and META has the lowest. META’s ratio is 1.5x, meaning it would take just 1.5 years of its current free cash flow to pay off all of its debt.
Other risks and final thoughts
In addition to the long and uncertain timeline, there are some risks in the short term as well, as outlined in my previous articles. These risks include foreign currency headwinds, margin pressures, and tighter monetization rates due to privacy changes. The US dollar in particular has recently recovered to a high in about 20 years. And given the latest CPI data, the strengthening could continue if the Fed hikes further. For global companies like META, such a strengthening could create stronger headwinds than expected. Finally, META has very likely overexpanded in recent years and has some overcapacity. During its most recent second-quarter earnings report, management mentioned fewer hires and the possibility of layoffs.
In conclusion, to finish first, you must finish first. I see no reason why the Metaverse innovation should go against the 10/10 rule that has governed so many other world-shattering innovations in the past. Rather than hoping for a sudden breakthrough, META investors should focus more on business fundamentals and see if they have the resources to play the long game.
And I’m optimistic that its existing digital ad segment can raise enough money to support the Metaverse initiative in this long game. It is true that the company has wagered close to $24 billion in cash over the last 1 to 2 years, a large sum by any standard. However, I don’t see any reason to be overly concerned as the company still generates a healthy amount of free cash flow. The company generated approximately $4.63 billion in free cash flow (operating cash flow of $12.2 billion minus $7.57 billion in CAPEX expenses) for the most recent quarter. To make the good news even better, it doesn’t have to spend too much on maintenance investments, further increasing its capital deployment flexibility. Finally, in the worst-case scenario, META has other means of raising additional capital either through the equity or debt capital markets. For example, it recently decided to issue a $10 billion jumbo bond deal for the first time in its history, as detailed in this Bloomberg report. Thanks to its robust cash flow generation ability and strong financial position, the bond offerings were welcomed by the debt market and orders for the bonds reached more than $30 billion.