Reality Labs Will Be A Costly And Unfruitful Bet, Impacting Earnings Power

Reality Labs & The Metaverse Is A High-Cost Bet with Diminishing Returns

The company formerly known as Facebook took an undeniably ambitious leap into the future with its transformation into a metaverse-focused company. The strategic realignment was so significant, that the company decided to abandon the name it was known throughout the world as to now be known as Meta Platforms. With the creation of Reality Labs, its research division dedicated to virtual and augmented reality technologies, it's evident that Meta is placing a significant chunk of its future bet on the metaverse.

However, the pathway into the metaverse is not without its significant challenges. Firstly, the technological infrastructure required to build and maintain a seamless metaverse experience is infinitely resource-intensive. Meta’s Reality Labs unit recorded a $4.28 billion operating loss in the fourth quarter alone, bringing its total for 2022 to $13.72 billion. This translates to immense research and development costs, which, if not met with proportionate consumer adoption, could drain earnings and impinge on the margins.

Current signals from the market are not overly promising. The adoption rate of Meta's metaverse-oriented products, such as the Oculus, while relatively decent, doesn't forecast the broad-scale consumer adoption Meta anticipates. The technological barriers, from expensive VR headsets to the need for robust internet connectivity, further hinder widespread global adoption. If this trajectory persists, Meta's enormous investments into the metaverse could become a persistent drag on its profitability and negatively impact shareholder value.

The growing diversity in VR ecosystems - Statista

The problem here as well is that these other headsets aren’t necessarily contributing to a global VR ecosystem. Rather these are all pretty closed ecosystems. Meta Horizon Worlds is only available natively, requiring an Oculus Rift S or Meta Quest 2. At present, competition among companies in the VR hardware industry is a reductive process. More often than not, the experiences available to users depends largely on the type of headset you have. Meta’s hardware dominance (Meta doesn’t have the strongest hardware, but the Quest 2 is frequently cited as the best value headset) could be at risk should another company arrive with an exclusive experience that requires different hardware. Conversely, excellent pieces of hardware like the HP Reverb G2 are suffering because of their reliance on Windows Mixed Reality as a platform.

Openness to VR by use case across younger demographics - Deloitte Insights

Now, Reality Labs is a multi-faceted segment. It encompasses the company’s entire push towards mainstreaming AR/VR experiences. So while AR/VR hardware is the largest part, it is not the only part. AR Insider estimates that only as much as 23% of Reality Labs’ revenues are attributable to the software and app sales. While this doesn’t sound ideal, it’s to be expected from an ecosystem that is still gaining traction. Get users through the door with hardware, then extract continual value from software and apps over the lifetime of the hardware. 

However for this to be achieved, the software has to be good enough to warrant users returning and remain engaged. This is where I see part of the problem being for Meta. Meta had already burnt some of its reputation by previously forcing users to create Facebook accounts in order to use their VR hardware. While this was changed in August 2022, the idea that the AR/VR experience was inexplicably linked with the idea of not being standalone and a part of an ecosystem which may turn some users away who long for a simplistic plug-n-play usage.

In addition, there are some glaring flaws with Meta’s first attempt at creating a metaverse. Zuckerberg recently tried to downplay metaverse spending, indicating that around half of Reality  Labs’ expenditure goes towards Augmented Reality, around 40% to virtual reality and the remaining 10% goes to social platforms like the metaverse. However, if you consider the over $21 Billion in losses Meta has already accumulated since the beginning of 2022 and allocate even 5% of this to social platforms, that still amounts to over $1 Billion spent to help projects like Meta’s Horizon Worlds game off the ground. Consider that GTA 5 generated $1 Billion in revenue in the first three days after its release on a budget of $265 Million and this metaverse is already looking like a poor return on investment.

Aside from the monetization issues, Meta’s flagship social platform is suffering from a host of other issues:

• The game isn’t differentiated enough from other virtual social experiences like Second Life, that existed all the way back in 2003; or even experiences like Roblox.
• Graphically, the game is uninspiring, often looking like a game that is much older than it actually is. While I appreciate there are hardware limitations, the game/platform looks like one developed by an Indie studio, not one of the largest companies in the world with near infinite resources.
• There are already more popular alternatives like VRChat that have captured the attention of VR/AR enthusiasts. VRChat is also not hardware restrictive, so users with Meta hardware can interact with people with hardware like the Valve Index.
• The game is already falling well short of user forecasts, with recent internal documents stating that monthly active users could be as low as 200,000. Well below the 500,000 goal that Meta had set for itself. This figure could even be overstated, with one YouTuber recently finding as few as 900 daily users in Horizon Worlds.

Furthermore, it seems to me like Mark Zuckerberg’s comments on Reality Labs expenditure is conveniently spotlighting Meta’s AR R&D, indicating that this could be where they expect the most returns. It’d be easier for investors to stomach 50% of Reality Lab’s funds being allocated towards AR initiatives when augmented reality is yet to hit the market in any meaningful manner. A “work-in-progress” is easier to justify than an unsuccessful launch of a fully-fledged consumer facing product. 

Meta have already dipped their toes into the AR Glasses market with Ray-Ban’s Stories smart glasses that were released in partnership with the eyewear manufacturer. However, reception for this first generation of AR eyewear was less-than-stellar with 27,000 of the 300,000 units reportedly sold between September 2021 and February 2023 still being regularly used each month.

The second and third generation of Meta’s AR glasses are in the development pipeline, with releases of gen 2 expected later this year and the third generation is expected in late 2024 but the billion dollar question will be whether these upcoming iterations can capture the attention of users - or enterprise businesses more importantly.

Advertising Is Still King, But A Regulatory Tug-of-War over User Data Means This Will Come At A Greater Cost

It’s easy to overlook the fact that data has always been the cornerstone of Meta's business model. Despite what their name seems to indicate, the company’s ability to aggregate, analyse and utilise user data has been instrumental in attracting advertisers. Unbeknownst to a lot of people, Meta has effectively been a data aggregation and advertising business that offers a social network, rather than the other way around. Previous company financials show this has been remarkably successful in the past, however, the tides could be changing. Increased regulatory intervention from governments worldwide emphasizing user data privacy has propelled Meta into the spotlight -perhaps for the wrong reasons. 

In 2018, the Cambridge Analytica Scandal kick-started what some articles have referred to as ‘The Privacy Awakening’. The Scandal and the ensuing inquiries revealed that millions of Facebook users’ data was sold to third parties. While this may seem insignificant to people who have minimal online presence, researchers from Cambridge University highlighted that it was possible to predict people’s personalities and other sensitive information from their freely accessible Facebook likes. This shows just how significant mismanagement of even minor user data can be.

Legislation that arose in the wake of the scandal, like the European Union's General Data Protection Regulation (GDPR) and California's Consumer Privacy Act (CCPA) signify a global trend towards stringent user data protection. These regulatory measures could significantly hinder Meta's ability to employ its traditional data-centric advertising model.

While it’s hard to ascertain whether or not the data privacy legislation has had a significant impact on Meta’s advertising revenues (the recent plateau seen on the below chart could easily be attributed to a slowdown in advertising spending globally due to macroeconomic factors), it’s likely that the revenue it has earned has come at a greater cost. This seems to be evident when referring to recent announcements about AI advancements improving ad system performance and efficiency, implying that the company is having to invest heavily in AI models to pick up the slack. While not related to R&D, the company was recently fined $1.3b for violating EU data privacy laws which is also another blow to its bottom line.

Meta's previous financials - Simply Wall St

If Meta is compelled to continually alter its data usage practices to maintain compliance or face substantial penalties, it could seriously hinder their ability to serve users with advertisements that are relevant to them. A departure from relevant advertising will be a huge hit to Meta as advertisers will be less inclined to spend big as their conversions will inevitably drop as they  won’t be able to target users as accurately.

Declining User Growth And Engagement Could Harm The Ability Of Meta’s Family Of Apps To Generate Revenue

Meta has remained one of the foremost players in social media. It’s where it made its name with the launch of Facebook and it still remains the largest segment of the business. Meta’s ‘Family of Apps’ include platform powerhouses like Facebook, Messenger, Instagram, and WhatsApp which have dominated the social landscape with billions of registered users. However in recent times, the dynamics of its user base have begun to show signs of systemic challenges. A critical aspect of the health of social media platforms lies in their user growth and engagement, which, for Meta, is beginning to reveal some disconcerting patterns:

1. Market saturation could be near: In Q4 2021, Facebook, a core product under the Meta umbrella, experienced a contraction. For the first time in its storied existence, the platform registered a decline of about half a million daily global users. Although subsequent quarters saw a recovery in this trajectory, the hiccup could be indicative of a larger underlying problem. Facebook could be nearing peak user registration. With the near-global saturation of smartphones and the immense reach of Meta's services, there are ever-decreasing pools of untapped users. The golden era of exponential growth that investors expect might be waning .
2. The Youth Dilemma: For any social media platform, the youth demographic represents not just immediate users but also the future user base. Recent trends indicate that Facebook is gradually losing its allure among younger users. With a stark 26% reduction in registrations from users under 18 in several of its leading markets, the platform's future user acquisition looks precarious. The perception of Facebook as a space primarily for older generations only exacerbates this decline. If Facebook fails to resonate with the younger audience, its long-term platform engagement could be at risk.

The decline in younger users' engagement and registration can be attributed, in part, to the emergence of newer platforms that cater specifically to their preferences. Platforms like TikTok have effectively tapped into the zeitgeist of the younger generation, offering them a fresh, dynamic, and interactive space. As the digital realm becomes increasingly fragmented with diverse platforms competing for user attention, Meta's flagship product faces the risk of becoming sidelined.

Change in social media platform usage among Gen Z - Comscore

Tom Alison, the head of Facebook (A role that shouldn’t be confused with Zuckerberg’s as Meta CEO) acknowledged the difficulty that Facebook was having with capturing the attention of young adults and he indicated there’s a plan in place to change that involving AI algorithms, Reels (short-form video content akin to Tik-Toks) and private messaging. 

I see one difficulty with that. The plan seems to involve competing directly with themselves with their Reels content (which is already prevalent on Instagram), or competing with platforms that have adequately gathered the attention of younger audiences like Tik-Tok or Snapchat (private messaging). This doesn’t mean it won’t work, but it seems far from a clear cut plan, particularly if users don’t have an existing Facebook account. If their needs are met elsewhere, then there’s little incentive to register an account to get a remarkably similar experience.

Once registrations begin to plateau, Meta is faced with the arduous and expensive job of maintaining active user levels. If this begins to drop due to users switching platforms or age related user drop-off, then Meta’s advertising will see less impressions. This will eventually kickstart the domino effect where advertisers are less inclined to spend big on advertising on Meta’s platform and ultimately, less revenue for Meta.

Reality Labs Will Hurt The Combined Business' Overall Profitability

While Reality Labs has been touted as a key growth vector for Meta, I have my own reservations. The convergence of the digital world and our own is one that seems great in theory, but in practice there are some fundamental issues with blurring the lines between reality and the virtual world. The impact of excessive screen time is already well known with link between increased internet usage in adolescents and increased rates of anxiety, depression, poorer sleep quality and less physical activity. I believe the wider public will show reluctance towards AR/VR due to concerns of mental health, screen time, and further detachment from physical reality, ultimately meaning that Meta’s Reality Labs project will fail to capture mainstream attention and will instead be confined to several commercial and entertainment niches.

In the last 12 months to June 30 2023, Reality Labs generated $1.629 Billion in sales. However, compare this to the same 12 month period last year, Reality Labs generated $2.581 Billion in sales. Now, I understand that linear growth can’t be expected in particular with macro-economic pressures, but it could be that the hype around AR/VR fell to the wayside as AI become the hot topic of the year. If this is the case, then I argue that the anticipated growth of the AR/VR industry wasn’t sustainable, if it was based more on hype than utility.

Recent leaks indicate that Oculus headsets have sold nearly 20 million units to date, however user engagement remains low at around 10%. This is quite an alarming statistic, particularly when the end goal of any ecosystem is to ultimately earn recurring revenue through software sales once hardware has already achieved widespread adoption. Imagine if Apple was selling iPhones that had only 10% of purchasers actually ended up using on a regular basis?

Furthermore, 2019 Studies showed that as many as 40-70% of people will experience motion sickness when using commercially available VR headsets. A technology that inherently turns away 40-70% of its potential user-base is going to have a hard time gaining traction.

Given Meta has sold 20 million Quest headsets to date between 2020-23, I anticipate that this number could reach 70 million total units by 2028. This might seem like a massive increase in sales but it’s considerably lower than some forecasts that expect global headset markets to grow at over 30% annually. Linearly this would mean 10 million headset sales per year, however, I believe it will be partially back-loaded and so I am envisioning 15 million units sold in 2028.

With Reality Labs’ current product line-up consisting of the Meta Quest 3 at US$500 per unit, the Meta Quest 2 at $299 per unit and the Quest Pro (Meta’s business oriented headset) retailing for $999 per unit. I believe we will see a product sales split of 80/10/10 across the 3 core products. I understand that the Quest 2 will be discontinued well before 2028, but I am anticipating that a similar pricing structure will be there when the Quest 4 supersedes the Quest 3. With these inputs, I calculate Reality Labs will yield $7.95 Billion from hardware sales alone in 2028.

It is harder to forecast the performance of Reality Labs' AR initiatives considering there is still many unknowns at this stage, consevatively, I’ll attribute $500 million in sales to future AR product releases and related software.

Owing to my hesitations about widespread adoption and consistent usage, I assume that active users remains low at around 10% of headset ownership and ARPU on the software side of things will be fair at $120 per active user annually. At an ARPU of $120 for 7 million active users (10% of 70 million headsets sold), I believe Reality Labs will generate $840m in software sales.  On the summation of these components, I estimate Reality Labs will be making $9.29 Billion in revenue in 2028.

Using a linear regression model, I calculate Reality Labs Operating Expenditure has been growing at 18.60% per annum over the last few years. I will this Operating Expenditure growth forward for 2 yearss, before dropping this to only 10% OpEx growth for the 3 following years until 2028. Therefore, I am anticipating Reality Lab’s Operating Expenditure to reach $29.73 Billion in 2028. While some will argue that R&D costs won’t be consistent, I argue that the VR/AR market will still be a fair way from maturity at this point and so I feel using this linear approach for the next 2 years is somewhat fair. On the balance of Reality Lab’s sales and expected expenditure, my estimate of Reality Labs' Total Operating Loss for 2028 is $20.50 Billion.

Family Of Apps Will Struggle To Keep Users Engaged And Advertisers Paying

Meta’s Family of Apps is the much more stable and successful side of the business, contributing to 98.6% of revenues and 100% of earnings for the company. However, as previously discussed, the Family of Apps is not without its threats to its future growth.

As mentioned previously, the changes to data privacy laws means that it’s harder for Meta to share user data with advertisers to improve the accuracy of targeted ads. To remediate this, Meta has invested heavily in AI hardware and AI models to bridge the gap, which can already be seen in the financials where Capital Expenditure jumped 68% from $18.69 Billion to $41.43 Billion likely attributable to a massive increase on spending for AI data centres and supercomputers. Not only do I believe their to be CapEx intensity concerns given the new data privacy measures, I also expect there to be significant early-stage AI efficacy issues once Meta begins leaning more heavily on the AI models they’ve created. I believe that the AI models will fail to be as accurate as user data models at assessing user interests and poorer advertising performance will mean advertisers be hesitant to pay as much for their advertising space. limiting Meta’s growth.

Like the Australian Government’s push to allows Australians to opt-out of targeted advertising amid privacy reforms could be one of the first dominoes to fall in privacy reforms that significantly hamper Meta’s advertising business 

Aside from the cost of revenue likely increasing due to he company’s push for AI, Meta’s attempts to monetize Reels on both Instagram and Facebook APPEAR to be an excellent play in the short-term but I do see some issues if this is a long-term strategy. In the short-term, content creators on Tik-Tok and other platofrms can greatly improve their exposure by essentially mirroring their posting habits on Meta’s platforms so that Meta’s users don’t need to jump ship to competitors’ platforms to keep up with their favourite content creators - a smart play in my books. However, I believe that there’s an inherent risk here where Meta’s platforms will lose what made them special. Platforms like YouTube, Tik-Tok, Twitter have always been about following content creators or thought leaders, whereas Facebook, Instagram and WhatsApp focused firstly on connecting you with your friends and family.

I think a shift away from personal content towards commercialised content will impact long-term user retention. Users may begin to ask themselves, “what’s the point of using Instagram, when I no longer see my friends' activity and most of the surfaced content are things I’ve already seen on other platforms?”.

On the balance of these factors impacting the Family of Apps, I’m assuming that Meta’s user growth will begin to plateau and that average quarterly revenue per user (ARPU) will begin to decline. Meta’s ARPU is sees a generous uplift owing to the large number of users in the United States, where ARPU is significantly higher than elsewhere, but I also believe this is the market that’ll be the hardest for Meta to maintain and grow.

I anticipate that Meta is closer to peak monthly active users (MAU) than the market expects and by 2028, MAU will be only marginally higher than it is now, coming in at around 4.2B. This 4.2B figure accounts for growth in emerging markets like Asia, Africa and Latin America but also declines in active users across Europe and the US.

As a result of the demographic change, I believe we begin to see ARPU decline due to greater presence of users in lower ARPU regions and poorer advertising performance. I estimate global ARPU to be $9.20 (down from $10.63), which correlates to $38.64 Billion per quarter or $154.56 Billion annually.

Year-on-year, the costs and expenses relating to the Family of Apps increased dramatically by 22% from $58.71 Billion in December 2021 to $71.79 Billion in December 2022. Margins were heavily impacted has a result, dropping from 49% to 37%. I could see this trend continuing to accelerate and I anticipate Family of Apps operating margins to drop to 32% amid increased R&D expenditure on AI initiatives to cover a shortfall in information on users owing to data privacy measures.

At an operating margin of 32%, I forecast Meta’s Family of Apps to generate $49.46 Billion in operating profit in 2028.

Effective Tax Rate To Remain Consistent

Meta’s effective tax rate has hovered around 20% for the last few years. While there has been a high degree of variability owning to R&D Tax credits and such, I’ll operate off the assumption that Meta’s effective tax rate will be 20% in 2028.

Meta effective tax rate 2018-2022 - Data compiled from Meta's earnings reports

Stock-based Compensation To Match Buybacks Over The Next Few Years

Meta’s total Share-based compensation totaled $11.9 Billion for 2022. While buybacks peaked at $20 Billion back in the final quarter of 2021 following a surge in profits during the COVID period, this has since dropped back to less than $1 Billion in the latest quarter.

For valuation purposes, I’ll use a fully diluted 2.612 Billion shares outstanding count as my estimate for company shares outstanding in 2028.

Meta’s Cash Reserves Allows For Strategic Pivots

Meta's substantial financial arsenal and technical expertise might allow them to pivot successfully, innovate, and adapt to changing consumer demands and regulatory landscapes. Where less mature and capitalised companies may take significant risks trying to preempt where the market is heading and thus remain conservative, Meta has the cash and talent to throw the kitchen sink at something to try and make it work. Meta’s attempts to get Reality Labs off the ground might take some financial brute-forcing, but could prove to be massively successful if the right resources are provided.

Meta's cash levels - Simply Wall St

Not to mention that a potential failure of the Reality Labs project could actually improve the financials of the business considering it is the leading loss-maker for the business.

Emerging Markets Are An Unknown Quantity

Emerging markets, where internet penetration is still growing, could offer Meta a significant new user base, offsetting any potential declines in mature markets. While I did account for some growth in Family of Apps users from emerging markets, this growth could be understated. If emerging markets perform better than my expectations whilst also delivering better ARPU than what I have assumed, then my forecasted growth could be invalidated.

Younger generations May Be More Prepared To Mix Reality And The Virtual World

The allure of a 'fully digitized' life may be more appealing to the upcoming generation than anticipated, setting up the metaverse a revolutionary success in years to come. A recent survey conducted by Snap indicated that 92% of Gen Z would like to use AR for shopping purposes and 60% of Gen Z consumers said that AR experiences feel more personal. As younger generations begin to have more buying power in the market, Reality Labs may experience exponential growth.

Twitter/X’s Instability Could Be A Rapid Growth Pathway For Instagram’s Threads

In July of 2023, Meta released Threads, a text-based Twitter/X competitor to much fanfare. In a particularly turbulent time for Twitter/X, Threads was able to capture the attention of social media users who had little faith in the continued operation of Twitter/X. Threads was able to capture so much attention that it became the fastest growing app in history, reaching 100 Million registered users within five days. Although interest has subsided since then, with daily usage dropping by 80% by the end of July to a little over 8 Million users, it tells us that should Twitter/X fail in the near future, Meta is poised to swiftly take its place - a valuable advertising opportunity for Meta.