Cold air relay race, Google and Meta do not have "Get out of jail free card".

Since the beginning of this year, the days of the leading advertising companies have been generally difficult, even the strong like Google are not so reliable anymore. Looking back, in fact, every financial report season on the advertising stock market is like a large-scale bombing site with intense thunder.

Of course, the complexity and high uncertainty of the macro environment have increased the difficulty of management and market expectations. The entrance of Apple and TikTok has torn off the last piece of fig leaf. After the cruel competition, the level of competition between the two becomes clear.

In addition, the other leg of these old advertising giants who have not yet fully matured has also begun to be in an awkward situation. Amid the macroeconomic expectations that international organizations have lowered season by season, investor attention has shifted from the top of the reports to the bottom. The short- to medium-term perspectives of investors focusing on return on investment and the long-term perspectives of entrepreneurs have also begun to collide fiercely. When to contract and by how much has become a core issue that investors are increasingly urging and anxious about.

As a member of the high-quality FAANMG portfolio, Google and Meta's stock prices have suffered from repeated discounts this year. However, the market is still not at all lenient on the performance of the two giants. Advertising is also an economic barometer. Behind the plummeting stock prices of advertising giants lies a deeper pondering point as to the reasons behind the poor performance:

1. Is the slowdown in revenue behind actual decline, competition, or the fault of the appreciation of the US dollar?

2. When will profit margins start to recover?

3. With interest rates rising non-stop, do $ Google-A.US and $ Meta.US have a safety margin?

I.

Revenue Slump, More Trouble Next Year

This year's digital advertising giants have generally suffered from macro, competitive, and regulatory influences.

To be more precise, the difference between China and the United States lies in the fact that Chinese digital advertising is mainly affected by regulatory and macro factors, while competition shows some trends of an easing situation.

In contrast, US digital advertising giants mainly face pressure from competition and macro, and regulatory influences also exist. For example, Google and Meta often receive fines for user data privacy protection, but compared with the impact of competition and macro, the influence of regulations seems insignificant and not within the scope of public debate.

1. Economy: Prolonged Sluggishness

Advertising is closely related to the macroeconomy. The overall market's advertising spending generally accounts for a relatively stable proportion of GDP, especially in developed countries and regions where consumption contributes more to the economy.

For advertisers, they generally prepare a marketing plan for the next six months to a year in advance, and conduct advertising placement one quarter or one to two months early. Therefore, predicting the economic outlook is crucial.

This year's economic slowdown is a foregone conclusion. The IMF has lowered the GDP forecast every quarter from the beginning of the year until now, and the situation next year is even more troublesome (generally significantly slower than this year).

Europe, needless to say, will be the first to fall into a growth slump, and the energy problem is a fatal medicine.

The U.S. economy is relatively stronger and more stable, but it is not invincible. The representative of endogenous growth, individual commodity consumption, has been negative for two consecutive quarters. Powell expressed the Federal Reserve's determination to curb inflation (targeting 2%) and the appropriateness of further rate hikes in his speech after yesterday's 75 basis point hike, which is also causing the market to become increasingly anxious that the economy will hard-land into a recession.

Dolphin Analyst generally provides a detailed analysis of China and the U.S. macroeconomics in the weekly strategy report. The analysis of the latest U.S. third-quarter economic data can be found in Longbridge's latest article "Behind the Expectation of Policy Shifts: Can the GDP Driven by a Strong Dollar be Trusted?".

As the title of the above mentioned weekly report, Dolphin Analyst also noticed that exchange rate disturbances have magnified the impact of macroeconomics on advertising leaders' income to some extent. As revealed in the third quarter reports of Google and Meta, exchange rate disturbances have dragged down income growth rates by 5% and 7%, respectively. For these two advertising giants, more than 50% of their revenue comes from outside the U.S. Under the circumstances of the strong appreciation of the U.S. dollar for over a year, the income value calculated in U.S dollars will inevitably be weakened, thereby affecting its growth rate.

However, exchange rate disturbances cannot change the overall trend of the (expected) economic downturn. Dolphin Analyst removed exchange rate disturbances and analyzed the growth situation of Google, Meta, and Snap in the North American market, and found a significant decline in growth rates in the second and third quarters.

Looking back over the past year and comparing different platforms, we can identify the most core reasons behind the growth changes of each platform:

1. The first steep drop in growth rates of the three platforms occurred in Q3 of 2021, which is probably due to the influence of the high base effect of the previous year (the start of the pandemic dividend in 2020), but Q3 was also the time when Apple's ATT officially began to assert its influence. Metaissued a notice to merchants mentioning that the measurement report of its advertising precision needed to be adjusted and delayed because of certain indicators. After the release of the third-quarter reports, Meta and Snap management also began to focus on discussing the policy, but the company was still relatively optimistic at that time. In Q4 2021, Meta and Snap were increasingly affected by Apple's ATT, but Google's search advertising benefited from it, with the smallest decline in growth rate among the three. However, from the perspective of the relationship between advertising volume and price, Meta's downward trend has begun to show signs (except for the company's own guidance that went bust): Meta's advertising quotation advantage started to sharply decrease in Q4, and sustaining revenue growth requires releasing more advertising inventory.

At the same time, the macroeconomic environment in which the three major platforms were situated in 2021 was strong, corresponding to the retail advertising for digital ads repeatedly reaching new highs, while the demand for service-type that shrunk due to the epidemic in 2020 is also retaliating.

At the beginning of Q1 2022, Meta collapsed as expected, with management attributing the cause to Apple's ATT. Google's YouTube was also affected by Apple's ATT, but continued to maintain its strength by relying on search advertising, which contributed a higher proportion of revenue. Snap has not seen any obvious impact due to its small scale, with few advertisers and mainly brand advertising in Lens. Dolphin Analyst analyzed the performance differences between Meta and Snap on the impact of Apple's ATT on February 17, 2022 in "Internet Advertising Review - Meta: Low Combat Effectiveness is the Original Sin."

In Q2 of this year, the growth rates of the three platforms have all shown a significant decline, but we believe there are still differences behind the reasons.

Google's main reason may still be the high base effect brought by the recovery of travel and finance advertising in search ads last year, but service-type consumption, which benefits from strong demand, is still supported by search ads. Snap was also affected by the high base effect.

Meta continued to blame Apple's ATT, but Dolphin Analyst believes that TikTok also dragged it down when it began commercializing at the beginning of the year.

Snap, which has user tags similar to TikTok and a heavier emphasis on brand advertising, was the first to fall after TikTok began commercializing. Although Snap also launched the embedded short video function Spotlight, given the progress of its big brothers in short video, the commercial prospects of Spotlight may not be too optimistic.

So far, among the three major platforms, only Google's search advertising has barely been supported by the rebound of customer industries.

Entering Q3, in terms of macroeconomics, the positive growth of personal consumption in the US depends only on service-based consumption, while commodity consumption continues to lag behind**. That is to say, Google still benefits from strong demand in travel and tourism, but the popularity of financial services such as loans and mortgages in service consumption is declining, which is related to the environment of interest rate hikes. In the end, Google's search advertising still had a year-on-year growth of 10% after excluding exchange rate effects, which is relatively stable. As for Meta, which primarily relies on retail advertising, the weakened consumer demand has put tremendous pressure on it. Additionally, the fierce competition in short video content, exemplified by YouTube and Instagram, also hindered their commercial development and somewhat negatively impacted their overall revenue.

In response to the slowdown in genre-related industries and video platform rivalry, Meta has released more aggressive advertising inventory to mitigate the pricing pressure. As a result, North American advertising revenue decline in Q3 was somewhat alleviated compared with Q2. Currently it appears that Google takes a more relaxed approach, but it is foreseeable that when the cold weather and reduced travel demand during Q4 attenuate the growth advantages of search advertising, Google may also take the old approach of releasing more ad inventory to ease growth pressure.

In summary, the main factors contributing to the upward trend in advertising revenue across the top three platforms over this past year include the online retail boom brought on by the pandemic and subsequent recovery in certain industries. In contrast, the main driving force behind the downturn in growth lies in the competitive environment.

On the other hand, the effect of macroeconomic slowdown on advertising may just be starting to manifest, while taking into account the IMF’s predictions for global economic prosperity in 2023, next year's economy may be even weaker, thereby reducing advertising market space even more.

2. Competition: Battlefield Heats Up More and More

The competitive threat primarily comes from two sources: Apple and TikTok. Apple's impact has been felt more over the past year, whereas TikTok's competitive pressure has only recently begun. Looking ahead, these giants will need to be cautious and ready to face increasingly fierce competition.

Dolphin Analyst (previously referenced in a previous July column on short video content and platform comparison) suggests that interested readers should review TikTok teaching "big brothers" to get things done, Google's and Meta's changes. Here, we will not delve into further detail.

Although Google has money and has announced that from next year, Shorts' ad income will be split equally with creators, while Meta has users and Reels is not just disseminated on Instagram, the world's largest pool of traffic, Facebook, can help Reels creators direct videos. It is still well known that short video app TikTok has left a trail of defeated social media platforms in China, and international version TikTok's power should not be underestimated. At present, its user base has approached 1.5 billion (not including the banned Indian market), with high user stickiness and daily active users spending more time per day than YouTube. TikTok is heavily investing in building its own logistic supply chain and its ambition lies in live e-commerce. Perhaps the only risk that can stop TikTok's progress is the risk of conflict between major powers (a US congress member recently called for a ban on TikTok, claiming that TikTok transfers data of US users to its Chinese mainland parent company).

However, competition is not only about short videos and TikTok. As mentioned earlier, Apple and e-commerce platforms with higher advertising conversion rates (closer to the payment link) will also have an impact on social media. The advertising market in mainland China has already shown this feature this year. Fortunately, in the European and American regions, third-party e-commerce platforms such as Amazon and eBay have a lower market share in the overall e-commerce market, and many American users are still accustomed to directly consuming on brand merchants' websites.

For example, in the United States, besides Amazon's dominance, the market share of the top 5 e-commerce platforms is only slightly above 60%. But in mainland China, the market share of the top 5 is as high as 80%. This also means that the speed of merchants' advertising migration from social media to e-commerce platforms will not be as fast as that in the Chinese market. No matter how demanding the conversion rate is, brand merchants still need to allocate some advertising budget on social media with huge traffic.

In addition, long videos in streaming media are also eager to try the advertising market. Netflix will launch an advertising package in the next few days, and there is only one month left until the end of the year. The effect can be seen quickly. At the beginning of December, Disney+ will also launch an advertising package.

Although the advertising price of long videos is relatively expensive, and the cost-effectiveness is not high for small and medium-sized businesses, the amount of time users spend on long videos on TV is increasing rapidly. For brand advertisers, it is also a channel to reach potential users.

In the limited market space next year, the competition will visibly become more intense. Looking at the growth potential of each platform alone is not meaningful. We can only predict the scale of revenue by allocating shares to each platform from the perspective of advertisers.

Entrepreneur and Investor Conflict: Is it worth it if there is no return on investment for five years?

Apart from discussing revenue growth pressure, the market is more concerned about platform profit allocation with regards to the third-quarter performance of social platforms. Should the platform continue to invest in expansion or give back to shareholders/investors through buybacks, dividends, and other means?

This attention is particularly reflected in Meta's investors. Since the year-on-year decline in operating profit in the fourth quarter of last year, Meta's expenditure plan has especially caused concern among investors. At the beginning of the year, management proposed a total expenditure (cost + expenses) of 90 to 95 billion US dollars, with 10 billion invested in VR. The announcement caused an uproar in the market.

Under pressure, management has continuously lowered expenditure budgets in the following three quarterly reports. However, as the economic outlook worsened visibly in the second half of the year, the market has higher expectations for cost optimization, including in 2023, when economic pressure will likely be even greater.

But Meta's management's response has clearly failed to satisfy the market. The scale of cost and expenditure is over 100 billion higher than the market's estimate, and capital expenditure has also exceeded nearly 5 billion. On the phone call with analysts, in the face of their concerns about expenditure issues, Zuckerberg still seemed determined not to change his mind.

Zuckerberg is not unaware of investors' demands for interests, but he believes that investment in VR not only should not be stopped but also needs to be accelerated. After Apple demonstrated its ecological barrier capability through the ATT privacy policy, this is also Zuckerberg's deeper feeling of the importance of seizing the next-generation traffic entrance.

However, for investors, investing billions of dollars annually, with returns that may only be seen in 5-10 years, a long investment return cycle and high uncertainty are present. Although there is a possibility of huge profits, after multiplying by a probability, the expected rate of return may not be high.

In addition, the funds invested in Meta for many years are mostly value investments, and they value Facebook, a highly profitable stable cash flow business, rather than Metaverse, a high-risk business with huge losses and more investment required for years.

Since the disclosure of the third quarterly report, Meta's stock has plummeted another 30%, and Zuckerberg's personal wealth has evaporated by nearly 100 billion overnight. Perhaps Zuckerberg will compromise and decrease VR investment due to a more challenging macro environment and competitive landscape. However, this is also the market's most optimistic expectation.

Similar profit pressures exist at Google as well. However, Google's problems are not as thorny as Meta's, mainly due to teams that expanded rapidly during the pandemic bonus period not being optimized in a timely manner. And the net addition of employees in the third quarter is still hitting new highs. What about freezing recruitment? Under the slowdown of revenue growth, continuous expansion of expenses has significantly eroded profits. With the need to continue to endure hard times in the coming year, investors are inevitably anxious about Google's laissez-faire attitude. Although management has stated that net additions of personnel in the fourth quarter were less than half of those in the third quarter, the possible increase in expenses calculated according to a net increase of 6,000 people is not much different from that in the third quarter. In addition, fourth-quarter revenue is bound to come under further pressure, and gross profit margins will continue to weaken due to the early low commercialization of short video Shorts, which requires more servers to support video traffic.

Regarding investor concerns and complaints about the company's Opex and Capex, Google's management responded much more friendly than Meta. They stated that they would make some optimizations, but still concentrate resources on the direction they deem fit, with investments made for the next ten-year growth driver.

Compared with Meta, Google's second pillar, Google Cloud, also appears to have more hope of seeing a turning point in profits in the short term. As of the end of the third quarter, Google Cloud's remaining performance obligations (mainly for cloud business) were still as high as 52.4 billion, and after signing some large long-term contracts in the fourth quarter of last year, they have sufficient surplus.

However, it is worth mentioning that the proportion of Google Cloud confirmed in the third quarter, that is, Google Cloud revenue/(beginning of period remaining performance obligations + current net increase in contract amount), is increasing rapidly (the change in confirmation ratio from Q1 to Q3 is higher than last year's situation), which is estimated to be due to weak economic expectations, short-term corporate IT budget cuts, and progressive slowdown in new contract expansion.

Three

Valuation update

Considering the economic downturn cycle, Dolphin Analyst's current portfolio does not include American advertising companies. Meta showed signs of disaster as early as the third quarter of last year, so it was never included in the portfolio. For Google, we mainly consider the logic of the benefit of search advertising due to Apple's ATT privacy, and the recovery of services such as tourism, finance, and healthcare after the pandemic. Therefore, we have made a low allocation, but have conducted in-depth research on Tiktok, "big brothers" are going to be taught by Tiktok. After the article "Changes at Google and Meta to impact the industry: a Dolphin Analyst's point of view", Dolphin Analyst removed Google from the recommendation list.

Despite the fact that the valuations of the two companies have continued to decline since the release of their third quarter reports, the macroeconomic environment and competition will likely continue to erode the profits of both companies in the coming year. The current undervaluation is not as low as previously thought after factoring in the impact on performance, so Dolphin Analyst still believes that it is not suitable to establish a position at this time.

The valuation assessment here is for reference only, and Dolphin Analyst's main changes based on previous assumptions were as follows:

(1) Market size: referring to Statista's latest forecast for the digital advertising market, the growth expectations for the macro economy were further lowered, but at the same time, the booming short video market helped further accelerate the penetration speed of internet advertising in the overall advertising market. The impact of these two factors partially offset each other, resulting in a slight decline in the overall industry market growth rate.

(2) Considering that the long video market has also begun to participate in the advertising market, the future market share of Google and Meta has been further reduced.

(3) Increase expenditure scale, which will significantly weaken short-term profit capability.

To reflect the impact of the short-term sustained interest rate hikes on valuation sentiment, we have raised the risk-free rate from 3.5% to 4%, while maintaining a perpetual growth rate of 2.5%.

1. Google: With a WACC of 10.73%, the DCF valuation is $104 per share, corresponding to a 2023 P/E ratio of 18x, which is in the lower range of the valuation center. The current stock price is oversold, but performance is still in a downward trend, so we still keep Google as an observation stock.

1. Meta: With a WACC of 11.43%, the DCF valuation is $99 per share, corresponding to a 2023 P/E ratio of 16x. It is also in the lower range of the historical valuation center. The current stock price has limited upward potential, and performance is also in a downward trend, so we still keep Meta as an observation stock.

(Regarding the valuation of VR and Metaverse businesses, only the valuation of hardware and basic content payments was considered. No assumptions were made regarding further commercialization after the establishment of the ecosystem. Thus the cash flow contribution was very low or even negative, and the DCF method may have some shortcomings. This is only used as a short-term conservative assumption for reference)

Historical Dolphin Analyst articles about Google Financial Reports (displaying only 2022)

October 26, 2022 phone call: "Short-term resource optimization, opportunities or reliance on search and YouTube (Google 3Q22 conference call summary)"

October 26, 2022 financial report review: "Google: Recession is approaching, the leader in advertising has fallen"

July 27, 2022 phone call: "Google: High economic "uncertainty" in the second half of the year, focused investment in areas with better long-term prospects (conference call summary)"

July 27, 2022 financial report review: "Google: A "tough turn in the road" in the face of expectations of a thunderstorm"

April 27, 2022 phone call: "Management avoids discussing TikTok, but competition intensifies behind the focus on Shorts (Google conference call summary)"

April 27, 2022 financial report review: "Google: Headwinds persist, the leader also struggles"

February 2, 2022 phone call: "Google actively seeks expansion by increasing investment and accelerating hiring (conference call summary)"

February 2, 2022 financial report review: "Performance shines, rare stock split, Google is going to take off again"

In-Depth

July 1, 2022: "TikTok wants to teach the 'big brothers' a lesson, Google and Meta are going to change"

February 17, 2022: "Internet Advertising Overview - Google: Sitting back and watching the storm rise"

February 22, 2021: "Dolphin Research: Google in Detail - Has the Restoration Market for Advertising Leader Ended?" On November 23, 2021, "Google: Performance and Stock Prices Are Soaring, Strong Repair Is the Main Theme This Year" was published on Dolphin Investment Research.

Historical Articles from the "Meta" section of Dolphin Investment Research

Financial Report Season (Only Displaying 2022)

October 27, 2022, Financial Report Review《 Despite Criticisms, Zuck Still Insists on Betting on the Metaverse (Meta 3Q22 Conference Call Minutes)》

October 27, 2022, Financial Report Review《 Headstrong Meta, Betting Big on the "Metaverse" Despite Hemorrhaging》

July 28, 2022, Conference call《 Macroeconomics, Apple's ATT, Competition, and Numerous Headwinds, Management's Short-term Outlook is Conservative (Meta Conference Call)》

July 28, 2022, Financial Report Review《 Meta's Slump Cannot Be Concealed Without Google-style Reversals》

April 28, 2022, Conference call《 Not Rushing to Commercialize Reels to Cope with Competition (Meta Conference Call Minutes)》

April 28, 2022, Financial Report Review《 Is the Breakthrough a Turning Point? The Rebound of Meta Is Yet to Come》

February 3, 2022, Conference call《 Can We Expect Reels to Drive Meta User Growth Again Like Stories Did Three Years Ago? (Conference Call Minutes)》

February 3, 2022, Financial Report Review《 One Disaster After Another, Facebook Becomes "God of Misfortune" After Changing Its Name to Meta》

In-depth

On July 1, 2022, "TikTok Wants to Teach the "Elder Brothers" How to Do Things, While Google and Meta Are About to Change" was published on Dolphin Investment Research. 2022 年 2 月 17 日《 Internet Advertising Overview - Meta: Low Combat Effectiveness is the Original Sin》

2021 年 9 月 24 日《Apple draws a knife, is the first giant to "see blood" Facebook?》

2021 年 8 月 6 日《Facebook: Digging Deep into the "Business Value" of the World's Number One Netizen Harvester》

2021 年 11 月 23 日《Facebook: After Spending a Lot of Money to Turn "Meta", the Turning Point is not Far Away After Double Pressure》

Risk Disclosure and Declaration of this Article: Dolphin Analyst Disclaimer and General Disclosure