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Quarter-End Insights

Meta, Netflix Drag Down Communication Services

Investors can find undervalued stocks in every subsegment.

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Following a weak 2021, communications stocks as a group continue to lag. The Morningstar US Communication Services Index has declined about 12% year to date versus a 5% drop for the broader market. The market has soured on two large firms recently—Meta Platforms (FB) and Netflix (NFLX)—driving most of the sector’s underperformance. While both firms face weakening growth, we expect these stocks to head in different directions.

Exhibit 1: Meta and Netflix have led the sector lower thus far in 2022.

Chart comparing the performance of communication services index and broad equity index.
  - source: Morningstar

Exhibit 2: Each communications segment now offers opportunities.

Bar chart of star ratings by communications subsector.
  - source: Morningstar

Meta provided a weak first-quarter revenue forecast in February, creating concerns that data privacy rules changes, especially at Apple (AAPL), and increasing competition from TikTok have permanently weakened the positioning of Facebook and Instagram. While these issues will create headwinds, we don't believe investors appreciate how thoroughly Meta dominates online social-media ad spending.

Exhibit 3: Meta's Facebook and Instagram dominate social-media ad spending.

Bar chart showing social-media ad spending by platform.
  - source: Morningstar

We like the niches smaller firms like Pinterest have created, but Meta's network effect is truly remarkable, with nearly half the world's population logging into Facebook or Instagram at least once a month. The gravitational pull of these networks is nearly impossible to escape, and Meta has shown that it can effectively counter features found on other networks to keep consumers engaged. 

The firm developed Stories to take on Snap five years ago, launched Reels in 2020 to match TikTok, and is now taking steps to monetize the feature. Meta's dominance leaves it open to regulatory challenges, but we continue to believe these issues are manageable as well. We believe the stock is deeply undervalued.

As for Netflix, the firm announced in January that it expects to add only 2.5 million net new customers during the first quarter, which would mark the lowest since the firm began disclosing streaming customer metrics more than a decade ago. While Netflix remains the world's largest streaming platform, its dominance is under threat.

Exhibit 4: A variety of firms are rapidly gaining on Netflix (subscribers in 000s).

Bar chart showing the number of subscribers for streaming platforms.
  - source: Morningstar

Most major media firms are now drawing on their extensive legacy libraries and sports rights to increase the appeal of their streaming services. Industry rivalry looks to take another step up in 2022: Comcast's (CMCSA) NBC Universal plans to double Peacock content spending this year, Paramount (formerly ViacomCBS) plans to triple annual streaming content investment through 2024, and Warner expects content costs to peak in 2022 as it merges with Discovery (DISCA). While the drop in Netflix shares has made its valuation more palatable, we believe the market is still slightly overoptimistic given the escalation in competitive pressure.

Top Picks

Meta Platforms (FB)
Star Rating: ★★★★★
Economic Moat Rating: Wide
Fair Value Estimate: $400
Fair Value Uncertainty: High

Meta remains well positioned, as its core advertising business (via Facebook and Instagram) continues to perform well, producing nearly 50% operating margins. The impact of lower ad prices, mainly from short-form video ads as Meta monetizes its TikTok-like Reels feature and Apple's iOS changes, will pressure ad revenue growth, we expect these pressures will be short-lived. Meta’s network effect remains intact, and user monetization continues to grow while other opportunities like commerce await. Meta's large user base should continue attracting advertisers as the firm utilizes more of its own user data to offset Apple's changes.

AT&T (T)
Star Rating: ★★★★
Economic Moat Rating: Narrow
Fair Value Estimate: $35
Fair Value Uncertainty: High

We believe AT&T management is putting the firm back on the right path, bringing a much-needed telecom focus and rebuilding the brand's image among consumers. We expect the wireless business to deliver consistent growth, allowing cash flow to remain solid after the Warner spinoff. Increased fiber investment should also provide revenue growth and some differentiation versus cable and wireless rivals. We believe HBO Max has built strong momentum that will solidify its place in the living room as Warner joins with Discovery. Even with the dividend reduction, we expect the stock will deliver a 4%–5% yield.

Disney (DIS)
Star Rating: ★★★★
Economic Moat Rating: Wide
Fair Value Estimate: $170
Fair Value Uncertainty: High

Disney remains the best-situated traditional media firm to navigate the transition to streaming, in our view. The firm's deep content library, teeming with major franchises, and its strong studios provide both the more family-friendly fare Disney is famous for and content suited to older audiences. We expect that fans will continue to flock to the firm's parks and resorts as pandemic restrictions lift. The cable networks, like ESPN, may continue to lose subscribers, but they generate cash flow to fund the firm's streaming ambitions, including platforms like Hulu and ESPN+ that will gradually displace traditional cable.

Michael Hodel does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.