The biggest news to come out of Facebook's (FB 0.75%) latest earnings report is its new reporting structure.
Starting in the fourth quarter, the company will divide its results into two segments, shedding more light on Facebook Reality Labs. The first segment is for its Family of Apps, including Facebook, Instagram, WhatsApp, and Messenger, which today represents the core of the business. The other is Facebook Reality Labs (FRL), the division that encompasses its augmented and virtual reality products or services. When CEO Mark Zuckerberg talks about the metaverse, he's talking about Facebook Reality Labs.
Facebook isn't just giving FRL its own line item. It's also plowing even more cash into the project, saying in the earnings call that the investment in Facebook Reality Labs would reduce operating profit by $10 billion next year. Only a handful of companies even generate that much in profit annually, so the fact Facebook is willing to spend that much on FRL, which is generating little revenue at this point, shows how strongly management believes in the metaverse opportunity. Zuckerberg believes it will be the next major computing platform.
But that $10 billion investment, which would equal roughly 20% of Facebook's 2021 operating income, underscores another important point: The ad business looks even better by comparison.
Image source: Facebook.
A digital gold mine
Currently, Facebook breaks out its revenue into two segments: advertising and other, which is largely made up of Oculus devices and Portal. The vast majority of its revenue comes from advertising. In the third quarter, advertising made up 97.5% of the top line, and though the other segment is growing much faster with sales tripling during the quarter, advertising is the core of the business and will remain that way for years to come.
However, Facebook didn't just flip a switch and decide to pour $10 billion into FRL in 2022. It has been building up to this moment. As of March, Facebook Reality Labs had nearly 10,000 employees, or about one-fifth of the company's total headcount. If one-fifth of employees are working in that division, it seems fair to assume FRL represents approximately one-fifth of the company's expenses, and Facebook's guidance for 2022 supports that theory.
Since Facebook Reality Labs is still a development-stage business at this point, that means Facebook's advertising business is several percentage points more profitable than it seems. After Facebook's post-earnings pullback, the stock is trading at a price-to-earnings (P/E) ratio of just 23, meaning the digital advertising business is valued at a P/E of around 19 when you back out the expenses connected to Facebook Reality Labs.
That's a great price for a business that just grew revenue 33% year over year with an operating margin that could top 40%.
What's next for the metaverse?
CEO Mark Zuckerberg made it clear it would be years before Facebook Reality Labs becomes a material business. Zuckerberg said on the call, "This is not an investment that is going to be profitable for us anytime in the near future," adding that he didn't expect it to become a business story until the later part of the decade.
For the next one to three years, he sees the company focused on building out the infrastructure and products in virtual reality and augmented reality as well as platforms related to social and commerce.
There's a lot of work ahead, but the company strongly believes the metaverse will be the next major computing platform after mobile, and it's motivated to be the leader in the metaverse, because many of the challenges it's experiencing today are because Apple sets the rules in the smartphone ecosystem. Zuckerberg alluded to this, saying, "Strategically, helping to shape the next platform should also reduce our dependence on delivering our services through competitors."
The company will share more on its push into the metaverse at Facebook Connect, the company's annual AR/VR conference, and fourth-quarter earnings will give investors their first look at the financials behind Facebook Reality Labs.
The metaverse bet may be a risky one, but Facebook investors are well-compensated to take it. In fact, it looks like they're basically getting it for free with the current price of the stock, and the payoff from this early-stage opportunity could be massive.
