On Oct. 27, image-sharing platform Pinterest (PINS 0.89%) reported financial results for the third quarter of 2022, and Wall Street loved it.
Stifel analyst Mark Kelley said that the company's results were "a rare bright spot thus far through earnings season," according to The Fly. Barclays analyst Ross Sandler was also impressed with Pinterest's 8% year-over-year revenue growth, considering how poor financial results were for other digital-advertising companies.
However, I believe Pinterest's Q3 report was a surprising step in the wrong direction. Here's why.
Pinterest's profit problem
If you look at its financial results from 2019 through the latest quarter (its time as a public company), Pinterest has nearly $1.3 billion in cumulative net losses. In Q3, its net loss was $65 million.
Net losses are common for technology stocks focused on growth. But this reality doesn't mean investors should indiscriminately look past the problem. Rather, investors should be distinguishing between truly bad business models and those in which there's a legitimate path toward profitability.
In Pinterest's case, it has made steady progress with its gross profit. In other words, the company has expenses that are largely fixed. And with more users and greater monetization, it's steadily generated more revenue without increasing its cost of revenue by the same amount. Therefore, the company made steady gross-profit margin improvement.
That is, Pinterest was improving until last quarter, the second quarter of 2022.
PINS Gross Profit Margin data by YCharts
As the chart above demonstrates, Pinterest commonly has seasonality in its gross profit -- certain quarters are better than others. However, the company was consistently improving on a year-over-year basis until Q2. In Q2, its gross margin fell to 75% from 79% in the prior-year quarter.
One quarter's results could be a fluke. But a second consecutive report starts a trend. In Q3, Pinterest's gross margin fell to 73% from 80% in the same quarter of last year.
Pinterest's management explained what's happening during its conference call with investors. CFO Todd Morgenfeld said, "We're investing in models to make product experiences more personalized and relevant for our users while also delivering improved ROI [return on investment] for our advertisers."
The company believes users will be more engaged with the platform as a result of these investments, allowing it to generate more revenue in the future.
Trouble ahead for Pinterest stock?
I want to be clear: Pinterest is in no danger whatsoever of going out of business. Pinterest is very well-capitalized, with nearly $2.7 billion in cash, cash equivalents, and marketable securities as of the end of Q3.
But I believe the gross margin deterioration does signal trouble ahead, and the stock's return could trail the market average. Over the long run, stock returns are driven by profits. In Pinterest's case, the stock is down more than 70% from its all-time high. I believe the culprit is not maintaining an upward trajectory on the bottom line.
To be fair, investing in growth is important for Pinterest.
Consider that the company is still somewhat early in its monetization journey. It only just launched ads in Argentine, Chilean, and Colombian markets during Q3. Ads are how the company makes money, so revenue will be coming in from those markets for the first time. Moreover, only last month did it start providing its trend-analytics tools to advertisers, which could also help it monetize its audience.
However, Pinterest's 8% top-line growth is its second lowest growth rate as a public company -- only the early days of the pandemic were worse. And management guided for only single-digit revenue growth in the fourth quarter.
If Pinterest's increased investments and spending boost revenue growth, it will happen at some unknown future point. The company doesn't necessarily need to be profitable on a net-income basis. But I believe it will need to show the market that it's on the right path before the stock can start delivering market-beating returns.
Therefore, I wouldn't buy Pinterest stock today on its Q3 report. I'll personally continue to hold my shares and watch financial results in future quarters -- but I'm not adding to my position. I'm looking specifically for either gross margin improvement, or for evidence that its higher expenses are paying off with user growth and monetization growth.
If Pinterest can demonstrate any of these things in future quarters, I'd consider buying more shares at that time.
