Metaverse upstart and parent company of Facebook, Instagram, and other social and communications platforms Meta Platforms (META -0.43%) just announced plans to reduce its workforce by 11,000 people. These job cuts amount to 12.6% of its 87,000-plus workforce at the end of the third quarter.
The layoffs come after a series of weak earnings reports over the past year. Apple's moves to increase user privacy have had a serious impact on Meta's ad business, and the macroeconomic environment has compounded the problem. On the day of the announcement, shares of Meta climbed almost 8% in morning trading, with investors glad to see the company taking steps to cut costs.
But is this move really a sell sign in disguise? There's reason to believe Meta's ad business has been permanently devalued, and the billions of dollars being spent on the metaverse may not generate the returns bulls are counting on.
How we got here
The past year has been challenging for Meta. At its core, the company is an advertising platform, and it depends on high engagement from users on Facebook, Instagram, Messenger, and others to drive ad sales. And up until about a year ago, Meta's value to marketers was juiced by its ability to track users' online activities even when on other websites or other apps. However, Apple undermined much of that value, changing from an opt-out model to an opt-in model, meaning the default setting on Apple devices now does not allow Meta and other apps to track users without explicit consent.
This almost immediately made ads on Instagram and Facebook less valuable, and we've seen this play out in real time as the average revenue per user (ARPU) that Meta's apps earn has fallen. This has occurred even as active daily and monthly users have held steady and even increased modestly. In other words, Meta is almost certainly earning less revenue per ad today than it was a year ago.
The reality is more complicated than "Apple did it." Chances are, the macroeconomic environment has also hurt ad revenue and ad values.
At the same time, Meta's expenses have continued to rise. Costs of sales and expenses increased 24% in the first three quarters of 2022, even as revenue stagnated.
Cost-cutting has become necessary (sort of)
The bulk of those increased expenses has been the result of founder and CEO Mark Zuckerberg's focus on Reality Labs, the company's metaverse division. So far this year, Reality Labs has generated more than $9.4 billion in operating losses on $1.4 billion in revenue. That $9.4 billion operating loss represents 80% of Meta's $12 billion increase in operating expenses so far this year.
And looking ahead, Meta will continue to spend billions of dollars on Reality Labs. In the same SEC filing that disclosed the staffing reduction, the company wrote, "We continue to anticipate that Reality Labs operating losses in 2023 will grow significantly year-over-year."
For context, Reality Labs' operating loss was $12.7 billion over the prior four quarters, but is on a $14.7 billion operating loss run rate based on the third quarter.
Combined with the weakening ad business, the result was operating income of $5.7 billion. On the surface that might sound good -- and it is a big number -- but it's down by half from the year-ago quarter.
Where the rubber meets the road: Cash flows
Meta's ad business is weakening; part of that is the temporary impact of the macro environment, but Apple's privacy moves could prove to have a lasting impact. At the same time, there are more and more new digital and programmatic ad options becoming available every day. Meta's ad business may never again be as powerful as it was at its peak.
Zuckerberg and team clearly see this reality and have hitched the Meta wagon to the metaverse. And it's costing a lot of money. Meta's free cash flow fell to $173 million in the third quarter, down 97% from its weakest quarter in at least two years.
And heading into 2023, those cash flows could shrink even more. We know operating losses at Reality Labs are going to increase, and cutting $1 billion to $2 billion in expenses related to these layoffs doesn't come close to bridging the gap in its weakening ad business.
In other words, Meta could be increasingly funding Realty Labs from its balance sheet, not operating cash flows. Working capital has already decreased by $10 billion so far this year, and capital spending is going to be high again in 2023 along with higher operating expenses.
It's also worth noting that even after these layoffs, Meta will still have a larger workforce than it did at the end of 2021.
Here's where investors need to evaluate what to do
As a result, investors should be very careful when considering Meta. It may trade for single-digit earnings multiples right now, but it could also prove to be a value trap as increased spending on Reality Labs and deteriorating ad revenues burn more and more of the cash on the balance sheet, with no promise of future returns.
Today, Meta has become a turnaround play. Turnarounds are hard, and at this point, we have little evidence that the billions Meta is spending on Reality Labs will result in future returns. For some investors, that uncertainty about its future could mean selling Meta is the right move. If you believe in the turnaround, and can stomach more volatility and future losses, there's also a case to buy. For most investors, the smart move right now is to let things play out, both in the ad business and at Reality Labs.