Is Zuckerberg's Metaverse Spending Out of Control?

Meta Platforms (META -0.04%) is going to keep spending billions of dollars developing its virtual and augmented reality products, and some people are not happy about this.

The company's Reality Labs segment, which is dedicated to advancing the metaverse, will account for about 20% of the tech giant's total expenses next year, according to CTO Andrew Bosworth. That's up from about 18% in the third quarter. The news follows a scathing blog post from former Oculus CTO John Carmack following his resignation criticizing the division as extremely inefficient.

Meanwhile, Meta's core advertising business is struggling following several changes in the industry. Without the cash cow of digital advertising continuing to grow, should Meta cut back on its spending on Reality Labs?

The pressure for profits is on

Meta is far from the only company facing pressure to make its business more profitable.

As economic uncertainty has led many advertisers to pull back ad spend and consumers to carefully consider their purchases, everyone in media -- traditional, digital, social -- is facing pressure on their revenue and profits. Meta's Family of Apps has seen its operating income decline 22% through the first nine months of the year.

Meanwhile, the losses at Reality Labs have gotten bigger. Operating losses totaled $9.4 billion for the first three quarters of 2022, up from $6.9 billion in 2021. The segment's total operating losses since 2019 now total more than $30 billion.

To be sure, Reality Labs is a massive bet on the future of computing. And all the company has to show for it right now are a few devices with around $5 billion in cumulative sales and a social platform that's struggling to build a user base. In October, the company had to slash its internal expectations for Horizon Worlds, the company's flagship metaverse offering for Oculus device owners, from 500,000 users by the end of the year to 280,000.

Without much it can show investors in the way of breakout successes, it's not surprising many are thinking the company should cut spending on the segment considering how little revenue it generates. But that could be a mistake.

What's behind the scenes

There's a lot of things Meta's working on in Reality Labs that aren't ready for release to the public yet.

Specifically, Meta's working on augmented reality (AR) hardware and hands-free controls. Both will be significant leaps forward in the space, and not many other companies are in a position to invest at the same level as Meta.

Investing now will increase the likelihood that the company will remain a factor as adoption of virtual reality (VR) and AR technology increases. That way it doesn't face the same challenges it faces today with building software for other company's devices. "It's not just about fortifying against outside threats," Zuckerberg said on Meta's Q3 earnings call. "A lot of this is just [that] you can build new and innovative things ... when you control more of the stack yourself."

But investors should keep in mind that this is an investment for the long run. Zuckerberg said earlier this year that messaging apps like WhatsApp present a bigger near-term revenue opportunity than Reality Labs.

Is it spending too much?

Apportioning 20% of all expenses to an experimental business may seem aggressive to some investors. That could be $18 billion to $19 billion next year.

But Meta has the balance sheet and operations to support it. It has over $31 billion in cash and marketable securities as of the end of September. What's more, it's generated over $13 billion in free cash flow through the first nine months of the year. And it's not like it's an unprofitable start-up building toward a future of positive earnings per share (EPS) that may never come. It generated $10.50 in EPS over the last 12 months despite the slowdown in the ad business and increased losses at Reality Labs.

Perhaps, however, Carmack's comments and the growing pressure on profits in the Family of Apps business will force Zuckerberg, Bosworth, and company to be more mindful of their spending. Ideally, the 20% figure acts as a constraint that puts the focus on projects that have high expected value. The VR/AR opportunity is massive, and it requires a massive investment, but that doesn't justify spending on every single idea.

Investors optimistic about the future of VR and AR should recognize Meta as a leader in the space and applaud management's efforts to remain committed to investing in the space despite the downturn in the other parts of its business.