If you simplify a business down to its essentials, there's not much complexity. Money comes in at the top line, the costs of operating the business come out of that revenue figure, and what's left are the company's earnings on the bottom line. Social media company Pinterest (PINS 0.53%) has a unique model, but when you boil it down to the basics, it also has a potentially big problem. Here's what investors need to be watching closely today.
If you (get your users to) build it, advertisers will come
Pinterest is a platform where users can create online pinboards, for lack of a better term. They put up content that interests them -- largely links to photos and such that are hosted elsewhere. That, in and of itself, would not be a compelling business model since it generates no revenue. What turns Pinterest into a business is the advertising space it sells around the boards created by its users.
Image source: Getty Images.
It's a great concept in many ways. A user, for example, might be a fan of a certain style of shirt, and along those lines, they could create a list of apparel items that might be buyable or lead toward the direction of something that could be bought. As an example, think about something direct like a list of "top 10 shirt fashions for the summer" or indirect like "10 unique design ideas for the kitchen pantry." It wouldn't take much effort to put some relevant advertisements around such content since you know people viewing it are likely interested in shirts and kitchen pantry updates, respectively.
The key is to get lots of people onto the Pinterest site as both creators and viewers while building a robust advertising engine on the back end. In the fourth quarter of 2022, the company had 450 million active monthly users globally and generated $1.96 per user. The U.S. was by far its most profitable market, with 95 million users and an average revenue per user of $7.60 in the quarter. The fourth quarter was the high point for the year, which shouldn't be shocking given its retail-oriented model. Revenue will be inherently seasonal, generally peaking during the holiday season in the fourth quarter.
If you are an investor looking at Pinterest, you need to pay close attention to these numbers and their trends over time. For reference, its U.S. user count was flat year over year in the fourth quarter, but overseas growth produced an overall jump of 4%. Revenue per user, globally, was up a modest 1%. That's not terrible, but it's not exactly great, either.
The problematic middle
So the top-line figure here is pretty well defined, but the middle figure -- operating costs -- is where things start to get really troubling. In the third quarter, Pinterest's cost of revenue increased by 600 basis points year over year, going from 20% of revenue to 26%. In dollar terms, that amounted to more than a 40% increase. In the fourth quarter, its cost of revenue took a 400-basis-point jump to 27%. Inflation was running hot last year, but Pinterest's costs are rising fast for a company that doesn't actually operate physical stores or sell any physical products.
Its research and development costs increased 500 basis points year over year in the third quarter and 400 basis points in the fourth. Sales and marketing expenses jumped 700 basis points in the third quarter and 900 basis points in the fourth. And general and administrative expenses increased by 200 basis points in the third quarter and 200 basis points in the fourth. The increases in general and administrative expenses were fairly modest, but only compared to Pinterest's other cost increases.
This is not a small issue, because the company's adjusted earnings before interest, taxes, depreciation, and amortization (EBITDA) fell by a huge 62% year over year in the third quarter. And it declined by 44% in the fourth quarter. That's better, but certainly not good given that revenue was higher by 8% year over year in the third quarter and up just 1% in the fourth. Essentially, those huge increases in costs led to upsetting adjusted EBITDA declines. Earnings went from a profit of $0.15 per share in Q3 2021 to a loss of $0.10 per share in Q3 2022. In Q4 -- generally its seasonally strongest quarter -- earnings per share fell to $0.03 from $0.27 in the prior-year period.
Pinterest's rising costs represent a very real headwind that investors need to watch.
Not done yet
The company is still building out its business, and it needs to keep current with technology and consumer trends, so the fact that its expenses are running high isn't exactly shocking. Luckily, Pinterest has around $2.6 billion in cash and marketable securities on its balance sheet. But if it can't get its costs under control, even that may not be enough to keep it going over the long haul.
