Few stocks have been as hot as Meta Platforms (META -10.56%) in 2023. Shares of the social-networking giant have doubled in just four months, with the latest jump credited to its strong first-quarter results. However, when a stock doubles, investors need to dissect why it occurred and whether it's still safe to buy or even hold on to it.
I think there are some considerable warning signs that many are ignoring, and investors need to be aware of them so they don't get burned.
The metaverse is not benefiting Meta's finances
Formerly known as Facebook, Meta Platforms changed its name to signify its focus on the metaverse. While most of its business still comes from its Family of Apps segment (WhatsApp, Instagram, Facebook, and Messenger), Reality Labs (the metaverse division) is sinking the company's finances.
In Q1, Reality Labs only brought in $339 million in revenue, down 51% from last year. However, operating expenses rose within Reality Labs, increasing by 19% to $4.3 billion. That's right; Reality Labs' operating margin loss is 1,178%.
While I've seen some interesting business financials, the absurd economics of the Reality Labs division just doesn't make sense. When Meta has a cash cow like its apps, it gives the company a license to engage in seemingly unwise activities.
Family of Apps revenue rose 4% to $28.3 billion, impressive considering the challenging advertising environment. It also produced a solid $11.2 billion operating profit -- a slight decrease from last year. As a stand-alone business, the Family of Apps segment would be comparable to Alphabet (NASDAQ: GOOGL) (NASDAQ: GOOG), Google's parent company, because of its revenue's dependence on advertising. But because of Meta's ambitious metaverse plans, the stock began trading at a discount to Alphabet. Now, however, that's no longer the case.
META PE Ratio data by YCharts
When both companies were optimized for profits in mid-2019, each traded around the same price-to-earnings (P/E) valuation. However, with Meta's latest run, the stock is returning to the same valuation as in mid-2021 when it was consistently growing revenue at a 20% or better pace.
Today's advertising environment is much more challenging, interest rates are higher, and Meta's infatuation with the metaverse has only increased. Yet, the market thinks it's worth as much now as it was two years ago.
This seems like a massive warning sign, but is there something else investors are considering?
The year of efficiency
Since Founder and CEO Mark Zuckerberg dubbed 2023 as the "year of efficiency" for Meta, investors have gone all-in on the stock as they are getting what they wanted. By reducing the employee count by about 21,000 through three rounds of layoffs, Meta has taken steps to control its expenses.
Because of one-time expenses associated with layoffs due to severance packages, Meta took a $1.1 billion charge in Q1. Without it, Meta's operating margin would have been four percentage points higher, and earnings per share (EPS) would have leapt from $2.20 to $2.64.
That's a significant change, and it would help explain why Meta's stock is so highly valued. However, Meta's stock doesn't look as expensive if you utilize a forward P/E ratio (which uses projected earnings over the next 12 months).
META PE Ratio data by YCharts
So don't be fooled by looking at the trailing P/E ratio. Although rising costs and falling revenue in its Reality Labs segment is a huge warning sign, the stock has returned to a valuation level more consistent with its long-term average.
Because of that, the easy money has been made already, so investors need to be careful about adding to the stock at this point. But if Zuckerberg continues down his efficiency path, the stock will start to look more like its old self -- even with an absurd amount of money spent on its metaverse aspirations.
