For years, Meta Platforms (META 2.10%) had one of the strongest business models on the stock market. The company regularly generated operating margins in the 30% or even 40% range, while also delivering strong revenue growth.
However, by late 2021, the company faced multiple challenges. Apple's improvements to ad tracking transparency and user privacy affected the company's ability to target ads on social media. Revenue growth stalled as the post-pandemic reopening began, and user growth looked sluggish, again, due to the reopening as the revival of in-person business and socializing took place away from screens.
Additionally, CEO Mark Zuckerberg -- convinced that the company had to own the next computing platform so that it didn't get pushed around by Apple -- doubled down on the metaverse, renaming the company Meta Platforms, and breaking out its "Reality Labs" segment to show investors the impact of its metaverse-focused business.
Investors didn't like what they saw in that division, which lost more than $10 billion in 2021 and lost more than that in 2022.
That was a major reason why Meta stock crashed in 2022. It has since rebounded as Zuckerberg committed the company to efficiency, initiating several rounds of layoffs and reducing its costs in other ways such as slimming down its office footprint.
However, Reality Labs remains a money pit. It lost $7.7 billion through the first half of 2023, and the chart below shows how those investments and the maturing of the ad business affected the company.
Meta's ROIC declined sharply
As you can see from the chart above, Meta's return on invested capital (ROIC) has fallen sharply since 2021, when its advertising business was still booming.
This data, which comes from New Constructs, measures how ROIC compares to Meta's weighted average cost of capital (WACC). New Constructs defines ROIC as net operating profit after taxes divided by average invested capital.
The gap between the two metrics shows how much net return Meta generates on its invested capital. It's not a surprise that ROIC sharply declined in 2022 as operating income fell from $47.3 billion to $28.8 billion. Invested capital also rose as its net property and equipment balance increased from $57.8 billion to $79 billion, and total assets increased from $166 billion to $185.7 billion. The increase in the weighted average cost of capital seems to reflect the increase in interest rates over the last two years.
Thus far, in the first half of 2023, operating income has been essentially flat, while invested capital has increased modestly with an $8.4 billion increase in property and equipment.
Can Meta make the metaverse work?
Meta is fortunate to be in a position where it can offset the losses of Reality Labs with profits from its advertising division, but it's worth remembering that in addition to the lower operating profits due to Reality Labs, the increase in spending on infrastructure to make its metaverse project work is also likely eating into its ROIC. Investments in servers and networks make up a large percentage of its spending on property and equipment, and they provide essential infrastructure for its Quest devices and related software to function.
We should learn soon enough if its metaverse investments are paying off as Meta is set to launch Quest 3 next week.
Why ROIC matters for Meta
The strength in Meta's ad-based business model is evident in its high ROIC margins, but the decline in those metrics shows how the business has weakened as it's taken on more risk.
With the stock's surge this year, however, investors seem to be banking on a recovery in operating margin and ROIC.
There are already signs that operating income is moving higher as the company has taken a number of steps to cut costs this year, which should help lift ROIC.
A high ROIC has long been evidence of the strength of its advertising, the efficiency of the company's business model, and its ability to generate high returns. Look for return on invested capital to start expanding as the company tames its expenses and grows revenue.
