It seems like just yesterday that a video went viral showing Meta Platforms' (META 0.61%) CEO Mark Zuckerberg putting his metaverse ambitions on full display. At the time, the prospects of the metaverse carried some allure, but investors quickly soured on the concept as Meta got a tad overzealous about its new pursuit.
The company invested aggressively in its metaverse-related ambitions, which led to a rise in headcount rise and a big rise in expenses. Even worse was, that by trying to grow too quickly, the company lost focus on its main revenue source: advertising. As its core ad business took a hit and expenses ballooned, the obvious byproduct was shrinking profits. The company eventually responded with a meaningful cost-reduction period driven mainly by layoffs.
The last few quarters contained a lot of bright spots for Meta and the stock rallied, but its Q3 earnings report was somewhat mixed. While its near-term outlook looks cloudy, investors may find that its long-term prospects can weather the impending storm.
The quarter was good, but not great
Meta derives revenue from two sources: its "family of apps" segment and its "Reality Labs" segment. The family of apps business generates revenue in the form of ad sales from Meta's social media properties including Facebook, Instagram, and WhatsApp. Reality Labs is the operating segment for Meta's hardware devices business, which today includes its virtual reality (VR) headsets. Advertising provides the lion's share of Meta's total revenue, accounting for 98% to 99% in any given quarter.
In the third quarter, Meta's advertising revenue grew 23% year over year. Initially, this looks like a cause for celebration. Meta's advertising revenue only grew by about 4% and 12% during Q1 and Q2, respectively.
Management attributed some of this growth to the generative AI features that Meta is rolling into its ad services. The mission here is to help advertisers generate higher returns on spending across Meta's family of apps by better targeting their campaigns. While it's still early, the initial results from these efforts look promising. For example, Meta's average revenue per person (ARPP) across its family of apps was $8.71 in Q3. This was its highest ARPP since Q4 2021.
In addition to progress on the revenue front, Meta continued to grow its free cash flow. Reporting $13.6 billion of free cash flow, a level not seen in nearly two years, Zuckerberg wasn't exaggerating when he referred to Meta as a "leaner organization."
Given that it displayed such a strong financial profile, why was the quarter worrisome? Well, after getting investors excited about its return to growth, management tempered the mood with some eyebrow-raising guidance.
Image source: Getty Images.
Advertising spend can be fickle
Meta guided for Q4 revenue to be in the range of $36.5 billion to $40 billion. Although this would amount to roughly 24% year-over-year growth at the high end of the range, the details around this estimate made for some discomfort.
On the geopolitical side of the equation, management spent some time speaking about the current situations in Ukraine and Israel. Meta CFO Susan Li made it clear that neither of these situations has impacted the business in meaningful ways. However, perhaps in an effort to express some caution and forecast conservatively, she tried to express that cross-border affairs can lead to periods of "uncertainty."
The broader point to keep in mind is that given how highly correlated advertising is to retail, ad spending can be cyclical. For this reason, it's difficult to predict how advertisers will allocate resources (i.e., budgets) from season to season. Furthermore, given the impacts inflation and high interest rates have had on consumer spending, advertising dollars are more precious than ever. Then, when you layer on the amount of competition Meta faces from platforms such as Alphabet, Snap, Pinterest, or TikTok, the equation becomes far more complex.
Should you let the past be the past?
There are numerous ways to value a stock. My fellow Fool contributor Keith Speights recently wrote a fantastic piece on Meta stock. By his analysis, Meta trades at a meaningful discount to its big tech peers based on its price/earnings-to-growth (PEG) ratio. While I am a fan of the PEG ratio, its obvious shortcoming is that it is highly sensitive to estimates about a company's future earnings power. Stated differently, if reality ends up being much different than analysts' forecasts, then the multiple is less useful. The problem is that you don't have any way of knowing that until later.
META PE Ratio (Forward) data by YCharts.
I've decided to look at Meta stock in a couple of different ways. First, the chart above benchmarks it against its Magnificent Seven cohorts -- Microsoft, Amazon, Alphabet, Tesla, Nvidia, and Apple -- on a forward price-to-earnings (P/E) basis. Investors can easily see that Meta's forward P/E of 22.3 is the lowest in this peer set. Interestingly, the next lowest name on the list is Alphabet -- another business heavily reliant on advertisers.
META Price to Free Cash Flow data by YCharts.
This chart tracks Meta's stock on a price-to-free-cash-flow basis over the last decade. Despite the company's return to double-digit percentage revenue growth and disciplined cost structures, that yield consistent free cash flow in the tens of billions of dollars, Meta stock still trades 65% below its prior highs by this metric.
What's the investing advice on Meta?
To me, there are a couple of factors in play here. First, Meta stock has risen by more than 160% so far this year. It's not unreasonable for investors to expect that a cooling-down period is due. Second, as artificial intelligence (AI) becomes more of a talking point, it's also appropriate for investors to begin questioning which companies will really emerge as AI leaders. For now, it's likely too early to know for sure which companies will dominate the AI arena for the long term. Moreover, with macroeconomic conditions very much in flux, businesses such as Meta that are more exposed to consumer spending may give investors some trepidation.
I'm not a fan of overthinking in life or investing. I would not be focusing on the near term. It's too hard to know how Q4 or next year will pan out. Management made that pretty clear with its references to the complicated issues in Europe and the Middle East. The bigger question for long-term investors is whether or not they believe that Meta will win out over its competition. Or, at a more granular level, do you believe in the company's artificial intelligence (AI) roadmap as well as its metaverse plans?
I personally viewed Q3 as a big win for Meta, and I'm cautiously optimistic about how it will fare in Q4 relative to its peers. The company has deep pockets, and it's pretty obvious how it plans to allocate its capital. With the stock trading at such a steep discount relative to its peers on a forward P/E basis, I think the investment thesis becomes more compelling. Meta is a proven leader in advertising and has held its own against Alphabet for some time -- all while crushing smaller platforms like Snap. The company's strong liquidity profile combined with the overall track record of Zuckerberg and his team gives me enough reason to believe that its AI and metaverse visions can be achieved. I'd be a buyer of Meta stock at these levels, and I'd be ready to double down over a long-term horizon.
