Meta’s ad business is doing better than you think

Meta platforms(META -1.80%) shares fell 25% after its third-quarter earnings report last week. Revenue fell 4%, earnings per share were cut in half, and the tech giant lost nearly $4 billion at Reality Labs, its metaverse division.

Meta shares are already down more than 73% year-to-date on the pain of added revenue. But investors appear to be overreacting to at least one aspect of the report. Despite its lackluster performance, the ad business is in better shape than it appears, and a recovery in the ad business is key to helping the stock recover. Let’s take a closer look at what’s missing from the market here.

Image source: Meta Platforms.

A wide range of headwinds

Advertising growth has slowed for a number of reasons over the past year. An appleChanges to ad tracking appear to be the biggest reason for the disappointing growth, as the new policy made it harder to target ads. But the company also faces growing competition from TikTok, as well as a tough macro environment where businesses are pulling back on ad spending in anticipation of a recession.

The good news for investors, however, is that these challenges appear to be temporary.

While Apple’s ad-tracking transparency initiative isn’t going away, Meta’s leaders said the financial impact faded as iOS 14.5 rolled out in the third quarter of last year. CFO Dave Wenner said on the earnings call, “We’re not going to face such significant headwinds next year from a signaling perspective as we’re now dealing with the big changes made to the iOS platform.”

On the TikTok front, Meta has invested heavily in Reels, its TikTok-like short-form video feature, but has yet to fully monetize that offering. At the same time, Reels is creating a $500 million headwind as it draws attention from products like News Feed and Stories. However, Meta management said that Reels adds to the time spent on the platform and that Reels advertising has reached a percentage of $3 billion on Facebook and Instagram.

Management also said the impact from Reels will be more neutral over the next 12 to 18 months. And importantly, the company said it believes Reels is gaining time share from competitors like TikTok.

These macro headwinds do present a challenge that may continue over the next few quarters, but the economy is cyclical. Advertiser demand will eventually return. Meta experienced an accelerated version of this cycle during the pandemic, and demand for digital advertising also collapsed during the global financial crisis before recovering steadily.

Is Meta stock a buy?

After last week’s decline, Meta stock looks awfully cheap by traditional metrics. The stock is trading at a price-to-earnings ratio of less than 10. However, analysts expect the company’s earnings per share to fall 40% in the fourth quarter and see a decline of about 15% next year as well.

There’s also a wild card here in the form of Reality Labs. That business segment reported an operating loss of $3.7 billion in the third quarter and looks set to worsen next year — Meta has promised that operating losses at Reality Labs will widen significantly in 2023.

Meta expects to drive overall operating income growth after that as it controls costs in the metaverse segment, but the increase could come from a much lower base in operating income.

At this point, Meta’s ad business looks undervalued, especially since the headwinds are temporary. But the stock seems unlikely to recover until overall profits start to increase again, or until Reality Labs proves it has a viable business, which includes significant consumer demand for the headset.

Neither of these things seem likely to happen until 2024 at the earliest. That said, investors are best off waiting on the sidelines for now, as financial results seem likely to get worse before they get better.

Randy Zuckerberg, former Facebook CMO and spokesperson and sister of Meta Platforms CEO Mark Zuckerberg, is a member of The Motley Fool’s board of directors. Jeremy Bowman holds positions in Meta Platforms, Inc. The Motley Fool has positions in and recommends Apple and Meta Platforms, Inc. The Motley Fool recommends the following options: long March 2023 $120 Apple calls and short March 2023 $130 Apple calls. The Motley Fool has a disclosure policy.

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