Snap (NYSE:SNAP) came public on 3/2/17 amidst much hype and fanfare. Subscribers to Trader's Idea Flow received an IPO day trading call that earned a 10.3% one-day gain to the long side of the trade as we acknowledged the IPO momentum. We then issued our first of two short calls at $27.78 that has now earned a profit of about 28% since our initial short sale for subscribers about a month ago. We believe that there are further significant gains ahead on the short side of this trade.
Here are a few key risks that Snap investors should be aware of:
Snap is losing money, and it is losing lots of money. Snap is losing so much money at such a rapid rate that it almost resembles an early-stage biotech company where the cash "burn rate" needs to be monitored to keep watch for the company's ability to remain solvent. Snap lost $372.9 million in 2015, and this staggering loss exploded up to a loss of $514.6 million in 2016. Based upon company data, Credit Suisse (NYSE:CS) produced the graphic below with eye-popping estimates for losses in 2017. Please note that CS makes a number of liberal assumptions about future growth for Snap, but all we can really be confident of is that the losses for SNAP this year will be mind-boggling. CS's future estimates do not account for Snap's rising competition from Facebook (NASDAQ:FB), Apple (NASDAQ:AAPL), and Microsoft (NASDAQ:MSFT).
The size of Snap's losses is alarming. The rate of growth of these losses is of greater concern. And the company's admission in its pre-IPO S-1 filing that it "may never achieve or maintain profitability" is stunning. Perhaps of paramount concern is the fact that acquisition costs for new users and other costs of revenue are higher than the actual revenue generated by the company. Rising competition means that this problem may actually become worse. In a continuance of this business model, the company's chances to achieve profitability would never occur, and its ability to remain solvent could be called into question. Bloomberg's Shira Ovide took to Twitter (NYSE:TWTR) to voice this significant concern:
Of great concern for Snap's chances to achieve the rapid growth required to maintain the sky-high valuations of its current stock price is competition from at least three of the world's most formidable technology competitors in Facebook, Apple, and Microsoft. It is clear that key metrics such as Daily Active Users, or DAUs, are already slowing dramatically for Snap. This article will discuss the emerging competition that may further slow Snap's growth of key metrics or even cause growth to go negative. Snap is simply not achieving the rapid growth required to maintain the current sky-high valuations of its shares. In view of this actuality, the current share price is very likely to decline dramatically. The following graphic from ReCode demonstrates just how rapidly DAU growth has decelerated in recent quarters. And this deceleration was prior to Facebook adding numerous new features or the emergence of the Apple and Microsoft products that are now launching.
Please note that the addition of new Daily Active Users decelerated from 21 million in Q216 to only 10 million in Q316, and a stunning decrease to only 5 million new DAUs in Q416. At this rate of deceleration, it appears that growth of DAUs could actually go negative. This event would be disastrous for the valuation of Snap's shares, and current valuations for the stock appear to be oblivious of the fact that this rapid slowdown in growth has already begun in early 2016. There is currently an extreme dissonance between the reality of rapidly decelerating growth in one of the most important metrics at Snap of DAUs and the perception of the valuation on the stock price. The stock's current valuation is priced for very rapid growth while the entire foundation of the company's growth premise has already crumbled. The market will likely resolve this dissonance by assigning a more appropriate valuation to the shares at much lower prices.
The current valuation of shares is priced for perfection and very rapid growth. In fact, quite the opposite has already occurred at Snap with the rapid deceleration of growth in one of the key metrics, DAUs. This rapid slowing of growth is unlikely to allow the current overvaluation of the stock price to persist. And if growth continues to slow or possibly even goes negative, then the current share price may decrease to a fraction of its current value.
Of further concern is the question of credibility on the reporting of key metrics, such as DAUs. DAUs are a form of soft currency that Snap presents to advertisers to illustrate ad reach, thereby determining ad pricing. And DAUs have been presented to investors to indicate growth in this key metric, thereby affecting the valuation arrived at in the IPO and in the current price of the stock. But what accounting firm measures and verifies a key metric like DAUs? None. What party outside of the company is able to give investors a reliable measure to confirm the accuracy of the company's reporting on key metrics like DAUs? This question was raised prior to the IPO by a former Snap employee, Anthony Pompliano. Mr. Pompliano became vocal in his allegations that the company had in fact inflated key metrics prior to the IPO to induce investors to assign a higher valuation to Snap as an enterprise.
Snap initially attempted to keep the allegations filed by Pompliano in a lawsuit redacted and under wraps where investors and the public could not view the allegations. Pompliano's request to the court to have his case unsealed was granted, and this bombshell was released today, Tuesday 4/11/17. The Pompliano allegations may have a degree of legitimacy to them. In fact, the allegations appear to have merit. If this is accurate, then this initial lawsuit will throw the doors wide open for a series of class action lawsuits. In fact, it is possible that these class actions may already be in progress.
In light of the possible legitimacy of the Pompliano allegations that are corroborated by the rapidly decelerating DAUs during the past several quarters at Snap, Trader's Idea Flow wants to ask the following inane, but highly relevant questions:
Who sits in their cubicle daily and counts DAUs at Snap? More importantly, who sits in their cubicle and counts DAUs independently from Snap?
The algorithm that measures DAUs at Snap is subject to the old acronym GIGO, Garbage In Garbage Out. Meaning that if the algorithm for counting DAUs is tweaked favorably towards increasing the number of DAUs, then that is what will be reported to advertisers and investors. Possibly, there are many number of other means of inflating of the numbers for DAUs. The following graphic shows an initial count of 294 million DAUs, but if the users are responsible for two snaps per day, then the actual number of DAUs is half or 147 million. Accordingly, if the same users log 10 snaps per day, then the actual number of DAUs is only a fraction that is one-tenth of the original number for DAUs or just 29.4 million. So the temptation by a company to inflate a soft-currency metric like DAUs that is difficult for independent parties to ascertain would certainly exist. Mr. Pompliano alleges that this is exactly what has transpired at Snap.
In any case, the rapid deceleration of user growth is now being highlighted by the unsealed Pompliano court documents earlier today on 4/11/17. Shining a bright light on this false premise that has been crucial to the current valuation of the stock began to negatively impact Snap's shares today and the stock may continue to decline in future sessions.
The following quote coming from IPO Candy references Snap's "hope" that it can innovate to come up with new products to stay ahead of better capitalized competitors with more established R&D programs. This hope by Snap is vague at best and a huge risk for investors.
Most investors now realize that the historical Snap business is now being eaten by Facebook.
Snap's shares are currently priced for perfection, which is absurd considering all evidence points to a slow motion train wreck that is already in progress. The current business model and rising competition could make it highly unlikely that Snap can reverse its slowing growth. The current valuation on the stock requires the company to achieve rapid growth in key metrics to justify the current price. Recent results have indicated that this required growth has actually been slowing. The existing and emerging competition from Facebook, Apple, and Microsoft make it highly unlikely that Snap will be able to reverse its trend of slowing growth. Candidly, Trader's Idea Flow believes that in no possible world will Snap's near-term results justify the stock's current valuation or any move to profitability.
Seeking Alpha fellow contributor Mantas Skardzius does an excellent job discussing the sky-high valuations being carried by Snap's stock price. In his prescient article, "Snap Among The Priciest Tech IPOs Of All Time," Mr. Skardzius discusses several key metrics that demonstrate how high valuations at Snap are now priced. The following key metric of Price To Sales Ratio for Snap illustrates the current overvaluation relative to the other priciest tech IPOs in history:
Price To Sales Ratio: When companies have financial losses instead of earnings, then there can be no Price To Earnings Ratio, or P/E Ratio. For money-losing companies, the Price To Sales Ratio, or P/S Ratio, is often used as a metric of valuation. The higher the P/S measurement, the higher the risk level for the investors holding the high P/S stock. Shares of Snap are trading at a P/S ratio that is close to 60. This is an egregious valuation that carries an extreme amount of risk, which no investor should blindly be exposed to without understanding completely the highly dangerous nature of their investment. And I hesitate to even use the word "investment." Owning shares of Snap at current prices is gambling, plain and simple, with all of the odds stacked against you. Please note that in the Investopedia link above for Price To Sales Ratio that in the examples given by Investopedia to explain P/S, the ratio is 1.92 in one example, and 2.2 in the second example. Compare the P/S valuations in the Investopedia example with the P/S ratio of nearly 60 that is currently assigned to Snap. This stock currently trades at an absurd valuation relative to historical standards.
A warning note to take extreme caution: Investing in companies that are losing money should pose a concern in the minds of all prudent investors since the risks are seriously elevated for these money-losing stocks. But when the P/S valuation of a money-losing stock is egregiously high, the risk of holding that stock becomes suitable only for those who can afford to lose all of their money placed in that investment. I became licensed as a stockbroker in 1986 and understanding the "know your client rule" was mandated by the regulators at the NASD, the forerunner to today's regulators at FINRA. I later became a Series 24 Supervisory Principal who supervised other brokers, so I am familiar with the know your client rule's suitability for investment requirements. The point here is that an investment in a money-losing, extremely high P/S Ratio stock like Snap would only be suitable for investors who are able to sustain a 100% loss of their capital invested in a stock like SNAP. Shares of Snap are among the riskiest of the risky stocks.
I bring up this important point because the media has made much of the fact that many less experienced, millennial investors have purchased this extremely risky stock in the aftermarket since this overvalued IPO came to market. When I was a broker and supervisory principal, we simply would not accept orders to purchase stocks like Snap. No matter how adamant an investor became about purchasing shares of a stock as risky as Snap, we simply would not accept the order. We missed out on some commissions up front, but we earned the trust and loyalty of our customers after they later saw most of these high-risk stocks plummet to much lower prices. Snap is highly likely to become one of those risky stocks to trade much lower.
Here is the graphic from Mr. Skardzius's article that demonstrates the absurd overvaluation of Snap's shares based upon the P/S ratio relative to the other most overvalued tech IPOs in history:
The above graphic showing Snap's egregious P/S ratio that is close to 60 illustrates why any comparison with Facebook's successful stock performance (after an initial post-IPO dip) should be immediately dismissed. No reasonable investor should believe that Snap's valuation and future stock performance will be anything close to what Facebook achieved simply because the current sky-high valuation of SNAP leaves no room to move higher. Facebook's financial results were much stronger, and its valuation using the P/S Ratio was 1/6 of Snap's current valuation. In fact, many investors believe that Snap's valuation could be reduced to 1/6 of its current price in the future. This would value the stock below $4 per share. This is the kind of risk that Snap investors should understand they are exposed to at current valuations. Investors in Twitter learned this lesson the hard way, and Snap's valuation problem is far worse than Twitter's situation was even at its peak price.
Cash flows: This metric is an essential measure of valuation. Negative cash flows call into question the ability of a company to remain solvent in the future. Snap's losses are staggering, and in the company's filing of its S-1, it admits that it "may never achieve or maintain profitability." This pronouncement should not be dismissed or taken lightly. Snap's ability to survive in the long term will be tested by rising user acquisition costs, an endless rise in the R&D spend to try to stay ahead of better capitalized competitors, and a myriad of other expenses required to grow the company. There is no end in sight to Snap's huge losses based upon the current trajectory of growth in both revenues and expenses. Snap has acknowledged this serious concern in its SEC filing prior to the IPO, which was required by regulatory mandate.
The following graphic also from Mr. Skardzius's article illustrates Snap's dismal financial performance relative to the other most pricey tech IPOs in recent decades. Snap's negative cash flows are in a class of staggering losses all by themselves. Snap has already indicated that losses will increase dramatically in 2017. It is hard to imagine the price of Snap's shares maintaining current valuations, as the upcoming earnings reports announce record losses of staggering proportions.
The following graphic further illustrates the stark contrast between the pre-IPO financial performance of these three distinct companies:
Investors would be prudent to take measure of the risk in this stock. Snap is losing large amounts of money. The company has stated that it has no pathway to profitability. Its current valuation is egregiously high at a P/S ratio of nearly 60. And we are about to discuss the increasing competition for Snap that is rapidly emerging from some of the largest, most successful technology companies in the world.
Facebook competition: It seems that Facebook launches new features to directly compete with Snap products regularly. The latest attack by Facebook upon Snap was announced today on 4/11/17, and it comes from Instagram's Direct that now enables disappearing messages. Directly competing products from Facebook have corresponded with the marked slowdown in DAUs at Snap in recent quarters. Facebook's developer conference F8 takes place April 18-19 in just one week. We may get insight into further products designed to compete with Snap.
Apple competition: Clips will attack Snap from additional fronts because it is well known that the Snapchat platform has been designed to prioritize the iOS platform. Snap acknowledges that a very large number of users on the Snapchat platform are iPhone customers. The makes Snap especially vulnerable to the emergence of competition from Apple as the Clips launch finds traction in the marketplace. The Apple competition for Snap may have the potential to deliver a devastating blow to future growth of users and revenues for this recent IPO.
Microsoft competition: Sprinkles is clearly targeting the same youth demographic in which Snap is trying to maintain its tenuous position. The Microsoft product is incorporating AI features, which are considered to be the "next big thing" in social media platforms. It is doubtful that Snap can match the long-term R&D spend and engineering acumen of more well-capitalized firms like Microsoft, Apple, and Facebook. After just being launched, Sprinkles already threatens Snap as it could be the next bright-shiny object that motivates the fickle and transient youth demographic to discard Snapchat and migrate to a "cooler" platform at Microsoft that incorporates AI features.
Conclusion: The competition that is now emerging for Snap is formidable. The already slowing Daily User Growth metric is likely to continue to experience further losses of market share to the likes of Facebook, Apple, and Microsoft. With shares priced for perfection with a P/S of nearly 60 currently, there seems to be a disconnect between the reality on the ground for Snap's rapidly slowing growth in DAUs and the stock price that requires rapidly increasing growth to justify its current lofty valuation. Trader's Idea Flow believes that Snap's shares will be more fairly valued in the single-digit price range by the end of year 2017.
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Disclosure: I am/we are short SNAP.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.