Can Snap Inc. Snap Back?

Summary

• SNAP’s first year as a public company has not gone well.
• Heavy short interest, market pessimism, and fears of competitors have darkened the picture.
• There have been some positive notes, including a vote of confidence from Tencent Holdings, app redesign, and integration of more advertising streams.
• Despite gettingbeaten down in 2017, SNAP has little prospect of being the phoenix of 2018.

Snap Inc. (NYSE:SNAP) has had a rough debut year on the public market. From the outset, an immature leadership team seemed unprepared for the rigors of quarterly performance reviews and the unrelenting scrutiny of stock analysts.

CEO Evan Spiegel has oscillated between apparent naivete and frustration at having to answer to shareholders and market sentiment. That has been a problem in the face of unrelenting criticism that has emerged since the company’s IPO.

Worse still has been the persistent financial underperformance and strategic miscalculations. The result has been a mounting short interest and intensely negative sentiment in the market.

Yet some analysts and investors feel the doom and gloom is overdone. Can SNAP snap back from the brink and deliver a turnaround story in 2018? Let’s see if we can find out.

The Boons of Low Expectations?

SNAP has repeatedly missed on earnings estimates, even as analysts’ predictions became more muted. Q3 2017 was no different, showing stagnant growth and a major overestimation of demand for its Spectacles glasses product.

The Spectacles debacle alone cost the company $40 million. User numbers were up just 3% and there was a 60% drop in advertising rates. Overall, it was not a pretty picture.

In the wake of the third quarter earnings bloodbath in November, in which shares fell as much as 22% in after-hours trading, SNAP promised a redesign of the app that would increase users and revenues.

With short interest so high and the market expecting only more of the same, any positive change could be seen as a comparative win. A well executed strategy of expectations management could see the stock turn around – or at least give it more of a floor from the bottomless pit it has been sliding into of late. Down 35% from its IPO price, some contrarians are starting to see an opportunity.

Tencent’s Two Cents

One interesting piece of information that emerged in November was the fact that Chinese investment giant Tencent Holdings had taken a 12% ownership interest in SNAP. The stock Tencent bought has no controlling power, hence it had no need to disclose its stake even to SNAP.

Some SNAP watcher saw the move as an opening gambit to gain influence in the company, but absent the voting rights or any statements about collaboration, the move for now seems to simply represent a belief that SNAP is undervalued. It is possible that Tencent anticipates SNAP get bought up by a larger tech player, or perhaps it feels as some analysts, including Barclays, do that SNAP has been beaten down a bit too harshly.

But no matter how big the vote of confidence, SNAP has to genuinely deliver in order to stop the bleeding. That now hinges on the redesign plan.

Redesign: What Can It Achieve?

The promised redesign does two key things:

1. It integrates a better sales algorithm that will allow it to place targeted content into users’ feeds, and to charge differential pricing – including premium pricing – for prime ad space in front of high value targets. This is meant to address the nagging problem of revenue growth and to optimize ad revenue from existing users.
2. A new Discover feature is the effort to jumpstart anemic user growth numbers. The function works by allowing users to explore content without being friends with particular users. Theoretically, this will expand usage and the attractiveness of the product to a wider audience, and make inroads with international markets.

Can the redesign achieve its promised aims? On the revenue optimization side, the better algorithm should indeed see improved returns. But that is still peanuts to the overarching problem: user growth. Q3 2017 saw just 3% growth quarter-on-quarter. For a tech company relying on a high-growth story, that is extremely bad news. The Discover feature may have some value in onboarding new users, but nothing about the redesign looks sufficiently new and innovative as to meet the mounting shortfall in user growth.

Competition Kills

Barclays’ latest research report on SNAP made the case that the company can find a way to coexist with the other big player in the photo-sharing social media space, Facebook’s (FB) Instagram. Comparing its potential future relationship with Instagram to the coexistence enjoyed by online travel companies Priceline (PCLN) and Expedia (EXPE), Barclays contends that SNAP can have its niche and not face destruction at the hands of Instagram.

That appears to be a naïve reading of the marketplace. While there is always competitive pressure in the online travel business – where price arbitrage is possible and monopolistic pricing models largely unstable and unsustainable over the long run – the same is not necessarily the case in the social media sphere.

Indeed, the preponderance of evidence suggests that the network effects of the social media ecosystem are sufficiently strong as to crowd out all but the strongest player in the end. Facebook did it to MySpace, and its Instagram seems set on doing the same to Snapchat.

And it is already happening: At the start of 2016, Snapchat’s new user enrollment was more than double Instagram’s. By August 2017, that lead had been eroded to nothing, and SNAP’s November earnings report shows the trend only worsening. Instagram already dominates the international market, and SNAP’s Discover feature seems unlikely to change that.

Exeunt Pursued by Bears

Despite being beaten down in 2017 and the continued pile-on of negativity, fundamental problems persist. Competition and anemic revenue growth, in particular, make it difficult to see how SNAP can truly turn things around. While 2018 may not be so savage a disappointment as its debut year on the public market, SNAP still has a lot to prove.

With a valuation of about 12 times forward revenue estimates, there is still a long way this stock could fall. It could do better, but investors would be prudent to give it a pass.

That burning smell isn’t from a phoenix rising. It’s from a dumpster fire.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.