Snap: A Turnaround Is Here

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About: Snap Inc. (SNAP)
by: MangoTree Analysis
Summary

Snap's Q4 release sparked a one-day run-up of ~27%. My call on an upward surge in Snap shares was accurate.

A top and bottom-line beat reported, with non-GAAP EPS nearing a break-even.

Gross margins are the number to watch, with gross margins hitting 48% in Q4. While this is meaningfully lower than say Twitter or Facebook, the upward trend is forming.

In the next 6-12 months, the focus should turn from Snap's ability to grow its ecosystem to its ability to better monetize its ecosystem. This could be similar to Twitter in 1H'2017.

Reiterating HOLD rating. Price target raised from $7 to $9 off lower loss expectations. Expecting FY profitability and free cash flow in 2022.

Another Strong Quarter From Snap

As of writing, Snap (NYSE:SNAP) shares are rising a staggering 26%. Here are the results:

Actual My Expectation Consensus Expectation
Revenue $390 million $381.1 million $378 million
EPS (non-GAAP) -$0.04 -$0.07 -$0.08
ARPU $2.09 $2.06 $2.05
DAU 186 million 185 million 184.26 million

Across the board, particularly with profitability, Snap beat both my expectations and consensus expectations. In my last couple of articles on Snap, I believed the stock would have substantial upside short term, with the stock moving to $8-9 short term. Sure enough, the stock closed at $8.59 (sorry, I had to take a victory lap). In the short term, there is not much of a limit to Snap's price action. In my view, between here and the next quarterly report, we could get a jump to $10.

That being said, I am reiterating my "hold/neutral" rating on the stock for the next twelve months, but I am raising my target from $7 to $9.

Now, let's talk about Snap's guidance:

  • $285-310 million revenue (for Q1)
  • EBITDA loss of $140-165 million (for Q1)
  • "cautiously optimistic" and "do not foresee a sequential decline in daily active users in Q1 2019".

With regards to their revenue guidance, the midpoint of their guidance ($297.5 million) came in shy of the consensus expectation for $307 million. With regards to their EBITDA loss guide, the company posted better than expected results. The midpoint of this guidance implies an $0.11/share loss, whereas the Q1 expectation was for a $0.13/share loss.

Snap did not provide an FY'2019 guide.

Conference Call & Earnings Slides Notes

Earnings Slides:

In Q4 2018, our iOS DAU increased both quarter-over-quarter and year-over-year, and average time spent on iOS grew faster during Q4 2018 than during Q4 2017.

In Snap's earnings slides, they noted that their iOS DAUs increased on a Y/Y basis, meaning the negative offset that led to the overall flatness came from Android. If you believe that Snap's Android redesign is coming, and that it will be effective, than a growing Android, coupled with a growing iOS, will further help Snap's overall financial results as well as their user growth results. On top of this, Snap notes that their time spent on the platform is growing, with a reported acceleration in Q4 of 2018 versus Q4 of 2017.

We reached over 70% of the total 13 to 34 year-old U.S. population with premium mobile video ads on a monthly basis.

This line shows the scale and reach Snapchat has within the younger Generation Z and the millennial community, despite Instagram's continued expansion. Snap's relevance amongst the youth should bode well once these consumers further their purchasing power over the next several years.

We began to roll out our new Android application and early test results are promising, especially on less performant devices, including a 20% reduction in the average time it takes to open Snapchat.

Snap is beginning to roll out their updated Android app, and the results are already showing performance improvements, even with simple tasks like opening the app itself. If iOS has a strong trajectory, then once Android is fixed, and is fixed for good, DAUs should move much higher. Snap's updates on Android progress will be essential in terms of their overall DAU number.

The Conference Call:

My notes for the conference call include notes from management's opening statement as well as the Q&A session with analysts.

We feel good about our cash position as we move forward and scale our business.

- Lara Sweet - Chief Accounting Officer

This is an important comment, as Snap continues to move quickly through its cash pile.

(Source: Snap IR)

While Snap has been able to better control its cash burn over the past few quarters, the company is still operating at a $100 mln+ quarterly cash burn. Unless the company turns cash generative soon, one would believe that the company would need to raise capital again. Whether it be from an equity dilution or a direct sale of stock to a large company like Tencent (OTCPK:TCEHY) or Amazon (NASDAQ:AMZN), or even some kind of sovereign wealth fund.

The company's profits and cash flow or lack thereof has led many to question Snap's long-term solvency without a substantial capital raise. The chief accounting officer seems to be putting capital raise concerns to rest, at least for the short term.

As it comes to breakeven, it's a reminder we had the internal stretch goal of accelerating revenue growth and full-year free cash flow and profitability, which is not a forecast and it's not guidance. But it is also what help us to achieve the strong results that we've seen this quarter. And as we look forward to our - achieving a profitability and free cash flow in the future, I think it really focuses on our revenue growth, which will come from expanding our community, increasing engagement, improving monetization, while keeping a close eye on the operating efficiencies that we've achieved to date.

Snap says their stretch goal of Q4 profitability came close and helped them get to their strong results. They mention that their ability to get to profitability and cash generation comes from revenue growth, with cost cutting in the background. Cost cutting, mostly from lowering operating expenses, has yielded better-than-expected earnings results many quarters in a row. Lowering their headcount, R&D, and marketing expenses has driven Snap's losses lower and lower.

(Source: Snap IR)

Longer term, we should expect Snap exhibit traits of cost growth as their community expands. Cloud hosting costs, as well as a higher headcount and marketing costs, will create a long-term trajectory of cost growth.

Is A Turnaround In Store?

A recent note from RBC suggests that Snap may be reminiscent of the Twitter (NYSE:TWTR) turnaround.

Is This TWTR At The Beginning of '17?! The pieces may be in place.

He also cites a stronger stories environment overall, with the stronger tide lifting all boats.

The short answer is no, not yet.

Despite my short-term optimism on the stock, the company has a substantial risk profile that could lead to a continued revenue growth slowdown and push-out of profitability. If we see anything change with Snap, we should see a change in the narrative, the story per se, around Snap's stock similar to the change in attitude investors exhibited towards Twitter when their turnaround first began. This change is the change from a company focused on growing its user count, to a company that is focused on monetizing its user base.

As a matter of fact, Twitter has reported a trend of declining users, but stronger monetization and its data licensing business have driven revenue growth and profitability. Meanwhile, Snap reported a strengthening iOS user base and a flat overall base. Now, the company is prioritizing monetization pathways.

A combination of rejuvenated user growth from the new Android rollout and the continued monetization of the platform itself will pave the way for continued growth over the next several years.

In order to understand why a turnaround could be in store, we need to understand where the business's growth will come from. Most notably, Snap has two things going for it: Exposure to stories and heavy exposure to the 13-34 demographic.

With regards to stories, any exposure at all is good. While advertisers prefer Instagram Stories over Snapchat Stories wholeheartedly, having some exposure to the newest social media and internet advertising trends will be beneficial longer term. Snap's ability to capitalize on advertiser's eagerness to purchase stories ads could further benefit their revenue growth.

The Snapchat platform's Discover sponsored content section has been ridiculed by investors, and mostly neglected by users. Snapchat users have historically used the platform for chatting, rather than viewing sponsored content. This sponsored content is where Snap fills in their ad slots. A lack of usage on this "Discover" side of the platform leads to less willingness from advertisers to advertise.

That being said, outside of the chat feature within the Snapchat app, users interact with each other primarily through stories. An increase in Stories ad output will offset any potential weakness from Discover. Stories may be Snap's solution to one of its most challenging problems: monetizing Discover.

Secondly, Snap may have one asset that will be crucial to retaining and increasing their advertiser base. This factor is Snap's heavy exposure to the 13-34 demographic. While Instagram has no doubt taken massive share in this demographic from Snap, Snap's core user base remains this younger audience. Snap is almost totally exposed, particularly to Generation Z users, an asset that proves scarce in the social media world. Snap's ability to lock in younger users could be an invaluable asset for advertisers.

Basically, Snap's exposure to stories and younger users can help accelerate monetization improvements on the platform.

Corporate Governance, Competition, And Cash

Snap's risk profile, at a high level, boils down to these three factors. With Snap's recent strength, I believe its risk profile has shrunk to these three key factors.

Corporate Governance: Snap's first issue is its corporate governance and management. My first problem with Snap's corporate governance is its voting share structure. This is a topic that, in my personal view, should concern the bulls on Snap deeply. Basically, CEO Evan Spiegel and CTO Bobby Murphy hold 96% of all voting shares, with owners of SNAP shares listed on the NYSE having zero voting rights. Class B shares hold 4% of the voting rights, while Class C shares (96% of the voting rights) are exclusive to founders.

This structure completely limits "shareholders" from making key decisions like determining Snap's board. Basically, if you own Snap's stock, you have to have absolute faith in management. If you don't, then you cannot help install a board that ousts the current management and implements a new one. You sit on the sidelines without any real say in the company's direction. It all hinges on your trust in management's ability to run the company smoothly.

Speaking of which, management lately has been a revolving door. This comes most notably from the departure of Snap's relatively new CFO Tim Stone. While I have some theories on his departure, I acknowledge that his departure follows that of over a dozen other executives. The trend of executive departures at Snap is unmistakable and could deal a blow on Snap's overall reputation. Continued executive turnover remains a risk to Snap's stock, but not as much to the business.

Competition: Competition is Snap's most relevant threat to their business. They recently disclosed to investors that they are listing TikTok as a competitor. For those that don't know, TikTok is a platform owned by Chinese social media company ByteDance that is extremely popular amongst the 13-34 demographic that Snapchat had previously established as its own. ByteDance also owns Toutiao, a digital Chinese news and information platform that people like Andrew Left have compared to Twitter. There are 500 million people using TikTok on a monthly basis. While we are all aware of Instagram's continued impact on Snapchat's user base, I would like to take some time to investigate TikTok a little more closely.

I have a very good in-depth source of this information here that delves into this information. I want to give them the credit for compiling these facts, not myself.

In 2017 (the most recent data I could find), TikTok generated meager user spend of $3.5 million. My points are not made to demonstrate TikTok's economic success but the potential harm they could cause to Snap as users migrate towards the TikTok platform. The parent company, ByteDance, is the highest valued privately held startup at $75 billion. The company, in October of last year, raised some $3 billion led primarily by SoftBank.

The bottom line is, TikTok is already extremely big and has exposure to their parent company ByteDance's vast economic resources.

This is something that Snap, as a standalone, doesn't have. With more money, TikTok can design better features, further drawing users towards TikTok, away from Snapchat.

Here is TikTok's relevancy in the App Store:

(Source: BusinessofApps)

Here is another chart showing TikTok's download growth versus other social platforms, including Snapchat.

(Source: BusinessofApps)

When TikTok is being downloaded more than platforms like YouTube (NASDAQ:GOOG) (NASDAQ:GOOGL) and Facebook (NASDAQ:FB), platforms that are already proven successful, you know they are extremely popular.

In terms of TikTok's popularity in the all-important Android category, the company utterly demolishes the competing apps.

(Source: BusinessofApps)

In terms of engagement, however, TikTok pales in comparison with Snapchat, Facebook, Instagram, and YouTube.

(Source: BusinessofApps)

This engagement figure is a measure of the total number of MAUs that log into the app on a daily basis. While the other major social media apps are in the mid-90% area, TikTok is struggling at roughly 28%. If you take 28% of the 500 million reported MAUs, you get a total DAU base of ~142.8 million users, over 40 million less users than Snapchat has.

Despite all the traction TikTok has gotten in the last handful of quarters, its current DAU number holds 40 million less users than a plateauing Snapchat. That all being said, TikTok's surge into relevancy amongst the 13-34 demographic should be carefully watched amongst Snap investors.

Cash: I believe Snap's final major risk is their cash pile. After their IPO, the company was flush with cash, recording as much as $2.04 billion at the end of 2017. Since then, the company has burned through an additional $760 million of its cash pile.

While the company continues to burn through $100 million plus per quarter, they are taking measures to improve their current cash bleed standing.

(Source: Snap IR)

A combination of continued revenue growth and controlling/lowering costs has allowed the company to push closer and closer towards cash generative and profitable results. Such cost-cutting moves include lowering their headcount, scaling back R&D efforts, and lowering marketing for their Spectacles hardware products. The company remains dedicated to lowering costs, something that will more than likely benefit their cash situation over the long term.

The real question pertains to whether or not Snap needs a capital raise to keep on going. I am of the belief that, in this environment, where interest rates are rising and credit markets are tightening, companies that need capital should not wait for another time to raise capital. In the case of Snap, the company has a few roads it could head down.

These roads include a direct equity dilution, a convertible bond offering, junk bonds, or reaching out to mega investors like sovereign wealth funds and tech titans.

With regards to equity dilution, there has been enough scrutiny already on Snap's dilution and stock-based compensation. So, the odds of a direct equity dilution are slim to none. A convertible bond offers Snap more flexibility to manage dilution while getting the funding they need at a more favorable interest rate than a junk bond. In my view, a substantial convertible bond may be the best route for Snap to take. The company only has $16.8 million in total debt, none of which is in publicly-traded bonds. Even with Snap's egregious cash burn, the company's debt levels are extremely low relative to their cash pile. A convertible bond offering also allows Snap to retrieve flexibility that it might not have otherwise with regular dilution or a junk bond.

Finally, we have the option of a large investor giving the company a cash infusion. While I won't speculate too much as to who and on what terms, there has been interest expressed from other external firms in the past. In November, Tencent purchased a 12% stake in the company. In addition, Snap has received buyout offers from Facebook in the past, and it was rumored that Google offered as much as $30 billion for the company. Evan Spiegel also met with the Saudis at one point in time. Though with recent political turmoil, an investment from the sovereign wealth fund of Saudi Arabia may be unlikely.

Overall, there are multiple ways Snap can raise capital to offset concerns surrounding its shrinking cash pile. The company is implementing internal controls on costs to help improve its cash burn, but if it doesn't, I believe the company has the ability to raise capital.

Valuation

For my valuation, I use a DCF model going from 2019 to 2028. I use a WACC of 13%, the same discount rate used by Credit Suisse's research team, with a terminal growth rate of 3%.

Here are my expectations for the business:

Moving on to the discount rates and final valuation:

This assumes Snap gets to a revenue profile of $6 billion in a decade's time. With a platform the size of Snapchat's, having 186 million users, $6 billion is not an unreasonable expectation. This assumes a continued deceleration in revenue growth as the years go on. To put this $6 billion into context, this is about the size of Spotify's (NYSE:SPOT) revenue profile today. While the two companies operate in different spaces entirely, they are both technology companies growing at high growth rates. And if you put this $6 billion revenue figure against the size of the internet advertising market as a whole, you see that Snap has plenty of room to grow.

Conclusion

Snap's delivered a solid Q4 report and has a strong growth trajectory ahead. I believe the stock is fairly valued at roughly $9. The company's risk profile is being minimized right now down to three main pillars. The company's strong revenue growth and higher gross margins deliver better than expected results. This may be the beginning of a Twitter-esque turnaround. Stabilization of user growth and strong monetization will drive revenue growth and eventually cash flow and profits.

Disclosure: I am/we are long FB, GOOG, AMZN. 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.