Snap, Crackle, Pop: It Rose, Then Fell And Rises Again?

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Includes: SNAP
by: Arya Nakhjavani
Summary

APRU growth is significantly higher than expectations due to increased ad frequency, user engagement, and new ad delivery methods.

DAU stopped its terrifying decline (for now) and the new Android Update promises DAU growth.

Overall, SNAP appears to have avoided the death spiral of accelerating DAU loss and desperate ARPU hikes to compensate.

As many of you know, last week I wrote an update to two earlier articles I wrote involving Snapchat (NYSE: SNAP) which you can find here. In the latest article, I updated the thesis and revalued SNAP and its outlook. I outlined two different outcomes, one bullish and one bearish. The conclusion was to warn investors that at the time, right before earnings, the future of the company was unclear. Downward pressure on ARPU and declining DAU had hurt the company for several months (something I had written about in the original articles). After their earnings surprise, some people have asked me what my thoughts are now that the proverbial cat is out of the bag. So let's brush off my week old model, update it with numbers from the latest earnings and see what they tell us.

First of all, looking at the models from last week's article, it is simple to see that my conservatively bullish model was in the ballpark but moderately off the actual mark. It was a pleasant surprise to see SNAP's DAU numbers. In our model, I did not project SNAP stopping the DAU losses so quickly. In reality, it seems that SNAP saw their declining DAU and was able to beat the trend before it began negatively impacting APRU which would have marked the death spiral for the company.

(Data Source: Snapchat 10K and 10Q)

Once DAU drops significantly, it becomes very difficult to increase ARPU without accelerating DAU decline. The reason for this is that once DAU losses become significant, advertisers are less willing to pay premiums for ad space/time which stagnate or decline ARPU. The company's only option becomes to increase the display rate of ads which deepens the decline of DAU. In SNAP's case, however, DAU decline stopped abruptly and avoided the whole issue altogether, beating EPS estimates by 50%.

Before we update the model and re-run the multiples analysis to arrive out the model's implied price per share, let's take a quick look at the quarterly results which we will be using for the model.

SNAP's 4Q18 results did a number of things past ease investor concerns. The numbers restored some measure of confidence in the company's ability to perform. First, let's look at ARPU. The data shows significant improvement in ARPU YoY and quarterly. Global growth was much larger than expected which was a result of increased generation across all regions. Looking at the North American numbers alone, it is a large milestone for SNAP to break the $3 APRU ceiling as it has been hanging around the $2.65 mark for some time. The interesting thing about this increase is that my surveys of college students did not find a significant increase in the frequency of ads. If my relatively small survey sample size can implicitly be indicative of the population, then we can guess that increased ad frequency is not the driving factor behind this big bump in ARPU for the North American region.

Unfortunately, after my initial survey in the first article, I have not maintained the European and "rest of the world" surveys in order to make this same statement for those regions. If I were to speculate without any hard data, I would say that ad frequency for those regions is lower than North America. Remember this because we will come back to this idea after we discuss DAU.

(Source: Company Investor Presentation)

For DAU, the story is one of stagnation which, given the low level of investor confidence, is a positive for SNAP. The expectation was one of the continued decline of DAU as users became disenchanted by the platform and its features. However, it seems that SNAP was able to halt the DAU bleeding for now. Global YoY growth was practically zero with an increase internationally offsetting declines in North America and Europe. While this shows stability in the user base, it raises concerns about the young platform's growth runway. Another thing that we do not get much visibility into is the DAU churn. For example, though we can see that the North American number for 4Q18 DAU did not change, we do not know if SNAP lost 3 million older users but was able to generate 3 million new users or if it actually did not move. This churn number can be important as it gives insight into user retention. For the mathematically inclined, you might consider churn to be the marginal "per user" first derivative of DAU.

(Source: Company Investor Presentation)

Now as I mentioned above, the ad frequency is very important. From my previous articles, we could see that the number of ads displayed to users was indeed dependent on their respective regions and across the board, it was significantly lower than if a user had spent a similar amount of time on Facebook. This was a key point in my original article and we are beginning to see that shift dramatically. The growth plan appeared to be to expand DAU as aggressively as possible and slowly increase ad frequency. This would have led a clear path to profitability without hindering DAU growth.

In reality, it is clear at DAU growth tapered off much faster than expected as SNAP failed to roll out key features such as an optimized Android platform. While from the latest earnings call, it is clear that SNAP has realized this and focused on fixing these changes, the DAU growth cycle is unlikely to change significantly with iOS users. Meaning, while DAU could potentially increase as SNAP recaptures disenfranchised android users, the market penetration is limited in short-term on the iOS side.

This predicament leaves SNAP only two options on the path to profitability: decrease cost or increase ARPU. Given that SNAP is not a mature value company, any meaningful move to decrease cost jeopardizes growth potential. APRU growth is achieved by increasing ad frequency and the creation of new methods and products for ad delivery. From the investor presentation, we can see that new ad methods were a strong growth point. As a non-traditional platform, Snapchat as an app does not have the same screen real estate to display ads on such as Facebook. Most interactions on Snapchat are peer-to-peer or peer-to-group in a way that makes traditional platform advertising difficult. If every time you wanted to open a snap, you were forced to watch a 20-second ad, I imagine the DAU would plummet. Luckily, from this latest earnings call, it appears that SNAP recognizes this and is investing in alternative forms of more native advertising as well as content partnerships. Sponsored content has been met with positive reactions and the new native advertising methods are rather innocuous and unintrusive (with the exception of forced video ads). The trend seems to be to become more and more effective at native advertising while adding features and content development.

This form of ad delivery is both highly effective and better received by the users. As a result, SNAP can increase APRU, not at the expense of DAU. As I mentioned before, the plateauing of DAU growth has changed the growth strategy. I think SNAP will now increasing ad frequency to monetize Europe and the rest of the world regions more now that DAU has stopped accelerating. The reason it has not already done so completely is that it needed to halt the unexpected decline of DAU before it focused on ARPU acceleration in these regions.

To summarize, I expect ARPU in all regions to accelerate as SNAP finds new ways to monetize its platform and increase ad frequency. On the DAU side, I think this depends highly on the success of the new Android update which could give DAU a substantial boost. All of these factors restored some of my optimism in SNAP's ability to perform. I think if I were to revise my model, I would lean more towards an optimistic growth projection which bodes favorably for investors. As for a hard price target, I will be waiting for more information and news to trickle in regarding the Android update. As has been one of my information sources, user surveys will play a key role in determining the success of the "re-launch" if you can call it that. I will be watching the Snapchat Android update carefully and will update the valuation model once I have something of material to present.

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.

Additional disclosure: I do not have any stock positions in Snapchat but I do currently hold OTM calls and puts which will expire 2/15.