Snap: A Sinking Ship

Summary

• Shares of Snap have lost nearly 50% of their value relative to all-time peaks above $80.
• Investors have lost confidence in the company's ability to grow users, especially as developed market/U.S. growth stalls.
• Snap's user growth is coming from its rest of world segment, which generates 1/10th of the U.S. ARPU.
• Now 10 years old, Snap is well aged as a social media platform that doesn't have the staying power of Facebook.
• Shares still look expensive at ~12x forward revenue.
• I do much more than just articles at Daily Tech Download: Members get access to model portfolios, regular updates, a chat room, and more. Learn More »

Mark Metcalfe/Getty Images Entertainment

The history of the internet is filled with the bones of once-popular sites and apps that have been left behind in the dust in favor of newer, shinier, trendier fads. Snap (NYSE:SNAP), I fear, is barreling down in that direction. The one-time social media upstart has seen its share price sink over the past few months, and in my view, the selloff still has steam. Evan Spiegel's disappearing-chat app is struggling to retain relevance in a very crowded social media space that is vying for eyeballs as we approach post-pandemic normalization.

Shares of Snapchat hit peaks above $80 briefly last September. Then, two major things happened. First, Snap released Q3 earnings results, which showed a meaningful slowdown in user growth - particularly in the U.S., where Snap has failed to grow users at faster than a mid-single digit y/y pace. Second, overall investor sentiment toward growth stocks tumbled - which means that the market is no longer willing to look past Snap's many flaws.

Data by YCharts

Snap lacks the staying power of Facebook to survive well past its tenth anniversary

Let's take a step back and ask a very simple, high-level question: do you think Snap is still going to be around in 5-7 years' time? In 2021, Snap celebrated its tenth birthday. So far, only one mainstream social media platform (and I'm not counting Twitter (TWTR) here, which I argue has evolved into more of a news platform) has managed to remain relevant after ten years, and that company is Facebook/Meta Platforms (FB).

Facebook has largely remained relevant thanks to a number of factors that are quite unique to it:

• Appeal across all age groups, from young to old (more recently skewing toward the latter)
• Purchase of Instagram, which has picked up popularity among the younger age groups where Facebook has faded
• Status as the "platform of record" as the largest social media platform in the globe, with 2+ billion active users, where you can look up almost any friend or acquaintance you have
• Launching of non-social media efforts, including enterprise software (Workplace by Facebook), Facebook Marketplace, and recent foray into building the so-called "metaverse."

In my view, Snap's fading user growth is a symptom of the fact that the company is facing very active competition, from both Facebook/Instagram as well as upstarts like TikTok. Up through the pandemic, it was difficult for investors to see or focus on Snap's issues retaining users because ad revenue was so volatile. In fact, Snap's second-quarter earnings were so well received because revenue more than doubled y/y, which in itself was largely a function of a very easy comp versus the onset of the pandemic last year.

But now especially that the market's growth appetite has waned, I think Snap shares have much further to fall. The bottom line here: steer clear of Snap, and resist the temptation to buy this falling knife on the dip.

Q3 download

Snap's most recent earnings quarter, published in October, reflected very poorly on the company's trajectory. While technically it could be considered a "mixed quarter" with weak top-line results coupled with profitability wins, I'm more concerned about Snap's decaying growth (particularly in users) as it has longer-term implications for Snap's survivability.

Let's start with revenue first. In Q3, Snap grew its revenue at a 57% y/y pace to $1.07 billion, as shown in the chart below. Unfortunately, this missed Wall Street's expectations of $10.10 billion (+62% y/y) by quite a wide mark.

Figure 1. Snap revenue trends

Source: Snap Q3 investor presentation

This miss didn't sit too well with investors: though Snap had been regularly disappointing on user trends for several quarters, revenue upside always blunted that blow. This was the first quarter since FY19 that Snap has missed a revenue estimate, even with the pandemic in-between.

Revenue growth also decelerated sharply from 116% y/y growth in Q2. Again, part of last quarter's strength was due to substantially easier comps relating to weakened ad rates in Q2 of the pandemic last year. Snap's comps in the post-recovery period, meanwhile, are about to look a lot tougher.

Even worse than the revenue miss, in my view, was continued weakness in user trends. Snap's overall DAUs grew 23% y/y to 306 million, on pace to Q2's y/y growth pace and adding 13 million net-new users in the quarter, the same as in Q2. However, when we look at the underlying composition of that growth, North America saw only 7% y/y growth while Europe saw only 11% y/y growth. In the case of North America, the absolute number of users also remained only about flat at 96 million.

Figure 2. Snap DAU trendsSource: Snap Q3 investor presentation

Management reported "mixed" engagement trends as the world shifted back to a post-pandemic normalization period. Per CEO Evan Spiegel's prepared remarks on the Q3 earnings call:

Many of the mixed engagement trends we observed during the pandemic and that we discussed on our last earnings call have continued through the third quarter. On one hand, while total content viewership and time spend has grown year-over-year, user-generated stories continue to see year-over-year declines in overall time spend [...]

On the other hand, we are seeing quarter-over-quarter improvements in engagement with the Snap map, story, posting, new friend connections, and bi-directional communication."

One of the chief reasons why Snap's regional mix of user growth is of such key importance is because of the wide disparity in ARPUs among its regional segments. A North America user (where growth was all but flat) generated $8.20 in ARPU in Q3, up 49% y/y - but in the Rest of World, where virtually all the user growth came from in Q3, ARPU was about an eighth of that amount at just $0.98, which also declined sequentially and was flat y/y.

Figure 3. Snap ARPUSource: Snap Q3 investor presentation

For right now, favorable ad rates versus the beginning of the pandemic last year are still optically showing "revenue growth" in North America and Europe, but these are temporary tailwinds due to easier comps. On the advertiser side as well, Snap's engagement weakness was further impacted both by recent changes in ad tracking/targeting plus global supply chain/labor challenges, which have both stymied overall demand for advertising. In other words, Snap's huge leaps in revenue growth - fueled by easy comps and higher ARPU in regions that are no longer really growing the user base - has a very limited future.

The only bright spot in Snap's third quarter was profitability. From a margin perspective, Snap's adjusted EBITDA margin leap to 16%, or $174 million in adjusted EBITDA (up more than 3x y/y) is a welcome sign in a market that has become more risk-averse and interested in profit over growth. However, the company has attributed a lot of the lowered operating costs to pandemic-driven reductions on travel, entertainment, and marketing - costs which the company expects to pick back up.

Figure 4. Snap profitability trendsSource: Snap Q3 investor presentation

Valuation and key takeaways

In spite of the sharp fall in Snap stock over the past few months, the stock remains expensive for bearing such widespread risks. At current share prices near $44, Snap has a market cap of $70.88 billion. After we net off the $3.48 billion of cash and $2.25 billion of debt on Snap's most recent balance sheet, the company's resulting enterprise value is $69.65 billion.

Meanwhile, for FY22, Wall Street analysts expect Snap to generate $5.57 billion in revenue, which indicates growth slowing further to 39% y/y in the current year (data from Yahoo Finance). At this revenue estimate, Snap's valuation is 12.5x EV/FY22 revenue - which, to me, is a steep ask for a social media company whose user growth in North America and Europe (which together comprise roughly 90% of total company revenue) has slowed to the high single digits/low teens.

When we take a further step back, we also note that Snap shares are still up meaningfully versus the ~$17 price point that they were trading at during the beginning of 2020, before the pandemic drove investors to rush madly into tech stocks. To me, I think Snap's correction still has a long ways to go.

Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such 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.