3 Reasons to Avoid Snap
- By Soid Ahmad
Snap Inc. (SNAP), the creator of popular app Snapchat, posted subpar second-quarter results on Aug. 10, missing both the revenue and EPS consensus. Despite missing expectations, however, the company posted impressive 153% year-over-year revenue growth.
The cost of growth was much higher, however, and the company lost 16 cents per share. Analysts were modeling for a loss of 14 cents per share. Revenue growth was supported by an expanding user base, which grew 21% year over year to reach 173 million users.
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The intrinsic value of SNAP
Sequential performance was not as rosy. Revenue grew 21% while active users increased 4% on quarter-over-quarter basis. The market reacted negatively to the earnings miss, causing Snap to shed 15% of its market cap after the announcement.
Despite sequential decline, the stock is up 5%. It is doubtful the gains will hold amid several problems facing the company.
Poor sequential performance
While the year-over-year growth is impressive, the sequential slowdown in growth is alarming. Daily active users (DAUs) and revenue witnessed a decline in growth on a quarter-over-quarter basis. The company posted DAU growth of 21%, resulting in top-line growth of 153% year over year. Despite this, DAUs grew a measly 4.2% sequentially, translating into quarter-over-quarter revenue growth of 21.3%.
Sequential decline isn't good news
The sequential slowdown would not be a problem if Snap was a cyclical company. Sequential measures are not meaningful for cyclical businesses. Snap, in contrast, is an app.
The life cycle of a typical app follows an exponential growth followed by decline in growth before plateau. Snap seems to be in the slowing-down phase and is nearing maturity.
X-Axis: Q1 2014 to Q2 2017
Recent quarterly results provide further insight.
First, revenue increased 21.3% during the quarter, down from 84.6% growth in the second quarter of 2016. This is indicative of slowdown in growth. In absolute terms, revenue increased $33 million in second-quarter 2016 and $32 million in second-quarter 2017, which indicates a slowdown in growth.
Source: Snap's 10-Qs
Second, slowdown in revenue is alarming because it is the result of slowing growth among active users, not the failure of management in marketing and sales. While daily active users grew 17.2% during the second quarter of 2016, the company posted a pitiful 4.2% DAU growth for the comparable period of this year. Again, this indicates a slowdown in growth. See the chart below:
Source: Snapchat's 10-Qs
Marketers are not going to take the slowdown in growth lightly, which can impact Snap's ability to attract business.
If the slowdown persists, average revenue per user might fall. ARPU growth has already begun to decline. ARPU grew 56% in second-quarter 2016; it only increased 16% in the most recent quarter.
The point is Snap must revitalize growth through new features. Otherwise, the company will have a hard time finding advertisers.
Seasoned competition
Snap's problems do not end with declining sequential growth. To revitalize growth, the company has to face competition from Facebook (FB). In order to compete, Snap has to churn out innovative features consistently. This is an uphill battle given the resources at Facebook's disposal. Not to mention, features can easily be copied. There is no clear cut competitive advantage. Intellectual property protection in this area is also premature at this point in time.
In additon, Facebook is not sitting quietly; it is assaulting Snap through its different brands, including WhatsApp's Status, Facebook's Story, Messenger's Days and, of course, Instagram Stories. All of Facebook's apps were above Snapchat in terms of downloads during the first half of 2017, according to AppAnnie. Business Insider notes Instagram will grow at a faster rate compared to Snapchat in the coming quarters.
Snapchat does deserve some credit, however. According to eMarketers, Snapchat is attracting more teenagers than Instagram. EMarketers expects Snapchat's U.S. user base to grow 25% monthly to reach 79.2 million users. Instagram, on the other hand, is expected to grow 23.8% to reach 85.5 million users on a similar basis.
If Snap is doing so well, what's the problem? The problem is Facebook will continue to fuel Instagram's innovation through cash generated from its already established businesses. Snap does not have that luxury; it has to burn through existing cash. The company may require additional financing to fight Facebook going forward.
Snapchat is a niche player
As indicated by eMarketers, Snapchat attracts teenagers. Unlike Facebook, which appeals to multiple demographic groups, Snapchat is a niche player. Consequently, it is not fair to value Snap like Facebook; it should be treated and valued like a niche player.
Valuation
Snap is priced for perfection, even by generous standards. I will not go into the details of its earnings or revenue for Snap's valuation. Although those metrics are important, they are not the most suitable for a growing app-based company. Active users are a go-to valuation measure for technology companies like Snap. Using a multiple based on Instagram's active users for the valuation, Snap has no upside.
A value/DAU multiple of 88.8 is derived based on a value of $37.29 billion and 420 million active Instagram users. The model is updated to reflect current DAU developments.
The multiple reveals a price target of $13.03 for Snap based on 173 million DAUs. Note this valuation is based on Instagram's multiple. The multiple for Snap would actually be lower due to its smaller reach, capital and experience compared to Facebook.
Discover feature will hopefully revive growth
If Snap manages to revitalize its growth, this will reflect in the growth of its active users. As a result, the company's appeal will increase. Reigniting growth will depend on new features that cannot be replicated.
It is worth mentioning Snapchat's discover feature is gaining traction. NBC attracted 29 million viewers through its program "Stay Tuned" on the platform. CNN followed suit and recently launched a daily news show exclusively for Snapchat. This opens up new revenue streams for the company.
It is important to remember the discover feature attracts advertisers more than users. Successful shows do not mean the number of DAUs will grow. Moreover, from a long-term perspective, nothing is stopping Facebook from launching similar features. That's why competing effectively against the social media giant will be a constant battle.
Final thoughts
Snap is a risky investment prospect. Declining sequential growth in DAUs and revenue are only a few of the problems the company must overcome. Competition from Facebook adds to the risk as it has the resources to continuously innovate or replicate features. Further, the stock is already trading high. All in all, investors should stay away from Snap as the risk-reward does not appear to be favorable.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
This article first appeared on GuruFocus.
Warning! GuruFocus has detected 2 Warning Signs with SNAP. Click here to check it out.
The intrinsic value of SNAP
