Snap Inc Stock’s Biggest Weakness Is Reason to Stay Away

Snap's business model isn't sustainable in the long run

By Lucas Hahn, InvestorPlace Contributor

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Snap Stock

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In July, Snap Inc (NYSE: SNAP) stock fell below its IPO price of $17 a share and it has remained there ever since.

I wrote my first article on SNAP stock on March 24, when the stock closed at $22.74 a share. Facebook Inc (NASDAQ:FB) has been copying many of Snap’s features over the years in its apps, not just for Facebook itself, but also for Messenger, WhatsApp and Instagram.

This imitation has taken a toll on Snap’s user growth, which has slowed in recent quarters. Snap boasted 25.4% more daily active users in the third quarter of 2016 than in the first quarter. But in the third quarter of 2017, Snap could claim only 7.2% more users than in the first quarter.

But Snap seems aware of its challenges, and appears to be shifting its strategy. Also, Tencent Holdings Ltd (OTCMKTS:TCEHY), the Chinese gaming and social media giant, recently purchased 12% of SNAP stock.

Tencent owns WeChat, the Chinese messaging app with 963 million active users. The company knows a great deal about building and monetizing chat apps, and if it thinks Snap stock is a bargain, it very well could be. Tencent might help Snap with producing video games as well.

Given these developments and Snap’s recent redesign, is SNAP stock a buy at current levels?

Snap’s Negative Gross Margin

As I mentioned in my article on Snap in May, Snap’s cost of revenues are greater than its revenues. This gives Snap a negative gross margin.  

Such a business isn’t sustainable in the long-run; it loses money on every transaction, even before operating expenses such as R&D are factored in. (This would be like a grocery store buying bread for $5 and selling it to you for $4; it loses money even before it can pay salaries and rent.)

In its 10-Q filing for the most recent quarter, Snap states that “Cost of revenue consists primarily of payments to third-party infrastructure partners for hosting our products.”

Most of this probably goes to Google Cloud, part of Alphabet Inc (NASDAQ:GOOGL, NASDAQ:GOOG).

Snap hopes that it can scale up and become profitable and, admittedly, this has worked with some companies in the past, like Paypal Holdings Inc (NASDAQ:PYPL).

In the early days of the Internet, PayPal paid customers to sign up; it needed to do this to reach critical mass. In the years that followed, PayPal became the dominant online payment processor and turned profitable.

However, PayPal could do this since it locked in customers. Switching to a competitor wasn’t easy, since there weren’t many alternatives. The venture capitalist Willy Braun writes that negative gross margins only make sense if the switching costs to another platform are high.

With Snap, this isn’t quite the case. First of all, there already is a dominant social network, and it’s not Snap, it’s Facebook.

Second, as Snap acknowledged in its IPO prospectus, “Snapchat is free and easy to join, the barrier to entry for new entrants is low, and the switching costs to another platform are also low.”

SNAP Stock’s Other Weaknesses

InvestorPlace contributors have a mostly bearish view of SNAP stock, despite the company’s redesign.

James Brumley thinks the updates don’t address Snap’s main issues — its lack of a clearly defined purpose and slowing user growth. He writes that “the platform lacks the scale advertisers (and media companies) seek.”

Vince Martin also notes Snap’s slowing user growth and high valuation. Investors have high expectations of Snap stock, and they may be disappointed.

Tom Taulli and Luke Lango note that competition from Facebook and Instagram isn’t going away.

Lango also raises concerns over Snap’s valuation relative to Facebook:

“Revenue growth at Snap is 60% and slowing. Revenue growth at Facebook is 50% and stable.

Consequently, I think the two companies should trade at a comparable sales multiple. But SNAP stock currently trades at 12.4x next year’s sales estimate. FB stock trades at just 9.5x next year’s sales estimate.”

Hilary Kramer tells investors hoping for a buyout of Snap not to get in now.

Why?

Snap CEO Evan Spiegel isn’t likely to sell unless he’s in distress, in which case you’d probably lose money by buying now. A hostile takeover of Snap is unlikely due to its share structure, which favors insiders. Most shares come without voting rights.

If I had to pick a social media stock, I would choose Momo Inc (ADR) (NASDAQ:MOMO).

Momo is a Chinese social app that boasted 94.4 million monthly active users in the most recent quarter. It has grown rapidly over the past few years and earns a profit, yet trades at a much lower valuation than Snap.

Momo has zero debt and holds $949 million in cash. It’s market capitalization today is just under $5 billion and analysts are bullish on the stock.

As of writing, Lucas Hahn did not hold a position in any of the aforementioned securities.


Article printed from InvestorPlace Media, https://investorplace.com/2017/12/snap-stock-biggest-weakness/.

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