These Are the Two Big Reasons to Stay Away From Snap Stock

A shrinking user base and slim gross margins will keep Snap stock stuck near its all-time lows for the foreseeable future

The Problems Facing SNAP Stock Haven't Gone Anywhere

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There was a time when Wall Street was excited about Snap (NYSE:SNAP) stock. The company’s IPO, which was considered one of the most highly anticipated IPOs in recent memory, was a huge success. SNAP went public at $17 per share, and within a few days, SNAP stock was closing in on $30.

But reality sunk in after SNAP issued a few bad quarterly earnings reports. SNAP stock dropped to $13 by Feb. 2018. Then it reported monster results that topped expectations across the board, getting everyone excited again. As a result, Snapchat stock soared to $20.

But the excitement didn’t last long. The rally of SNAP stock immediately faded, and subsequent dour earnings reports which featured slowing growth, widening losses, and drops in daily active usage kept the stock on a downward spiral.

Today there isn’t much excitement surrounding SNAP stock, which is trading around $6.30, versus its all-time low of $4.81.

Unfortunately, Snapchat stock probably won’t have a recovery rally in 2019. Right now, there are two big issues weighing on SNAP stock: falling usage and slim gross margins. Those headwinds are unlikely to reverse course. In fact, if anything, those two headwinds might actually get worse before they get better.

And until those headwinds ease, Snapchat stock will remain weaker for longer.

Users Are Leaving, And They Aren’t Coming Back

SNAP’s core problem is that users are leaving the platform when it’s not yet hugely popular (it has less than 200 million daily active users). Moreover, there aren’t any signs that these users will come back anytime soon.

Snapchat stock used to be supported by huge user growth. In fact, the company’s early user-growth outlook was so promising that many observers were saying that this company could become as large as Facebook (NASDAQ:FB).

But Snap’s user growth started to stall when multiple other platforms (Instagram, WhatsApp, Facebook, and Messenger) all integrated Snapchat’s core Stories feature into their own ecosystems. Then, in the first quarter of 2018, Snap’s user base peaked at 191 million daily active users. Since then, primarily due to churn stemming from a questionable redesign of Snap’s Android mobile website, its user base has dropped to 186 million users.

There is no fundamental reason to believe that SNAP’s user growth will return any time soon. Broadly speaking, Instagram does everything that Snapchat does and more, and Instagram has a tight grip on the teenage and young-adult demographic. WhatsApp and Messenger have the global-communication market cornered. And the success of Facebook Stories shows that Facebook is attracting the older demographic to its Stories feed.

What is SNAP left with? Not much. Outside of the current sub-200 million user base, there isn’t much reason for new members to join Snapchat, since they are getting all they need from their other social-media platforms.

The best argument for Snap is that it can attract more users overseas by fixing its Android website. But the overseas Stories space is already dominated by WhatsApp and Instagram.

Overall, the outlook for SNAP’s user growth remains bleak. As long as this remains the case, advertisers won’t flock to Snap. And as long as advertisers don’t flock to Snap, its revenue growth will continue to slow, and the market will have a tough time justifying the current valuation of SNAP stock, which stands at 7.7 times the company’s trailing sales.

SNAP’s Gross Margins Are Anemic, And They Won’t Roar Higher Soon

SNAP stock’s other big problem is that it has extremely low gross margins that aren’t expected to head sufficiently higher anytime soon.

Snap just reported Q3 revenue of $300 million and generated just over $1 billion of sales over the past 12 months. Facebook was that size back in 2009-10. At that point in time, Facebook had 70%-plus gross margins. Snap’s gross margins today are just 36%.

Why is there such a large discrepancy, even though the two companies have similar business models? The difference is SNAP’s huge cloud costs. SNAP doesn’t own and operate its own data centers, as Facebook does. Instead, SNAP pays Alphabet (NASDAQ:GOOG) to utilize Google Cloud ‘s storage space.

SNAP has committed $2 billion to Google Cloud over a five-year span, so it’s spending about $400 million per year on data storage. Throw in all of SNAP’s other costs of revenue, and Snap’s total cost of revenue over the past twelve months is about $750 million.

Even if that figure doesn’t grow at all in 2019, and its revenues double to $2 billion, its gross margins would still only be around 60%. That won’t happen. Instead, its revenue costs will rise, as they have over the past two quarters (its cost of revenue jumped 25% and 17% in Q2 and Q3, respectively).

Assuming that SNAP’s cost of revenue increases 20% in the next twelve months, its 2019 cost of revenue would come in at $900 million. SNAP’s top line this year is expected to be $1.5 billion. Thus, its 2019 gross margin should be around 40%.

That’s not very good. Considering that the company’s operating-expenditure rate presently hovers around 82%, 40% gross margins won’t put SNAP in the black. In fact, considering the company’s huge cloud costs and low gross margins, it’s unclear when SNAP can become profitable. As long as that remains the case, the market won’t be too eager to buy the dip in SNAP stock.

The Bottom Line on SNAP Stock

There are two headwinds holding back Snapchat stock: user declines and low gross margins. As long as those headwinds persist – and it looks like they will for the foreseeable future – SNAP stock will fail to launch a successful turnaround.

As of this writing, Luke Lango was long FB and GOOG. 

Article printed from InvestorPlace Media,

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