Following a rough late 2018 sell-off, stocks have bounced back strongly in early 2019. Year-to-date, all three major indices are up more than 10%, led by a 16% gain for the Nasdaq. Few stocks, though, have done as well as Snap (NYSE:SNAP) in 2019. SNAP stock was left for dead in late 2018 amid slowing user growth and profitability concerns. Those concerns quickly turned a corner in 2019, and SNAP subsequently has risen more than 100%.
You read that right. SNAP has more than doubled this year. It’s only March. For emphasis purposes, that means SNAP stock has more than doubled its value in two and a half months.
This rally is not sustainable. To be sure, the fundamentals are quickly improving. The user base is finally stabilizing, and potential for growth in coming years is promising. Revenue trends are strong. Gross margins are marching higher. Opex rates are rapidly falling. Profitability is a real possibility within the next few years.
But, after a 100% YTD rally, SNAP stock is already fully priced for all those positive developments. Up at $11, the stock is trading at what my numbers suggest is a reasonable price target for this stock by the end of the year. We are only two and half months into the year.
As such, I don’t expect much more upside out of SNAP stock in the foreseeable future. The stock has already made its big 2019 turnaround, now comes the choppy part.
The massive 2019 rally in SNAP stock really picked up steam following the company’s fourth quarter earnings report, which broadly confirmed that the fundamentals underlying this stock are dramatically improving.
Most important, the user base stabilized in the fourth quarter, following two consecutive quarters of declines. That put to bed concerns that Instagram is eating Snapchat’s entire pie. It also largely confirmed that despite intense competition, Snap has staying power in today’s social media landscape.
On top of user base stabilization, unit revenue trends improved in the fourth quarter. ARPU, or average revenue per user, rose 37% in the fourth quarter, matching the best ARPU growth rate Snap reported through all of 2018.
ARPU growth acceleration implies that advertisers are increasingly flocking to the platform, and not just for the cheap ads, giving credence to the thesis that Snap as an advertising platform has large growth potential.
Meanwhile, margins improved in a big way during the fourth quarter. Gross margins improved by 12 points year-over-year. The opex rate shrunk an eye-popping 30 points year-over-year. Net loss narrowed to under $100 million for the first time ever as a public company.
Overall, Snap’s fourth quarter checked off all the boxes it needed to check off. The user base stabilized. ARPU growth accelerated. Gross margins expanded. The opex rate fell. Net loss narrowed. So long as Snap keeps checking off those boxes, the long term bull thesis in SNAP stock will gain traction.
Everything Is Priced In
The problem with SNAP is that, after a 100%-plus rally in two and a half months, the stock is fully priced for all these positive developments.
The user base is stable, but it’s not growing. With Instagram at over a billion users, and much bigger platforms like Facebook and WhatsApp successfully replicating Snap’s core Stories feature, it’s pretty clear that Snap won’t grow its user base by much in the long run. At scale, Snap can get to maybe 200 million daily active users, versus 186 million today.
The big growth driver here is ARPU. Quarterly ARPU was narrowly above $2 last quarter. Over at Twitter (NYSE:TWTR), quarterly ARPU is running around $7. At Facebook (NASDAQ:FB), it’s up at $11. Thus, there is a long runway for Snap’s ARPU to improve in the long run, and presently large growth rates (37% ARPU growth last quarter) imply that Snap has momentum on that runway.
Having said that, ARPU won’t ever get to Facebook levels, which benefits from multiple advertising channels. Instead, it will likely max out around current Twitter levels, or roughly $7.
Gross margins are currently under 50%. At Twitter, they are north of 60%, and closing in on 70%. At Facebook, they are north of 80%. Due to lack of scale, Snap won’t ever get to 80% margins. But, 70% seems doable if ARPU can grow to $7. Also, the opex rate should normalize to a much more normal ~40% rate at scale.
Overall, I see Snap as being a 200 million user platform one day with $5 billion-plus in ad revenue, and roughly 30% operating margins. Assuming all that materializes by 2025, I think the company can do about $0.75 in EPS by then.
Based on a digital ad average 25 forward multiple, that implies a fiscal 2024 price target for SNAP stock of nearly $19. Discounted back by 10% per year, that equates to a fiscal 2019 price target in the mid-$11’s.
That’s exactly where Snap trades today, and it’s only March.
Bottom Line on SNAP Stock
The fundamentals underlying Snap are materially improving, and the stock is staging a huge turnaround as a result. But, the best of this turnaround has already come and gone. Chasing here seems unnecessarily risky. Waiting for a big dip before buying seems like the smarter move.
As of this writing, Luke Lango was long FB and TWTR.