I’ll admit it: I’ve gotten Snap (NYSE:SNAP) wrong. I’ve spent much of this year arguing that Snap (or, as some still refer to it, Snapchat) shares have moved too far and that the SNAP stock price was too high. So far, that cautiousness has proven foolish.
That performance, however, includes a bit of a pullback of late. Despite a blowout Q2 report last month, the SNAP stock price has fallen roughly 10% from post-earnings highs. There may be some profit-taking after the big gains. And with even analysts turning bullish, it could be that, at least in the near term, SNAP is running low on potential buyers.
And there are still valuation concerns. SNAP remains unprofitable. It’s one of many high-flyers that could get dinged in another market swoon. There’s still a lot of work for Snap to do to support even the current valuation.
All that said, first-half earnings show that there’s a real path for Snapchat stock to keep its elevated levels. Also, it could potentially move higher. At this point, an investor’s opinion on SNAP comes down to whether he or she believes it can move down that path.
Incremental Margins and the SNAP Stock Price
One of the concerns with SNAP stock is that its margins might not be quite as good as those of social media rivals like Twitter (NYSE:TWTR) or Facebook (NASDAQ:FB). Incremental usage on, say, Facebook costs the provider almost nothing. For Snapchat, a messaging app, the costs are higher, if still modest.
Indeed, Snap’s gross margins were negative as recently as 2016. But first-half results show real progress in moving toward profitability when looking at the company’s incremental margins. Incremental margins are the profitability shown on each additional dollar in revenue. For Snap in 2019, they’ve been very strong.
In fact, in the first quarter, they were over 100%. Revenue increased $89.8 million year-over-year; adjusted EBITDA increased by $94.4 million. That type of improvement probably is unsustainable, but even second quarter results were strong. Incremental margins (again, on an EBITDA basis) in Q2 were 72%.
How Much Revenue Does Snap Inc Need?
Over the past four quarters, Snap Inc has posted an adjusted EBITDA loss of $391 million. Assuming 70% incremental margins, it would need another roughly $560 million in revenue to break even on an EBITDA basis.
That’s still a lot of growth: revenue over the past year has been roughly $1.4 billion. That figure, then, probably needs to increase about 40% for Snap Inc simply to get back to zero. Of course, Snap posted revenue growth of 39% in Q1 and 48% in Q2, meaning the company should get to positive adjusted EBITDA by Q2 or Q3 of 2020.
That said, near zero EBITDA doesn’t support what remains a $22 billion market capitalization. To get to that point, Snap probably needs to get to at least $750 million in EBITDA, using Twitter’s approximately 30-times multiple. That requires at least another $1 billion in revenue.
Looked at another way, Snap’s revenue needs to at least double just to get the company to the point where it can support a stock price of $16 on an EV/EBITDA basis. And so, anyone buying Snapchat stock here needs to believe that the top line can roughly triple in the next few years. That seems like a big ask.
How Snapchat Improves
That said, it’s certainly doable. 200% revenue growth in five years would require a roughly 25% annual growth rate. Snap has grown revenue 43% year-over-year for the past six quarters. And it has tools to keep that growth intact.
Notably, Snap has tremendous room for improvement in monetizing its users. An analyst noted in April that its monetization was one-third that of Twitter and one-fifth that of Facebook.
One way to do that is by getting more advertisers. Chief Business Officer Jeremi Gorman made exactly that point on the Q2 conference call:
We believe the single biggest driver for our revenue in the short to medium term will be increasing the number of active advertisers using Snapchat. We have significant headroom in our business, given high levels of user engagement and ample supply of available impressions.
In other words, Snapchat has plenty of inventory to sell to advertisers. The issue, at least per management, isn’t necessarily user growth, which had flatlined before an impressive Q2 jump. Rather, Snap has to find those advertisers.
And it’s making progress doing so. ARPU (average revenue per user) has steadily increased at least 37% in each of the last four quarters. Yet Snap still has minimal monetization, particularly overseas. The company generates barely $1 in quarterly revenue per user outside of North America. That’s almost 60% of its user base.
The Case for SNAP
If Snap Inc can triple revenue in the next five years, Snapchat stock likely rises over that stretch. To get there, it needs to get more advertisers. To beat that mark, it needs user growth as well.
And so, the case for SNAP stock comes down to largely those two aspects. Can the company better compete with Facebook, Twitter and Alphabet (NASDAQ:GOOG, NASDAQ:GOOGL) for online advertising dollars? And can it drive user growth, particularly where it’s struggled outside of the age 13 to 34 demographic?
In December, investors largely thought the answer to both of those questions was “no.” Now, they’re more confident. But there’s still more upside ahead if Snap Inc can deliver on both fronts.
As of this writing, Vince Martin has no positions in any securities mentioned.