Shares of social media company Snap (NYSE:SNAP) have been red hot in 2019, rising more than 200% year-to-date to their highest level in 18 months. Thanks to a re-engineered Android app Snap stock has found a future.
The app update sparked renewed user growth which has accelerated ad demand, sustained big revenue growth, and driven healthy gross margin expansion on top of positive operating leverage.
But, at $17 and change, SNAP is now one of the more richly valued digital ad stocks in the market. As such, the question becomes whether Snap can defy valuation standards and continue to fly higher. The short answer is yes, but there are major risks to the bull thesis.
There is a pathway for SNAP stock to eclipse the $20 in mark in 2019, but that pathway is presently clouded by multiple risks that ultimately could derail the red-hot growth narrative. If any such derailing does happen, SNAP stock will close 2019 below $15, not above $20.
As such, while I understand the bull thesis in SNAP and do think there is fundamental support for the stock above $20, I remain sidelined due to what I perceive as “too big to ignore” risks. I simply think there are lower-risk, higher-reward situations in the market at the present moment, especially in the digital ad sector.
How Snap Could Close Above $20 in 2019
There is a pathway here wherein SNAP stock is fundamentally supported at prices above $20 by the end of 2019.
This pathway is pretty simple. Snap’s user growth trends have sprung back to life in 2019. Those favorable user growth trends could persist in the long run, as Snap:
1) expands more aggressively in under-penetrated international markets with a revamped Android app,
2) doubles-down on its core value prop of picture messaging with unique face filter and swap technology, and
3) expands into the gaming and original content segments.
Broadly, then, Snap could be in the early innings of a long term growth trajectory wherein the company adds users at a cadence of roughly 10 to 20 new million users per year. At the same time, such reinvigorated and consistent user growth should be accompanied by accelerated ad demand, which should push Snap’s ad load and prices up.
As ad load and prices go up alongside the user base, revenues will rise, too. That big revenue growth will drive the opex rate down, while gross margins should expand as data center hosting costs become proportionally smaller.
Net-net, I do see runway here for Snap to be a 275 million user platform by 2025, with a quarterly ARPU of roughly $6 (much more normal for a developed digital ad platform), revenues of about $6.6 billion (which should equate to about 1% of the digital ad market by then, versus 0.4% share in 2018), operating margins of around 40% (also much more normal for a digital ad platform), and EPS of roughly $1.35.
Facebook (NASDAQ:FB) and Alphabet (NASDAQ:GOOG) have both, over the past five years, averaged around a 25-times forward earnings multiple. Based on that developed digital ad company average multiple, $1.35 in 2025 projected EPS should equate to a 2024 price target for SNAP stock of ~$34. Discounted back by 10% per year, that implies a fundamentally supported 2019 price target of around $21.
How Snap Could Close Below $15 in 2019
In one world, SNAP stock could close 2019 above $20. In another world, SNAP stock could close the year below $15.
The aforementioned bull thesis sounds great. But, there are big risks to it coming to life. Most of those risks start on the user growth front. When it comes to Snap, everything is about user growth. Without big and sustained user growth in the long run, the current valuation on SNAP stock does not make sense.
Unfortunately, competition could derail Snap’s user growth trajectory. Instagram is reportedly building a Snapchat clone that focuses on direct person-to-person picture messaging. If that app ever gains traction globally, it could put a stop to Snap’s international user growth narrative.
At the same time, TikTok is the most popular app in the world right now, and many see it as taking time and engagement away from Snapchat. If TikTok does indeed turn into a Snapchat replacement, then that could be a big problem for Snap’s user growth going forward.
If user growth falls flat, ad demand won’t accelerate higher. Quite simply, advertisers won’t pay up for a 200 million user audience, when other platforms are offering more reach. Ad load and ad prices will remain depressed. Revenue growth trends will stall out. As will profit margin expansion, and profits at scale won’t be that big.
In this world, I see Snap by 2025 as a 250 million user platform, with $5 ARPU, $5 billion in revenues, 30% operating margins, and $0.80 in EPS. Doing the same math as above, that produces a 2019 price target for SNAP stock of about $12.50.
Bottom Line on SNAP Stock
SNAP stock could go one of two ways into the end of the year. It could shoot materially higher if user growth trends remain healthy, ad demand accelerates, and margins improve. Alternatively, it could drop in a big way if user growth trends stall out, ad demand recedes, and margins stop expanding.
Right now, the bull thesis looks more likely that the bear thesis, but the bear thesis has enough merit that it can’t be ignored. And, the bull thesis doesn’t comprise enough upside firepower to compensate for the downside risk.
As such, while I understand the bullish sentiment surrounding SNAP and do think the stock has a very realistic chance to end 2019 above $20, I’m simply not buying into the rally today.
As of this writing, Luke Lango was long FB and GOOG.