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Snap Inc Might Be the Wrong Stock for This Market

The long-term story for SNAP stock still looks attractive, but near-term trading might still prove challenging

Give credit where credit is due: Snap (NYSE:SNAP) is executing well. User growth has been jump started, monetization is improving and the price of SNAP stock has risen nicely. Even with a pullback in recent weeks, the stock has gained 161% so far this year.

Snap Inc Might Be the Wrong Stock for This Market
Source: Puckpao / Shutterstock.com

But that pullback can’t necessarily be ignored, and it highlights a key concern for SNAP stock investors going forward.

Currently, investors aren’t nearly as interested in stocks that provide revenue growth with little profitability (or losses). Snapchat stock is going to be one of those names for a while, which suggests that even solid execution might not be enough for a near- or mid-term rally.

Snap Gets It Turned Around

It was less than a year ago that Snap looked like an absolute disaster. The price of SNAP dipped briefly below $5 in December. At those levels, shares had dropped over 70% from the company’s IPO price, and 80% from their first-day close back in March 2017. A poorly received app redesign led to declines in the user base, and investors worried about the remaining users defecting to Facebook’s (NASDAQ:FB) Instagram.

But over the past four quarters, Snap has righted the ship. Users are returning: the daily active user count increased 13% year-over-year in the third quarter. Snap is also better at monetizing those users by attracting more advertisers: quarterly average revenue per user (ARPU) jumped 33% in Q3 against the year-prior figure.

There’s room for further improvement on both fronts. Snapchat still has enormous appeal to younger users, and it may eventually gain some penetration in older demographics. The runway for monetization growth, meanwhile, looks enormous. Snap’s ARPU is still dwarfed by those of Facebook and Twitter (NYSE:TWTR). International audiences account for 60% of Snap’s total, but the average user outside North America generated barely $1 in revenue in the third quarter.

More users and better monetization can combine to drive solid revenue growth going forward. Snap should grow revenue roughly 45% in 2019. Analysts expect 35% growth next year. The nature of a platform is that incremental revenue will add big profits, which suggests that, eventually, Snap can start generating positive net income and free cash flow as well.

The Profit Problem for SNAP Stock

At the moment, however, the key word in that sentence is “eventually”. On the Q3 conference call, Chief Financial Officer Derek Anderson did guide for positive Adjusted EBITDA (earnings before interest, taxes, depreciation, and amortization) in the fourth quarter. And analysts on average see positive adjusted earnings per share in 2020.

But both metrics exclude share-based compensation. That expense is on track to near $700 million this year against $538 million in 2018. And even consensus estimates for 2 cents in EPS next year on their own hardly seem to justify a SNAP stock price still above $14.

Again, if Snap can keep growing, it can drive profits that will support the current market capitalization of $20 billion. But that’s a big “if.” Even with SNAP shares down 20% from July and September highs around $18, the stock is still pricing in tremendous bottom-line growth. And what we’ve seen of late is that investor patience for these types of growth stories — big revenue increases combined with minimal profitability — is not what it once was.

Growth Names Stumble

Early last month, I wrote that it seemed like good news that SNAP stock traded at $16. That price suggested just over a 10% pullback from the highs. Meanwhile, two other high-flying stars of 2019 — Shopify (NYSE:SHOP) and Roku (NASDAQ:ROKU) — had declined more significantly.

Six weeks later, SNAP looks more concerning in that context. Shares have lost another 10% of their value. And the focus on profitability in the rest of the market persists. SHOP and ROKU have bounced from recent lows, but investors mostly shrugged at strong Q3 results from both companies. Cannabis stocks trade at 52-week lows or worse. Recent initial public offerings like Uber (NYSE:UBER) and Lyft (NASDAQ:LYFT) continue to slide.

I argued relative to SHOP stock that the WeWork debacle might well have been a catalyst for the pullback in unprofitable or minimally profitable stocks. A Bloomberg article last month made a similar argument with more detail. A demand for “growth at any price” has become a demand for the right kind of growth at real margins and with real cash flow. And it seems likely that shift is responsible for much of the 20% decline in SNAP stock from September highs.

The Changing Market for SNAP

After all, under the “old” way of thinking, Snap’s Q3 report probably would have been well received. The outlook for the fourth quarter was seen as a bit soft, but companies like Snap generally guide conservatively. And it was revenue and user growth, not margin improvement, that led SNAP stock to more than triple off those December lows.

But if investors really are going to focus on profitability, that’s a problem for Snap stock. It can’t deliver on that front likely until 2021. Given its growth and its need to pull advertisers from other social media plays, it probably shouldn’t deliver on that front, either. There’s little need to focus on profitability or free cash flow right now, given a solid balance sheet and big incremental profits from new users.

Without that profitability, however, and with still-huge trading gains in 2019, SNAP stock may stay stuck. After all, it was the perfect stock for the market in the first eight months of 2019. That’s simply no longer the case.

As of this writing, Vince Martin did not hold a position in any of the aforementioned securities.


Article printed from InvestorPlace Media, https://investorplace.com/2019/11/snap-inc-might-be-the-wrong-stock-for-this-market/.

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