Should You Take Advantage of Snap’s Slump and Buy Shares?

The public markets haven’t been kind to Snap Inc. (NYSE: SNAP). Since spiking on the company’s first day of trading, shares of the social media company have been on a downward slide; they currently trade hands at around $13 per share.

Snap’s recent retreat is courtesy of a pair of negative analyst reports. Needham & Company cut its revenue forecast by 15%, pointing to fewer brands spending on Snap, while Cowen Inc. dropped its forecast for daily active users during the quarter.

Should investors take advantage of the recent bearishness and buy shares on discount? My answer is no.

Image source: Getty Images.

Let’s revisit Snap’s buy thesis

When Snap conducted its IPO, the buy thesis was relatively straightforward: The service is growing daily and monthly active users at a high clip; these users were in the coveted 18-to-24 age range, once considered to be abandoning Facebook (NASDAQ: FB); and marketing revenue would follow eyeballs, allowing the company to grow into its rich valuation.

Growing users at a rapid clip: While it was always expected Snap’s user growth would slow, the first quarter’s figure of 191 million was significantly below expectations of 194.2 million. Needham further lowered its forecast for second-quarter daily active users from 196 million to 194 million, which would be the first sequential decline in Snap’s history as a publicly traded company.

The “anti-Facebook” now admits it wants to be more like Facebook: Snap’s big selling point to marketers was simply that it was not Facebook, particularly from a demographic standpoint. Its users were younger, with a lifetime ahead to earn and spend money; this made them a more valuable demographic to marketers than Facebook users, who are now trending older.

That’s why it was surprising when the company announced its redesign to “make it easier for new people, especially older ones.” Younger people rebelled and stopped using the app, the end result being less new-user growth and slowing DAU (daily active users) growth.

Rapid revenue growth justifying its valuation: Snap was always an expensive stock, trading for nearly 60 times trailing-12-month sales at its IPO. As an example, perennially richly valued companies Facebook, Amazon and Tesla debuted at price-to-revenue ratios of 28, 19, and 14, respectively. (For comparison’s sake, the slower-growth S&P 500 traditionally trades at a ratio between 1 and 2.)

The rationale was that Snap would make it up in growth — top-line growth would lead to earnings and to free cash flow (FCF), and quickly, as advertisers followed eyeballs. But both Cowen’s and Needham’s reports seem to point to slowing revenue growth in future years, which is bad news for the stock.

More about valuation

In all fairness, Snap is still growing its top line at a rapid clip: Last quarter Snap grew revenue 54% year over year, but its FCF loss widened from $173 million to $268 million. Simply put, every incremental dollar Snap recorded in revenue over the prior year’s quarter made shareholders poorer on a cash basis. Although GAAP (generally accepted accounting principles) earnings looked better year over year, this was due to huge stock-based compensation expenses in the year-ago quarter.

Perhaps the company will attain profitability in future quarters, as it’s CEO Evan Spiegel’s stated goal to do so. Management has taken a hatchet to employee headcount, with at least four separate rounds of cuts in recent months to get to profitability. However, it’s likely the company will do so via slash-and-burn expense-cutting rather than growing into its valuation.

Even with slowing user growth, demographic challenges, and widening FCF losses, shares still trade at 18 times sales.

I’d steer clear of Snap, until either these issues are resolved or valuation significantly improves via continued sell-off.

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