Is Snap (SNAP) A Good Buy?

Snap (SNAP) is a $13B technology company, that almost every teenager uses its app to connect with friends. It has successfully engaged and satisfied its users but not so much its investors. Its stock is down more than 50% since its IPO in 2017. Many attribute Snap's fall to TikTok's fierce competition in recent years. Is that reason justified, or is the 50% drop in the stock price a buying opportunity?

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I'm Hoda Mehr, founder, and CEO of Stock Card, and on this blog and its accompanying YouTube channel and Podcast show, I share detailed fundamental analyses and interesting investment stories.

This post is part of a series I started last week to research companies I own that are down significantly from their all-time highs to decide whether to buy more or sell and allocate money to other companies. I've already researched Canopy Growth (CGC), and Fastly (FSLY), and I'll continue with this series for a few more weeks.

​Remember, these videos are for education and sharing ideas and not advice to buy or sell any securities.

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TikTok Is The Stock Market's Boogeyman

TikTok's influence on the stock prices of companies such as Snap is like a stock market boogeyman story. In general, investors assume the rise of TikTok means the fall of Snap, Facebook, Instagram, YouTube, and other content platforms. On the surface and intuitively, this seems true. TikTok is one of the most downloaded and used content consumption platforms in the U.S. Anything that consumes people's time leaves less time for engaging and interacting with other applications such as Snap. However, in investing, relying on only your intuition can be catastrophic. We must dig into the facts and confirm or reject our intuition. Today. We will research Snap's fundamentals to bring logic to our intuition.

Let's talk Snap now.

TikTok Isn't Killing Snap

People, I'm 41 years old and have never used Snapchat. But I own its shares. Why?

In 2019, I researched the stock fundamentally when it was trading at around $17 per share and concluded it's a financially solid company worth owning. Here's the link to that 2019 fundamental analysis in the show notes if you want to go back and watch or listen to it.
But in summary, revenue was growing 48% year over year. The average revenue per user was about $2, significantly lower than Facebook's average, highlighting a significant revenue growth opportunity for Snap. Its daily active users were around 13 million, and there was no TikTok to worry about. 

Fast forward to 2023, and the stock is down to roughly $8 per share, 50% lower than when I researched it in 2019. It still makes money primarily from advertising. However, it added other revenue sources such as subscription revenue from more than 3 million subscribers and enterprise SaaS revenue from selling its AR-based Shopping Suite functionality enabling customers to try retailers' products using AR before buying. It made $4.6B in revenue in 2022, up 35% per year compared to 2020. The company's daily active user is now up to 383 million, from the 13 million I told you about in 2019. In the United States, users open the app more than 40 times daily.
So compared to 2019, the company is in a much better position, but the stock price is down 50%.

In comparison, TikTok is expected to make $10 Billion in ad revenue in 2023, with its daily active users across iOS and Android devices being around 45 million, excluding the Chinese version of TikTok. 

Snap is competing head-to-head with TikTok's short-form video platform. Its new feature, Spotlights, is a TikTok-comparable short-video sharing feature with more than 5 billion Snaps created daily.

The company continues to focus on investing in Augmented Reality (AR), with 250 million users interacting with AR features. 

The interesting and unique aspect of Snapchat is its myopic focus on the younger generation of 13- to-34-year-olds. The platform focuses on becoming the first app kids download when they get their first mobile phone. With its focus, it has managed to attract 75% of its target market in 20 countries representing more than 50% of the global advertising market.

In comparison, TikTok covers a much broader demographic. For example, roughly 3.5% of TikTok's audience is above 50 years old. 

In summary, Snap has more engaged users daily and has been able to grow its user base just like TikTok. But Snap makes half the revenue TikTok does. 

If TikTok was Snap's problem, we should have seen user and engagement losses for Snap. That's not the case, meaning Snap's stock price decline is not because of direct TikTok competition.

So if TikTok isn't a problem, what is?

Snap's Quarterly Earnings Report Recap

1. The most important factor is the recent deceleration of the company's revenue growth, from 116% quarter-over-quarter revenue growth in Q2 2021 to flat revenue growth in Q4 2022.  Even scarier is the recent quarterly revenue results in Q1 2023, down by 7% year-over-year. The situation was even grimmer in the eyes of investors because META reported its quarterly earnings report one day before Snap, highlighting a 4% year-over-year revenue growth in Q1 2023. 
   
2. The second issue is the company's insistence on investing in artificial intelligence and machine learning. I was listening to the quarterly earnings call live, and the questions asked by analysts dampened were so telling. The analysts accused Snap of wasting money investing in Artificial Intelligence and Augmented Reality. Analysts are scared that the company's investment will result in more user engagement but won't enhance its monetization and ad revenue. Snap is investing 46% of its revenue in research and development. While the revenue is down 7%, the R&D has remained at the same level. Interestingly, TikTok's parent company, ByteDance, reportedly spent $15B in R&D in 2021 on a $60B revenue in the same year, representing 25% R&D expenditure. With a 46% R&D to revenue ratio we discussed earlier, Snap is investing a much bigger portion of its revenue in R&D comparatively, and analysts have the right to worry about the high cost. 
   
3. The third problem with Snap is its high stock-based compensation, dilution, and how Snap uses its cash. Stock-based compensation allows companies to retain employees. They give them a chance to own shares in the company. However, every time you give your employees stock-based compensation, you have to issue new shares. Issuing new shares dilute the existing shareholders' ownership of the company. In Q1 2023, the company allocated 30% of its revenue to stock-based compensation. But, we see the count of shares going down. That's because Snap uses its available cash to purchase its shares back. In the last 12 months, the company spent $1B in share repurchases, and the cash it generated with its operations wasn't big enough to offset the share repurchase.
   

Those are some serious concerns about the company and have nothing to do with TikTok or the global advertising market. 

Snap's Fundamental Analysis

Let's turn the conversation around and explore whether Snap has a way to redeem itself. Firstly, can it resume revenue growth? 

Aside from external factors, such as the advertising market's short- to mid-term recovery, Snap has to convince advertisers to spend their dollars on its platform. 

Typically, revenue is a lagging indicator. That means revenue growth is the last financial metric showing a company's financial strength. Things like the number of users and growth in active users are early indicators. Snap's user and engagement growth could signal higher revenue a few quarters down the road. 
Snap's investment in AI and machine learning isn't only focused on user engagement and is dedicated to enhancing advertisers' ability to get and measure the return on their advertising dollars spent on Snap. The investment would pay off, I believe. I based that belief on seeing how the management has grown users and engagement and cut costs enough for the company to generate free cash flow in the last two quarters. Those tell me the management is capable of delivering on their plans. 
Moreover, despite more than $1B in stock buybacks and high R&D expenses, Snap still has more than $4B in cash and marketable securities, and it doesn't fear immediate balance sheet concerns. 
So let's summarize what we've learned about Snap:

1. The company is super focused on the younger demographic. It has continually grown its daily active and overall number of users.
2. Although revenue has been significantly higher in the last 2-5 years, the growth has decelerated, and the latest earnings report hinted at a continued declaration pace.
3. There is a disagreement between the management and the financial analysts on how much the company should spend on R&D. 
4. Despite revenue declaration, Snap has managed to cut costs. It has generated free cash flow in the last few quarters. 
5. High stock compensation dilutes current shareholders, but the company has tried to balance that off with its buybacks.
6. ​It has more than $4B in cash, but the management doesn't seem interested in cutting back on R&D or buybacks, which will deplete its cash without sustainable profit.​ ​

Is Snap A Buy Now?

If the best investment strategy is to invest in a company with a lot of upside potential and not much downside risk, let's do some quick math to decide whether Snap fits that strategy.
To set the foundation, let's make some valuation comparisons. Snap is priced at 3.5 times its sales. META is priced five times its sales. TikTok isn't a publicly-traded company, but we can do some math. According to Bloomberg, TikTok U.S. can be a $40 to $50 Billion dollar company. With an estimated $10B in revenue in the U.S., the company is priced at 4 to 5 times its 2023 revenue. With those price-to-sales comparisons, Snap is an undervalued stock. 

What's the optimistic scenario?

Optimistically, if we believe in the assumption that higher user engagement will eventually translate to revenue growth, the upside is that the company will grow its revenue by 15% starting next year and gets a price-to-sales ratio of 5 which is the current META or TikTok's price-to-sales ratio. In five years, Snap would be a $40B company or 2.5 times bigger than today. 

What's the pessimistic scenario? 
Snap can fail on all its revenue growth targets, use up all its cash, and become a worthless company. 
What's a bit more realistic scenario? Snap's revenue stays flat for another year or two and slowly recovers to its historical 15% year-over-year growth in the next five years. Its R&D expenses and stock-based compensations stay elevated, preventing higher valuation multiples than today. With those assumptions, the company has about 20% growth potential in the next five years. 
Knowing all that, what do we do with Snap shares:
There is at least 20% upside potential in Snap's shares. If we are patient and keep looking, we will find better investment opportunities to grow our investment faster than Snap. However, considering that upside, I don't see any reason to scare away and sell my SNAP shares now because the company isn't in immediate danger. For me, Snap goes in the hold-until-better-opportunities bucket. 

However, I would have looked for better investment opportunities if I didn't own Snap shares. 20% realistic return in five years isn't a good investment, especially in an environment where the risk-free investment return in CDs is already at 5% per year. 

It's your turn to share your research. What other investment opportunities justify selling Snap at a loss and buying up those shares now? You can go to Stock Card and look up Snap's Stock Card to start your research. Click here to jump to it's Stock Card.

​Next week, I will be back with another beaten-down stock fundamental analysis, for now, go ahead and watch the rest of this series by clicking on the link in the show notes. I'll see you next time.

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