2023-05-31 17:41:40 ET
Summary
- Snap Inc.'s growth will depend on innovation, product monetization, and internationalization.
- The company faces challenges in growing its North America user base, monetization of international regions, competition, and the need to improve investment efficiency.
- Snap stock is overvalued by more than 40% at its current price of around $10 per share, with a computed value per share of $6.
- A Monte Carlo simulation shows more than 90% chance Snap Inc. stock is overvalued at its current price.
Introduction
After a very long break, I decided to resume my writing here on Seeking Alpha starting with Snap Inc. ( SNAP ). This is going to be the second time I am writing about the company - the first article (which you can find here ) was written more than six years ago, around the time the company filed its S-1 statement for an IPO. However, given how much time has passed since then, I intend to be as broad as possible in discussing the company.
SNAP describes itself in its filings as a "camera company" that "reinvents the camera to improve the way people live and communicate.” The company's flagship product is Snapchat, a mobile app that enables users to create and share Snaps. Users can also chat with friends, watch curated content from publishers and creators, play games, use augmented reality ((AR)) features, and shop on the app. As of Q1’2023 ( April 2023 investor presentation ), the company had 750mln monthly active users ((MAU)) and 383mln daily active users ((DAU)) globally.
Importantly, Snapchat's main source of revenue is digital advertising. The company offers various ad formats to help advertisers reach its audience, especially among the younger demographic. Some of the ad formats include:
- Snap Ads: full-screen videos with sound or images that appear between Stories or Shows on Snapchat. Snap Ads can also include interactive elements such as attachments, collections, or commercials.
- AR Ads: Creative tools that allow users to overlay 3D objects, animations, or effects on their Snaps or their environment. Advertisers can create sponsored lenses and filters to promote their brands or products in an immersive and viral way.
- Spotlight: A new feature that showcases the most entertaining Snaps from the Snapchat community and where advertisers can place ads right within Spotlight to reach a large and diverse audience.
In addition to advertising, SNAP also generates revenues from the:
- sale of hardware products, such as Spectacles, a line of smart glasses that allow users to capture and share their perspective with Snapchat, and Pixy, a flying camera;
- subscription service, a relatively new product called “Snapchat+” that was launched in June 2022 and gives subscribers access to exclusive, experimental, and pre-release features. In its Q1 2023 results, the company reported that the subscriber base had more than 3 million users, up from 1 million mark reached in August 2022.
Growth Opportunities
SNAP’s growth will very much depend on innovation, product monetization, and internationalization.
Innovation
Innovation is at the backbone of achieving and maintaining a high user engagement, underpinned by such app features as Spotlight, Lenses/AR, Map, Originals, Games, Bitmoji, and equipment. We can signify two important drivers behind that: R&D spending and the user base.
Over the last five years, the company has spent, on aggregate, 45% of its revenue on R&D, with only in TTM Q1’2022 dropping below 40%.
Figure 1
Compare that to its closest competitors (on aggregate, over the last five TTM years) and the contrast is quite visible:
- Alphabet Inc. ( GOOG ) – 14.4%
- Meta Platforms, Inc. ( META ) – 23.6%
- Twitter ("TWTR") – 23.4% (de-listed but still an applicable and recent case)
- Pinterest, Inc. ( PINS ) – 42.4% (notably, TTM Q1’2020 has been an outlier, with other years posting around 33%).
The data above may indicate that the company is either committed to investing aggressively in the R&D to spur future growth, or that this spending is highly overblown. There could also be another argument that both GOOG and META have significantly higher revenue bases, hence lower ratios; however, this assertion is dispelled one two counts: first, by looking at PINS and TWTR revenues, with the former having lower in each of the observed periods (relative to SNAP) and the latter being not that far above; and second, by looking at META’s TTM Q1’2011 ( S-1/A filing ) ratio of 7.4% (the period when META had a somewhat comparable DAU count of 372mln).
Switching to the user base, we can draw several conclusions, both positive and negative. On the upside, the company has grown its daily active users by more than 100% in total (or about 15% CAGR) over the last five years, from 191mln (as of the ending period Q1’2018) to 383mln (Q1’2023). That user base is also much diversified, coming not only from North America (N.A.), but all over the world:
Figure 2
In fact, of the 101% DAU growth indicated above, the N.A. region contributed only 9.9 percentage points to the growth rate, with Rest of the World (RoW) region having by far the greatest contribution of 74.3pp. As a result of this explosive growth, the share of RoW in the total DAU has basically reversed with that of N.A and now comprises almost half of global DAU.
Table 1
On the downside, the N.A. DAU growth has stalled, as the last three quarters showed no growth at all (flat at 100mln) and only 2% YoY growth in Q1’2023, compared to 26.7% for the RoW over the same period. Given this data, it is interesting to note that the company indicates (Investor Presentation, slide 29) there are significant opportunities to grow DAU in the N.A. However, given that the younger demographic comprises a large portion of SNAP’s user base (especially with Gen Z users , which is also supported by the company’s own focus on 13-24 / 13-34 age groups, as per its presentation), and that the target number of people within these age groups across the top 10 most populous countries of North America (calculated using the data here , here , and here ) is, roughly, between 88mln (13-24 age group) and 175mln (13-34 age group), it appears that any significant growth beyond the current 100mln DAU is likely to be limited.
Monetization
SNAP, by and large, is still a digital advertising company. While it does attempt to diversify its revenue stream by means of equipment sales as well as adding the layer of the so much popular these days subscription model (Snapchat+) – currently, the company does not disclose the breakdown of revenue by sources, admitting it is immaterial – it is highly likely SNAP will remain a digital ad company for the foreseeable future (again, the company admits that in its risks section on page 45 of the latest 10Q ).
Importantly, and picking up from the previous section, there could be further headwinds in the revenue growth, given that almost 70% of revenue over the last five years had been generated from the N.A. region, with the rest shared virtually equally between Europe and RoW.
Figure 3
This trend is even more pronounced when viewed from the quarterly ARPU perspective. The table below compares Q1’2023 ARPU with that of Q1’2018. Comparing the regions, N.A. generated $6.4 per each dollar of ARPU earned in the RoW region in Q1’2023, up significantly from $3.5 in Q1’2018. From the total firm-wide perspective, N.A. contributed almost 65% to total ARPU ($1.7 of the $2.58 total); and even though N.A. share in ARPU has somewhat decreased from 74% in Q1’2018, its contribution is still significant.
Table 2
As a consequence, should DAU slowdown in the N.A. continue, much would depend on how ARPU performs. That, however, presents another challenge. Since Q2’2021, N.A.’s quarterly YoY ARPU growth has steadily been slowing down, becoming negative during the last three quarters.
Figure 4
Internationalization
It is an undeniable fact that the last five years (TTM Q1’2019 – Q1’2023) have seen an explosive growth of SNAP’s user base. As we have seen from the Table 1 above, most of that increase can be attributed to the RoW region, followed by Europe. Given the likely headwinds in the DAU growth across the N.A. region, further expansion internationally is important for the company.
The major challenge, however, will be in the monetization of the international markets, given the substantially low ARPU levels there relative to the N.A. region. Again, we can compare the ARPU levels with PINS and META:
Table 3
ARPU by Region | ||
PINS | Q1'2022 | Q1'2023 |
N.A. | $5.0 | $5.1 |
Europe | $0.7 | $0.7 |
Rest of W | $0.1 | $0.1 |
TOTAL | $1.33 | $1.32 |
ARPU by Region | ||
META | Q1'2022 | Q1'2023 |
N.A. | $48.3 | $48.9 |
Europe | $15.4 | $15.5 |
Rest of W* | $3.8 | $3.9 |
TOTAL | $9.54 | $9.62 |
Source: Company 10Q presentations. *Average of the APAC and RoW regions.
It appears that SNAP is marginally better than PINS but has a significant upside potential, given the META figures. However, this is likely going to be a long way for SNAP to even come close to those levels, especially given the last quarter’s decline in the ARPU level across all regions.
Valuation
To start with, the value drivers that we shall discuss below will center around the following narrative (based on general conclusions that can be drawn from the analysis above) – SNAP is a niche digital advertising company aspiring to have a global reach to its young audience through its messaging app Snapchat, but faced with significant headwinds in user growth in its most revenue-generating region of North America, further monetization of the international markets, high competition, and the need to improve on the efficiency of its investments.
- Growth – Let us start with what the overall global digital advertising market looks like. According to eMarketer , a market research company, digital ad spending will grow by 9.5% in 2023 and reach about $602bln. On the upside, the industry as a whole is still growing and represents an improvement against the 8.5% rate of growth recorded in 2022. It is also interesting to note that the digital ad spending expansion within the total media ad spending is continuing, rising from 63.2% in 2021 to 64.8% share at the end of 2022 and expected to reach 73.8% over the following five years. As a result, SNAP’s own market share, based off of these figures is only 0.84% globally (implied) and less than 2% in the US ( Q1’2023 investor presentation ). On the downside, however, this growth, in addition to being adjusted downwards in March 2023 by eMarketer, relative to a 10.5% expected at the beginning of the year, is also the second-slowest ever-recorded by the firm since it started tracking the industry more than a decade ago. This slowdown may potentially have a negative impact on smaller players, such as SNAP, as advertisers will likely focus more on developed and time-tested platforms.
As a result of these market-wide trends, the analyses provided in Part 1, and the fact that the company’s total revenue growth has been steadily declining since Q2’2021, so much so that the Q1’2023 became the first quarter, since the IPO in 2017, when it posted negative YoY growth rate (see Figure 5 below), it is difficult to see the revenue growth rates in excess of that of the market.
Figure 5
As such, the base-case revenue growth will be based on four stages:
- 0% growth in Year 1
- 8.5% growth in Year 2 (in line with 2023 overall market) gradually growing to 25% in Year 5 (to reach a market share of around 1% globally).
- 8.5% to 3.8% ( 10-Year US Treasury Note ) gradual decline from Year 6 to Year 10
- 3.8% in the terminal period (Year 10 onwards).
- Profitability – From the GAAP perspective, SNAP is still an unprofitable company. Yet, in its reporting, the management also provides the adjusted EBITDA calculation, which, starting from TTM Q4’2020, indicates that SNAP has become profitable. As per the company, the adjustments (relative to GAAP EBITDA) include non-cash and non-recurring items – the most frequent ones being the stock-based compensation ((SBC)) expense and the restructuring charges.
However, while being a non-cash item on the face of it, SBC is a recurring expense on the income statement and, therefore, by adding this item back, we run the risk of understating future expenses. To see the extent of the issue, we can look at the percent contribution of SBC to the EBITDA adjustment in each of the last five years:
Table 4
TTM Q1'2019 | TTM Q1'2020 | TTM Q1'2021 | TTM Q1'2022 | TTM Q1'2023 | |
EBITDA | -$1,111.1 | -$940.8 | -$740.8 | -$395.7 | -$1,243.4 |
SBC | $567.5 | $695.5 | $835.2 | $1,130.5 | $1,427.3 |
Adj EBITDA | -$481.2 | -$160.0 | $124.7 | $682.9 | $313.9 |
SBC contribution | 90% | 89% | 96% | 105% | 92% |
Source: 10Ks/Qs and author’s calculations.
We can clearly see that the SBC expense is quite a staggering item in the positive adjusted EBITDA figure. By this logic, it is preferable to retain the SBC expense, thus reconfirming that the company is not yet profitable.
This does not mean, however, there are no other adjustments required. General candidates for capitalization are usually lease and R&D expenses. With the introduction of the ASC 842 standard, the former has been covered; since the latter remains, the corresponding EBIT adjustment had been made.
Looking forward, I will assume that as the company grows and unit economics come into play, SNAP will expand its operating margins to reach 20% over the next 10-year period, or slightly above the 19% level (on R&D-adjusted EBIT margin basis) reached by Twitter in TTM Q1’2022 (this is still much lower than what both GOOG and META have).
- Reinvestment – this is a composite term that includes three important items: capital expenditures (including acquisitions and divestments), depreciation and amortization expenses, and working capital investments. For the purposes of valuation, the sales to reinvestment ratio will be used to project future reinvestment activity of the company. By the way it is being computed, a ratio of, say, 1.5 indicates that per each $1 reinvested, a company will generate $1.5 in additional sales. Furthermore, the higher the ratio, the more efficient the company is at generating revenues. For SNAP, over the last three years (in TTM periods), the ratio hovered around 1.42.
To calculate the reinvestment rate in the terminal period, we shall use the re-arranged sustainable growth formula at the stakeholder level:
Reinvestment rate = Sustainable growth / ROIC,
whereby the sustainable growth will equal the 10-year Treasury Note rate of 3.8% and an ROIC of 8.3% (equal to terminal period WACC):
Reinvestment rate = 3.8% / 8.3% = 45.78% (to be multiplied by the after-tax adjusted EBIT to arrive at an absolute value).
- Risk – using market values of equity and debt (including leases), we have the following for the calculation of the transition-period WACC:
Equity | After-Tax Debt | Capital | |
Weight in Cost of Capital | 83.3% | 16.7% | 100% |
Component cost | 13.44% | 4.44% | 11.93% |
The equity component was calculated using the risk-free rate of 3.8%, ERP (geographically weighed by sales) of 6.61% and a levered bottom-up beta of 1.46. The pre-tax debt component was computed as the SOFR plus 0.75% (in line with the terms of the company’s Credit Facility):
Cost of Equity = 3.8%+1.46*6.61 = 13.44
Cost of Debt = (5.05%+0.75%)*(1-23%) = 4.44%
The 5-year transition-period WACC of 11.93% will be linearly adjusted downwards over the remaining projected five years to a terminal rate of 8.3%.
Apart from these value drivers, the following data has been applied in the model as well:
- Share count of 1,730mln (including RSUs)
- Marginal tax rate of 23%
- Value of debt of $4,164mln, including leases;
- Value of options of $4mln, based on 3.2mln shares underlying options, average strike price of $19.36, average maturity of 3.73 years and standard deviation of 40% (10Q filing);
- Loss carryforwards of $15.6bln, which will reduce the taxable base once the company becomes profitable;
- The value of strategic investments held by the company in the amount of $1bln: Q1’2023-end carrying value (recorded as a non-recurring fair value measurement) of $223.3mln multiplied by a P/B ratio of 4.61x (internet software companies).
The table below presents the model results:
At current price per share of around $10 and the computed value per share of almost $6, the stock is overvalued by more than 40%.
To account for the uncertainty factor in the main assumptions discussed above, the Monte Carlo simulation of 10K trials has been conducted by applying probability distributions to base-case assumptions of revenue growth, operating margin, reinvestment ratio, and the WACC. The results are provided below:
Figure 6
Figure 6 shows the median value per share of $4.35 (vertical green line) and the area (colored red) above $10 of value per share. As a result of these simulations and given the distribution assumptions, it appears there is around 93% chance Snap Inc. stock is overvalued at the current price of about $10.
For further details see:
Is Snap Stock Worth Your Attention? A Look At Its Valuation And Challenges