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Morningstar | Leverage Widening Snap’s Margins, But Lackluster User Growth Has Us Worried; Maintaining FVE

Snap reported mixed third-quarter results, with revenue in line and margins expanding well beyond our expectations and consensus, but daily active users, or DAU, declining for the second consecutive quarter. Management indicated that they expect DAUs to be lower sequentially in the fourth quarter, and issued top line guidance that was well below our expectations. Even in the midst of strong EBITDA guidance, the market did not react well to the news, with shares trading almost 10% lower after-hours. After incorporating lower near-term user growth, offset by higher profitability and monetization, we are maintaining out $14 fair value estimate as well as our no-moat rating for this name. We think the margin of safety in the name currently is sufficient to warrant consideration by investors, though we caution that near-term catalysts to revitalize investor sentiment in the stock are scarce.

Revenue of $298 million and average revenue per user, or ARPU, of $1.60 represented year-over-year increases of 43% and 37%, respectively. DAU of 186 million represented a 4% increase over last year, but was down from 188 million last quarter. Qualitative evidence from management commentary suggests that engagement remains high despite user declines. DAU/MAU, a popular measure of user engagement on social networking platforms, we estimate remained stable at close to 80% for Snap, which compares favorably to Facebook’s 66% (excluding Instagram) and Twitter’s sub-50%. This engagement, along with streamlined ad-sales initiatives, is driving robust growth in ad impressions and allowing the firm to extract more value from their base.

Management indicated that the sequential drop in DAU was mostly among Android users, and the firm is hoping to stem the tide with the redesigned Android application that is currently being tested. The absence of a timeline, however, along with management’s seeming lack of clarity, makes us dubious as to the ultimate success this release will enjoy.

We were quite impressed by the firm’s strides toward profitability in the quarter. On the gross margin front, GAAP gross margins widened to 27% from 16% last year and 15% last quarter. Even though relying on the public cloud for infrastructure inherently fosters less operating leverage as the business scales, we still think the firm will be able to continue to expand gross margins and become profitable by 2022. In terms of operating expenses, programmatic advertising is paying dividends much more quickly than we anticipated. According to Snap, 85% of advertising revenue in the quarter was self-service, versus 35% a year ago. The efficiency of this approach is driving tremendous operating leverages on the sales and marketing line, with this expense falling 4% year over year, and representing only 33% of revenue versus 50% a year earlier.

While we applaud the firm’s progress to go-to-market more efficiently, we think the firm’s overall margin profile is also being propped up by less prudent operational decisions. Less investment in R&D has also played a role in the firm’s improving margin profile, as this line has essentially been flat on an absolute basis since the first quarter and stood at 68% of revenue in the third quarter versus 87% in the first quarter. While we expect some leverage on this line as the business scales and adoption ticks up, the drastic improvement gives us pause. We are pleased the cost structure is improving, but we worry that it may be coming at the expense of necessary reinvestment in the business, particularly given the intensity of the competitive landscape. If Snap is prioritizing short-term profitability over long-term growth and sustainability, it may be a short-lived victory for the firm. If DAUs continue to decelerate as a consequence, the cachet the company has with advertisers may be lost.

Ultimately, we think the subpar user growth thus far this year lends credence to our thesis that competitive dynamics limit the extent to which Snap’s network effect can manifest into economic profits. Competitors, such as Facebook’s Instagram, have larger ecosystems, more extensive resources (which facilitate more financial flexibility for innovation), and cachet amongst a broader age range of users. Additionally, while the specific code and algorithms driving Snap’s platform features may be patent-protected, the overarching conceptual ideas are not, making it increasingly unlikely that Snap will be able to consistently achieve competitive differentiation. These realities form the foundation of our no-moat rating for the firm.