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Morningstar | New Methods of Monetization Are Arriving for Snap; Maintaining $14 FVE

Snap’s first-quarter results were exceedingly good as user monetization and top-line figures surpassed our expectations. We believe the results confirm Snap is taking the necessary steps to keep users engaged and it is scaling accordingly. We’re also encouraged by plans for monetization in future, such as the relaunch of its Android app and an Ad Kit which could lead to increased customer engagements "off-app". As a result, we believe Snap is likely to become profitable over the next five years. We are maintaining our $14 per share fair value estimate for Snap. After rising more than 140% from its 52-week low in December to its $12 range currently, the stock is trading in 3-star territory and we recommend waiting for a wider margin of safety before investing in this no-moat and very high uncertainty brand.

Snap reported first-quarter total revenue of $320 million, an increase of 39% year over year. While average revenue per user (ARPU) increased more than we expected--to $1.68, which is 39% year-over-year growth--daily active users were below expectations at 190 million users, a 1% year-over-year decline. Feeding ARPU growth, direct response advertising revenue more than doubled year-over-year because of an increase in active advertising accounts and increased advertising budgets.

Gross margins expanded to 39%, improving by 2,100 basis points from 2018 as the company continues to make unit cost efficiencies in cloud infrastructure. Employee-related costs were largely responsible for lower operating losses compared with 2018, as the company experienced fixed-cost leverage.

Just after the quarter’s end, Snap launched its long-awaited rebuilt Android app to combat speed and technical issues. Snapchat believed this was the reason why there was less engagement from Android users than those on Apple's iOS ecosystem. Management gave little insight into progress made with Android user engagement after it redesigned the operating system, but we aren’t surprised because the launch only occurred recently. Still, we hope user engagement improves by the end of 2019 because Android engagement is essential if Snapchat wants to expand the number of international users.

Apart from Android-driven growth, we think monetization will continue to improve at healthy rates, considering there are new ways to monetize users--even apart from Snapchat’s app. In early April, Snap hosted its first annual Snap Partner Summit and unveiled its Snapchat Ad Kit. The kit will allow third-party apps to integrate with Snapchat Stories so that Tinder users, for example, can see Snapchat stories on the app if users opt to include it in their “Tinder story.” We think this will boost user engagement and provide advertisers with an attractive option to target diverse platforms via one advertising vendor. However, management said this should have little effect on financials for 2019 because it precedes the launch. We also like that Snap revealed more augmented reality features with Scan. One of the new Scan features will automatically interact with whatever is “scanned” in a camera by recognizing the subject of the Snap camera and interacting with it, in a similar way to solving a math problem in a photo or creating pertinent Giphy reactions by detecting what the subject of the camera lens is. Giphy is an online database and search engine that allows users to search for and share short looping videos with no sound, that resemble animated GIF files. Daily active users have spent more time on augmented reality, making it a more important platform for advertising spend in the long term.