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Morningstar | Snap’s User Monetization Continues to Improve; Cost Control Remains Intact; Maintaining $14 FVE

Snap’s fourth-quarter numbers comfortably beat our internal estimates and the consensus as the firm continues to display improvement in user monetization while maintaining cost control. While user growth was pretty much nonexistent, as expected, Snap’s efforts to increase user engagement and ease ad buying, along with offering tools to attract various types of campaigns, appear to be bringing in more advertisers and ad dollars. We remain confident that with further cost control as demonstrated during the last 12 months, Snap is likely to become profitable during the next five years.

We are maintaining our $14 per share fair value estimate on Snap. Although Snap shares are up more than 20% in after-hours trading in reaction to the good numbers, this no-moat and very high uncertainty name continues to trade at a significant discount to our fair value estimate.

Snap reported total revenue of $390 million, up 36% year over year as surprisingly the firm’s number of daily average users, or DAUs, declined by only 1% from last year and remained steady sequentially at 186 million. More effective monetization, as more advertisers and ad dollars are jumping on the firm’s platform, drove Snap’s top-line growth with average revenue per user, or ARPU, growing 37% year over year to $2.09.

Gross margin expanded by approximately 1,200 basis points from last year to 45% as the firm continues to benefit from much slower growth in hosting costs, or costs associated with its cloud structure provided by Amazon and Google. We note that this was partially offset by higher revenue share cost as Snap remains focused on bringing onboard more professional content which increases ad revenue share for the firm. Snap reduced its operating losses to only $195 million during the quarter, compared with losses of $361 million and $323 million in 2017 and last quarter, respectively. The firm has successfully controlled its R&D and sales and marketing expenses during the last 12 months, and we expect this to continue. In our view, investments in R&D in the range of $800 million to $1.5 billion per year is enough to allow the firm to develop more innovative tools going forward. Plus, while Snap needs to keep spending more on sales and marketing as it currently lacks the network effect moat source, we expect annual increase in that spending to lag revenue growth. We continue to foresee Snap becoming profitable in 2022.

In our view, while Snap is having difficulty attracting new users, it is successfully keeping its current users engaged, which can still help the firm attract ad dollars, as shown by growth in ARPUs. If we assume that Snap’s monthly active users, or MAUs, have remained above 100 million (the figure which the firm announced as its North America MAU count in second-quarter 2018), then the user interaction or engagement measure (DAU/MAU) is likely higher than Facebook’s. As management indicated, what is driving higher user engagement is professionally created content which is provided in stories and shows. According to the firm, viewers of such content increased by a third from last year and the consumption per user is also going up. We think that as the consumption of such content increases, more advertisers will purchase more ad inventory from Snap. We note that user generated content, especially the type that includes augmented reality, or AR, is also grabbing the attention of advertisers and ad agencies.

The firm is welcoming the increase in ad buying demand by not only making available a self-service and automated ad buying option, but also by providing various format and measurement tools for the advertisers. For example, Commercials, which are 6-second non-skippable ads like Google’s YouTube bumper ads, are welcomed by advertisers. Plus, it appears that the option to create and integrate AR ads is attracting advertisers, one of which was New Balance. It started an AR ad campaign targeting Liverpool soccer fans to try on the team’s jerseys, see how they may look in them, and purchase them if wanted. Adidas also ran an AR ad campaign on Snapchat.

In terms of ad measurement, Snap mentioned that the application of Snap Pixel, which basically helps advertisers track performance of their direct response ads, has increased significantly.

In our view, improvement in user engagement and content consumption, along with more scalable and flexible tools made available to advertisers and the agencies, will attract more ad dollars to the Snap platform, which will drive strong double-digit top-line growth during the next 10 years. We note that resolving the Android issue, which we think may take place in late 2019, could also be a revenue growth driver, especially in 2020. We think operating leverage and profitability is likely as strong revenue growth will be accompanied by further cost control.

Regarding the departure of Snap’s CFO, Tim Stone, which was announced on Jan. 15, the firm is still searching for a replacement. While we are not aware of any candidates, we hope Snap can attract someone with experience in guiding smaller firms through growth and various transitions, similar to what Stone's background suggests. In the meantime, Lara Sweet, the firm’s chief accounting officer, has been appointed as the interim CFO.
We are also assuming that the departure of Stone will not impact Jeremi Gorman’s stay as Snap’s chief business officer. The two were at Amazon where Stone was the VP of finance and Gorman headed Amazon’s global ad sales. We note that Gorman did participate in the earnings call and provided more color regarding her strategy to restructure Snap’s sales team to a more vertical model where they will become more knowledgeable about their clients’ industries. She believes that this model will help Snap retain its ad customers longer, generate more ad sales, and possibly function a bit more like an ad agency, with which we agree.