July 22 2020 - Snap: Impressive Quarter, Downside Ahead

Summary

SNAP shares are down ~6% in after-hours trading after releasing their Q2 earnings numbers.

Overall, the numbers were very solid, at least in my view. ARPU and revenue beat, while margins were strong, and EPS and DAUs came in line.

From the beginning of Q3 to July 19th, SNAP reported that revenue was up 32% Y/Y, though they expect moderation in this growth as the quarter progresses.

Margins, cash bleed, user growth, and ARPU were all strong points for the quarter. SNAP's progress thus far in Q3 was also a point-of-interest for me, I didn't expect a turnaround in the financials that fast.

Rating reiterated at SELL. PT raised from to .

General Summary

Snap (NYSE:SNAP) reported Q2 numbers today, delivering some very strong numbers on virtually all fronts.

  • DAUs (daily active users): 238M vs. 238.4M expected
  • ARPU (average revenue per user): .91 vs. .81 expected
  • Revenue: 4.16M vs. 4.52M expected
  • Non-GAAP EPS: -.09 vs. -.10 expected
  • Gross Margin: 47% (flat q/q)

With these numbers, I am a little surprised that the stock is down ~6% in the after-hours session, and anticipate a recovery in the share price as Wall Street and the sell-side digest the results.

What I Liked About The Quarter

There was a lot to like about Snap's Q2 report. Here are a few things I liked:

  • ARPU-based revenue beat
  • Cost-controls/cash bleed minimization
  • Gross margins

As you can see, while Snap saw strong sequential user growth, this was expected. Snap didn't disappoint on the user growth side, but they did surpass expectations in terms of ARPU. What was so shocking to me was that in a global pandemic that shutdown the vast majority of the world economy, Snap's global ARPU declined sequentially by only ~5%, while ARPU was flat Y/Y. A 5% decline while the rest of the economy was getting shelled is impressive. The fact that Snap was able to keep a relatively strong group of advertisers purchasing ad inventory on the platform was surprising. And clearly, this surprised the Street too, with Snap beating expectations on the monetization front by ~5.5%. Essentially, Snap's strength in keeping advertisers locked into the ecosystem despite coronavirus related spending headwinds is commendable.

Second of all, Snap was able to keep their cost structure relatively grounded. They grew operating expenses million sequentially, and yet, they didn't see too much damage to their overall EBITDA margin. I would have expected a nine-figure cash burn number this quarter, but because of management's fiscal discipline, cash-bleed was relatively low, especially in this economy. Keep in mind, that even with this cash burn, Snap has a total cash reserve of .8 billion. Worries about the company's ability to stay afloat without a capital raise are now unfounded.

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(source)

And finally, even though ad pricing across the internet advertising industry was being shelled, Snap's gross margins remained flat sequentially. As ARPU and ad pricing fell, Snap was able to lower internal costs, particularly infrastructure costs to the point where they wouldn't lose any margin. This was very surprising to me, as I anticipated that Snap didn't have much leverage in terms of reducing COGS (cost-of-goods-sold) in an environment where ARPU and ad pricing were in decline. When Snap's revenue growth returns (fueled mostly by ARPU growth), gross margins will begin to expand at a much greater rate. The company's strength in terms of delivering consistent gross margins during this pandemic is, again, commendable.

The Minimal Guidance Commentary

Snap gave us a little bit of commentary, but did not gives us a formal guide for Q3 or for the fiscal year as a whole.

From the beginning of the quarter to July 19th, revenue was tracking up 32% Y/Y, a stark re-acceleration in growth. That being said, because of the disruption in normal activities that occur during this time, activities that drive revenue growth (like sports, back-to-school, and film releases), they anticipate a moderation in this growth rate. Revenue growth is still expected to accelerate sequentially, with the company planning their investments around 20% Y/Y revenue growth in the quarter.

They also expect somewhere around 242-244 million users, and 20% growth in COGS/OpEx combined. Plugging these new assumptions into my valuation model yields a higher price target on the stock.

I Liked The Quarter, But I Remain A Bear

While I concede that Snap's quarter and even a bit of their forward-looking commentary was positive, I remain generally bearish. In my view, post coronavirus usage of Snapchat could underwhelm, as general life returns to normalcy and time that used to be spent on-app moves to real world activities. My DCF (discounted cash flow) model implies a valuation of /share, a stark downside from these prices. And yet, this /share valuation (~ billion market cap) implies a little over an 8X 2021 P/S (price/sales) ratio. It uses an 11% discount rate and a 3% terminal growth rate. The valuation model goes out to FY2029, estimating just under billion in revenue and ~67% gross margins by then. Even at /share, one could argue my valuation is too rich. With the stock at >11X sales, even for all the growth potential the company has, there is always a price for everything. Relative to other names, 11X is definitely a premium.

ChartData by YCharts

And right now, the risk/reward is heavily skewed in the bearish direction. For that reason, I remain a bear on the stock.

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