Nov 3 2021 - Snap: A Tech Darling In Distress

Summary

• Yikes. After the knockout 2Q print, SNAP's 3Q print was rough to say the least.
• IDFA, competition from TikTok, and macro supply chain issues are weighing on and could continue to weigh on revenue growth going forward.
• The risk profile, even after the correction, is relatively elevated. That said, value can be found here. SNAP continues to be an advertising powerhouse with a large TAM.
• That said, valuation may be stretched even after the correction. Some of these headwinds including TikTok competition and IDFA reconciliation continued to seem more structural in nature.
• Downgrading SNAP from Buy to Hold, reducing PT from to . Waiting for greater visibility on competitive headwinds and IDFA targeting problems.

Wachiwit/iStock Editorial via Getty Images

3Q Headline Numbers - Diagnosing the Damage

Snap (NYSE:SNAP) just delivered its 3Q earnings report and commentary, with outlook to 4Q. It was ugly, very ugly, causing a massive decline in the share price. As of the time of writing, shares of Snap have gapped down ~23% off their pre-earnings level. Let's look at the headline numbers.

• DAUs: 306mn vs. 301.8mn expected (1.4% beat)
• ARPU: .49 vs. .67 expected (4.9% miss)
• Revenue: .07Bn vs. .1Bn expected (2.7% miss)
• EPS: .17 vs. .08 expected (113% beat)
• 4Q Rev. Guide (midpoint): .185Bn vs. .36Bn expected (12.8% miss)
• 4Q DAU Guide (midpoint): 317mn vs. 311.56mn expected (1.7% beat)

There are more detailed numbers, but these are just the headline numbers that I was looking at in this print. Starting from the top, engagement continues to wow me. Heading into the print, I was tracking app installs and other checks which had me closer to 305m DAUs, well ahead of Street. They actually beat that number, adding 13mn DAUs sequentially, the same as 2Q. The best word to describe Snap's engagement story is with 'inertia'. Growth continues almost limitlessly, fueled primarily by expansion into Android-centric geographies in ROW. Think Latin America, APAC, etc.

Now, moving to the ugly part of the print, monetization. Snap identified two key headwinds heading into the print, I'm going to add one more that they likely wouldn't want to identify. Headwind one: IDFA. Headwind two: supply chain. Headwind three: TikTok grabbing share. We'll look at these further along in the article but for now what is important to note is that monetization progress fell through this quarter.

The strength in engagement was more than offset by the weakness in monetization, leading to revenue falling below Street expectations. This is massive, as the unwritten rule with growth stocks has been that they should beat expectations. The buy-side is always ahead of sell-side expectations, and if that hidden number isn't beaten, then the stock doesn't perform well. Not only did Snap not beat expectations, they downright missed. A miss in the growth tech world is just plain bad.

Earnings were strong, fueled by solid infrastructure expense efficiency and overall operating leverage. Again, this was another highpoint of the print as a whole as Snap continues to move towards profitability and cash generation, knocking down another key pillar of the bear argument. While there remains much work to be done, Snap is clearly improving.

3Q Conference Call Breakdown

Normally, I would break down the earnings presentation and slides prior to reviewing the conference call and Q&A session. That said, the presentation itself didn't add much insight into the changes Snap is witnessing or the moves it is making to turn the tide. So, without further ado, let's delve into this conference call.

We grew sequentially in North America and Europe, which represent our largest monetization opportunities in the near and medium-term, and we continue to build on our momentum in the rest of world geographies, where we see massive long-term potential. Our DAU and rest-of-world represents just 5% of the overall rest-of-world smartphone population, which is currently more than 2 billion people and growing. - Evan Spiegel, CEO

Europe and North America continue to see engagement growing. While engagement isn't growing as fast, these two geographies are going to drive revenue growth over the medium term. That said, the real fuel of user growth remains in that coveted ROW segment. Penetration in the ROW segment remains low, meaning there is quite a bit of runway for growth on the table.

Many of the mixed engagement trends we observed during the pandemic and that we discussed on our last earnings call have continued through the third quarter. On one hand, while total content viewership and time spend has grown year-over-year, user-generated stories continue to see year-over-year declines in overall time spend. - Evan Spiegel, CEO

Total content viewership is increasing as is total time on platform. This is good, especially content viewership. Snap's Discover platform is the key driver of ad revenue right now, and with engagement on this part of the platform growing, maybe the business can be sustainably large. Stories are declining, for now. For me, this is okay as Snap hasn't moved aggressively to monetize here yet.

Our advertising business was disrupted by changes to iOS ad tracking that were broadly rolled out by Apple in June and July. While we anticipated some degree of business disruption, the new Apple provided measurement solution to not scale as we had expected, making it more difficult for our advertising partners to measure and manage their ad campaign for iOS. - Evan Spiegel, CEO

Now, anybody who remembers my breakdown of the 2Q Snap conference call remembers that Snap was bracing for the impacts of reduced ad targeting by recommending advertisers use SKAdNetwork, Apple's (NASDAQ:AAPL) privacy-centered ad measurement tool. Snap, at the time, was enthused by the results of this tool for measuring iOS campaigns. As the quarter went on, it didn't scale well leading to a reduction in ad relevance, while also rendering advertisers 'blind' to a lot of the signals they were getting pre-IDFA changes.

We have remained very focused on driving ROI for our advertising partners, and we continue to see strong consistent performance on our ad platform, based on first-party data and conversion lift studies, and are working on building flexible first-party tooling and measurement solutions to serve the diverse needs of our advertising partners. - Evan Spiegel, CEO

As third-party signals become more limited, Snap is building out tools based on their proprietary first-party data because third-party signals are being reduced. Rather than take the Facebook (NASDAQ:FB) approach of building proprietary first-party tools, Snap spent the middle of the year trying to find workarounds while also recommending advertisers use SKAN (SKAdNetwork) rather than spending the time building out their own solutions. Now they are working on building their own tools.

This impact was compounded by the ongoing macroeconomic effects of the global pandemic with our advertising partners facing a variety of supply chain interruptions and labor shortages. This, in turn, reduces their short-term appetite to generate additional customer demand through advertising at a time when their businesses are already supply constrained. - Evan Spiegel, CEO

The macro-environment isn't helping either. While IDFA is bearing the brunt of the blame for Snap's lackluster report, it is important to understand that large economic forces also weighed on the print.

We have re-engineered the spotlight incentive programs to reach more creators who are publishing a greater diversity of content in more markets. We are committed to making Spotlight a platform on which professional creators can grow an audience and build a business, and both gifting and the creator marketplace for Spotlight are now live.

We are extremely pleased to see daily Spotlight submissions more than double when compared to last quarter and are encouraged by ongoing quarter-over-quarter growth in both daily active users of Spotlight and daily time spent per user. - Evan Spiegel, CEO

Snap continues to work to build Spotlight into a formidable piece of the platform. An inefficient compensation structure for creators has become retooled and now Snap continues to work to build Spotlight into a platform with critical mass. While engagement continues to trend higher, I remain skeptical, as Spotlight remains well behind TikTok and Instagram Reels, the two main competitors, in both monetization and engagement.

And we were among the first platforms to lean into this solution and push for widespread industry adoption. However, over time, we saw SKAN measurement results diverged meaningfully from the results we observed on other first and third-party measurement solutions, thinking SKAN as an unreliable of a standalone measurement solution. Furthermore, as our advertising partners have explored and tested SKAN solutions, they have serviced a variety of concerns about its limitations. Every advertiser has their own unique, fine-tuned perspective on their optimal parameters to measure ROI for their business. but SKAN requires them to use Apple's fixed definitions of advertiser success.

For example, advertisers are no longer able to understand the impact of their unique campaigns based on things like time between viewing an ad and taking an action, or the time spent viewing an ad.

Snap bet big on SKAN, and it failed to deliver. SKAN simply isn't scalable and offers too little granularity. Over time, Snap realized this and began to understand that they would inevitably lose advertisers if they didn't build out their own tools.

Additionally, real-time campaign and creative management is hindered by extended reporting delays and advertisers are unable to target advertising based on whether or not people have already installed their app. As a result, we have accelerated our focus on developing additional first-party privacy safe solutions to help our advertising partners measure their campaigns effectively.

Our primarily solution is advanced conversions, which work seamlessly with our mobile measurement partners, and uses aggregated privacy safe methodologies to help advertisers understand the impact of Snapchat and their media mix. This solution is now launched for all eligible advertisers and we are encouraged by the early adoption we're seeing from apps.

Even with a basic feature set, we have approximately 50% of app advertisers opting in via their media measurement partner or direct integrations. We are excited to invest in both third-party and first-party solutions to provide a richer set of privacy-safe tools to our partners to help them measure and optimize their advertising.

Snap is working on bringing their advertisers new tools like advanced conversions. Traction has been strong thus far, but the education and scale process is a slow process that will take time. The bottom line is it is going to take time for Snap to see these tools take hold with their core advertisers.

Over the last couple of years, our direct response business has grown at a faster rate than our brand business. This is something of which we are incredibly proud and continue to feel is the right strategy for the long-term. Proving performance and delivering ROI are our top priorities, and we've made significant progress over the past several years.

As we've mentioned, for the past few quarters, DR has grown to comprise over 50% of our business. While this has been a historic strength, given the recent ATT changes coupled with Snapchat's existence as a mobile-only platform, our strengthened DR has become a more significant headwind in the current environment.

Direct response advertising, while clearly a long-term value driver for Snap and ad companies in general, has been the worst affected segment of Snap's business as ROI has decreased significantly and DR advertisers are much more ROI sensitive than brand advertisers.

Separate from these iOS related issues, we've heard from advertising partners across a wide variety of industries and geographies that they are facing headwinds in their business related to disruptions in global supply chains, as well as labor shortages and increasing costs. In turn, we expect this to impact advertising demand in Q4 in particular, as in many cases, their businesses do not have the inventory or operational capacity to support incremental demand.

Supply chain issues have had a macro impact on advertising and Snap is not exempt from this. This issue weighed on Snap's 4Q guide and as it is a macro issue, I can't fault management for this one. As supply chains stabilize through 2022 and 2023, this headwind will likely fade.

Adoption of our new measurement solutions, such as advanced conversions is ongoing but will take time to be fully adopted. In addition, the ecosystem for measuring advertising returns is continuing to shift, with more changes anticipated as part of IOS 15, that are expected to further reduce the availability of certain signals that are currently used broadly as tools for optimization and measurement.

Headwinds are already affecting Snap's ability to target ads, but broad rollout of iOS 15 will lead to further signal loss in the coming quarters. So, this story hasn't even fully played out yet. While the sell-side calls for transitory headwinds, we haven't even seen the broadest extent of signal loss that Snap could experience from further iOS updates. Again, just less vision through this problem.

We currently estimate the DAU will be 316 million to 318 million in Q4, implying year-over-year growth of 19% to 20%. On the monetization side, we currently estimate Q4 revenue will be between 1.165 billion and 1.205 billion implying year-over-year growth of between 28% and 32% in Q4. On the expense side in Q4, we intend to continue to invest in our teams and products to support the long-term growth of our business in order to build on the momentum we have established with our community and our partners.

Our estimates for Q4 adjusted EBITDA reflect our revenue guidance and our expected level of investment, resulting in a range of 135 million to 175 million for Q4.

In essence, here is Snap's guidance. Incredible engagement inertia continues, with the company guiding for sequential net adds of 10-12mn. This is the number I look at when evaluating user growth, rather than y/y comps. Revenue growth is slowing drastically, but EBITDA is showing progress towards a big quarter.

We were really confident in our ability to drive results with our advertising platform despite the signal loss. But what I think we really underestimated were the tooling changes. And so, what I mean by that specifically is that, advertisers have essentially for a long time now used a set of really sophisticated tools to measure and optimize their campaign.

So that allows them to test out a bunch of different creative and see what's performing more effectively and so on and so forth. And the big change there was that with these new Apple changes, those tools were essentially rendered blind, and in their place, Apple released a new product called SKAdNetwork that allows advertisers to measure across different advertising platforms but without a lot of the flexibility that they're used to.

For example, you can only really measure your advertising results using the success parameters that Apple's already defined. The reporting is delayed for a significant period of time and often unavailable if you don't hit a certain threshold of conversions. It's very hard to see performance on a creative level. But of course, it does have the benefit of being able to look across different advertising platforms.

So, what we've done is built our own solution called Advanced Conversions that allows people to do much more sophisticated things and really get the benefits of a lot of flexibility using the advanced conversions product so they can understand performance at the creative level, optimize for down funnel conversions and things like that. And we've been working really hard to make that solution more effective and help advertisers onboard.

But the obvious challenge with advanced conversions is that it only has Snapchat first-party data, it doesn't have the benefit of looking across all of the other advertising platforms. So, what advertisers essentially have to do is use both of those tools, SKAdNetwork and advanced conversions.

And when we look at incrementality testing, when we look at first-party data like on platform swipes or installs, things like that, we see that those conversions are still happening at similar rates that they did in the past. So, I think we can work through the tooling issues; it will take time because they're new. But the underlying performance of the advertising platform is still very strong.

While management remains confident in the overall state of the ad business, they do recognize the challenge of onboarding advertisers onto both SKAdNetwork and Advanced Conversions to get the most optimal ad measurement possible. Getting advertisers to understand this new framework of Advanced Conversions and SKAN will take time, and I do expect some permanent level of third-party signal loss though it is too early to quantify the damage.

And so, one of the things that's really important about that is that they will be able to get signals from within our app itself, which include our augmented reality experiences, many of which we've talked about, business profiles, which are growing and we're excited about, as well as the native commerce products that we're building on Shopify and their advertising sets, for instance.

Getting a greater share of signals from the Snapchat platform will be critical to driving efficient tools longer-term. I think this will be a learning curve for advertisers, but the signals themselves are likely there to build on.

The data that we're seeing does give us confidence that adoption and the adoption of advanced conversions, is a good place to be. We are confident in that solution. We believe it is the right solution, but that education, it takes time. There's going to be a lot of testing and learning.

Management is confident in their ability to execute on providing quality first-party ad measurement tools in tandem with SKAN. I like this confidence, and it strengthens the notion that there is a bright post-IDFA world coming out of this.

So, we're continuing to learn, test, iterate with our advertising partners there. And then in terms of just [Indiscernible] in general, our first-party measurement tools and studies continue to show that our ads are effective and they are approximately as effective as they were prior to these changes.

It seems Snap Ads continue to drive high levels of value for advertisers, and that adoption of Advanced Conversions is bringing back a high level of signal to advertisers who have already adopted it. This is a good thing. A very good thing. Ad efficacy is paramount and broad adoption of Snap's measurement solutions will bolster continuously strong ad efficacy. This is a good thing, as it proves the value proposition Snap provides advertisers remains intact.

So, it's really that the loss of signal required significant changes to our overall technology, and we believe it's actually mostly a measurement challenge, not a question of the efficacy of our advertising, and as we talked about before, it's going to take time for advertisers to sort through what they are seeing in their new measurement solutions.

And relative to what they have available to them, including an SKAdNetwork, and with conversion studies. We are optimistic that our first-party solutions, including Advanced Conversions and estimated conversions are going to help close that measurement gap for our advertising partners.

Here is that same point on ad efficacy vs. ad measurement being re-emphasized by management. This is a temporary headwind surrounding measurement it seems, not necessarily a structural headwind surrounding the value proposition.

This is all I have to note on Snap's 3Q conference call.

Has The Story Changed? Yes and No, Mostly No

What was the story entering this 3Q print? Let me break it down from my perspective, as Snap was a core holding going in.

• 50%+ revenue growth CAGR
• unique offering for advertisers
• margin expansion
• multiple screens for long-term monetization
• massive TAM

Addressing this point by point: management failed to reiterate its previous target of 50%+ revenue growth CAGR for the next few years. This lack of confidence and vision to see through this headwind isn't necessarily management's fault, it just signals that the headwind is probably less transitory than the sell-side believes. Notice, the sell-side hardly brought down revenue growth expectations for 2022 and 2023 on this print. The reality is now, IDFA changes from Apple will take time for advertisers to adapt too. Snap's new 1P data-based tools like Advanced and Estimated Conversion will take time to adopt among the advertising community. This target for hyper-growth may be at risk in the short-medium terms (3-12 months in my view) until adoption scales and the advertising industry builds a new framework for effective ad targeting. While we will likely look back in five to ten years and observe that this was a brief headwind, the next few quarters will definitely feel the blow, and the Street isn't modeling that right now.

The second point is providing a unique offering to advertisers. I expect Meta (FB) and TikTok to pick up some share from Snap for a few reasons. Firstly, Meta has been more on top of adopting their own 3P framework for advertisers, rather than being totally reliant on SKAN. Additionally, Meta has three 1B+ user platforms to cross-target signals from (Facebook, Instagram, WhatsApp) and enable improved targeting. A flight to safety might occur among performance advertisers who are seeking the ROI that it seems Meta can most effectively provide. Additionally, the coveted 13-34 demographic is no longer exclusively reachable on Snapchat. TikTok has amassed 1B+ users with a high concentration on global 13-34 year olds. Combined with a feed/video-centric format, it seems TikTok is built for effective advertising. In essence, I think that Snap could see short-term market share to Meta (ROI hungry direct response advertisers) and TikTok (global brand campaigns trying to target young demos). Until Snap gets its act together on measurement tools (with high adoption), I would be reluctant to assert that headwinds are constrained to 2H.

The third point is margins. While Snap actually beat EBITDA and earnings expectations, my takeaway on margins was actually slightly net-bearish. I think that the Street underestimates the competitive nature of TikTok to Snap's brand advertisers. As such, I would anticipate scaling content investments on both Discover and Spotlight to keep advertisers and users engaged. Over the short run, this could cap gross margins in the 60s, leaving operating leverage relatively hamstrung in the short-medium term.

Other than these dynamics, which I believe management can execute through, I think the size of the addressable market and the ability to unlock ad supply on other screens (Spotlight, Snap Map, Stories, AR, etc.) can juice long-term revenue growth and profits. This is a slew of issues that have elevated the risk profile of the business in the short to medium term. And while the long-term narrative can be dented if these issues prove to be sustained, I am cautiously optimistic that management can steer this ship wisely going forward.

Valuation

Right now, my year-end 2022 price target is based on two factors: rev. multiple and revenue (derived from growth rate). The reason I have moved from a terminal earnings-based valuation is because of the lack of medium-term visibility into the changes in the ad-tech ecosystem. For now, I am more comfortable modeling into 2022 than out to 2030 like normal. I'm targeting (way south of consensus) revenues of ~.3B (32% y/y revenue growth) for 2022. While engagement should remain strong, I have y/y net adds slowing to +~45mn off a 2021 number of 317mn (midpoint of management's 4Q guide). Combined with ~16% y/y ARPU growth in 2022, I am modeling some relatively weak revenue in comparison to consensus. However, considering the strength of the narrative, the high likelihood of a rebound in 2023+, and the core investment thesis that I haven't written on time and time again, I'm using a higher multiple. I'm targeting a multiple of ~16x my 2022 sales estimate, leading me to a market cap of ~.8B. On the current share count of 1.61B, that implies a YE'22 valuation of .67, ~, which is my price target. Considering the fact that the stock is trading roughly where I believe it to be fairly valued, I'm downgrading the stock from buy to hold until the risk/reward profile points more favorably.

Why Am I Now Short?

You might be asking yourself, wait, Mango, if you're at a hold rating on the stock, why are you short? Good question. First of all, I own 2022 expiry puts that I purchased when the stock was in the mid-to-high s after the earnings drop. The stock has come down since then. The reasonable I plan on holding the puts is for a few reasons:

• estimates are likely too high
• Fed removing the punch bowl of QE, growth to underweight
• still a high multiple

On the first note, the sell-side by and large came out to defend the daylights out of Snap after they reported. Estimates for 2022 growth, while cut, are still at ~42%. If headwinds prove to be more structural than the sell-side anticipates, these numbers need to be reduced further, providing more room for downside.

Secondly, on a more macro level, I am turning bearish. The Fed is likely to begin the tapering process by year-end and I am expecting at least one rate hike in 2022. Long-duration growth assets are hurt by increasing rates as they depress the current value of earnings that the business is projected to generate down the road. Essentially, Snap has the perfect storm of a cloudy macro outlook, with a cloudy business outlook short-medium term.

And finally, even against inflated (in my view) consensus expectations for growth in 2022, the stock still trades at ~15x sales, meaning we aren't necessarily at a valuation bottom.

For these reasons, and to have short exposure in my portfolio, I've elected to buy puts on Snap.

Conclusion

All in all, Snap's 3Q print didn't dazzle me. The business has some serious headwinds it needs to work through. Headwinds that it appears the street straight up hasn't priced into their estimates yet. While I believe the business can experience a turnaround over the long term, I have to downgrade from Buy to Hold on this print and lower my price target from to .

This article was written by

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Disclosure: I/we have a beneficial short position in the shares of SNAP either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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