I used to watch cartoons as a kid, and there would be shows where the good guy would catch the villain and remove their mask at the end to reveal their true identity.
Social media platform Snap (NYSE:SNAP) has a logo that brings me back to those memories. The company’s recent Q2 earnings put up some figures to dress up its performance as a step forward for the business.
However, you reveal some troubling signs when you dig deeper and pull off Snap’s “mask”.
I previously covered Snap years back; you can find that note here.
Today, Snap is a bigger company with substantially more users than before. Yet, it continues struggling with fundamental problems that could prevent the stock from becoming a worthwhile long-term investment.
Here is what you need to know.
Yes, Snap is growing its user base
To Snap’s credit, the app itself continues to resonate with users. The company is picking up users rapidly, which is the primary goal of any social media platform. Snap makes money by selling ads; the more eyeballs you can advertise to, the better.
Global users grew 14% year-over-year in Q2, driven by impressive growth in emerging markets. Snapchat is still at just under 400 million daily active users, so there is still a long runway for user growth.
But Snap’s monetization is under pressure
My sticking point last time I covered Snap was the company’s reliance on North American users to drive revenue. That worked for the company when the pandemic pushed commerce to online channels, and advertisers piled on.
Snap generated average revenue of $3.14 per North American user in Q2 2019. That swelled to $7.93 in Q2 of 2022. But that dropped 14% year-over-year in 2023 to $6.83. It raises the question of whether Snap is beginning to give back market share if advertisers are reverting to pre-pandemic habits and tightening their spending.
That would be potentially bad news because Snap still relies heavily on North America. Emerging markets, or Rest of World users, are generating less revenue now at $0.98 than four years back when ARPU was $1.20 in Q2 of 2019.
Snap must still show that it can consistently monetize its users enough to turn a profit.
Removing Snap’s financial mask
Despite this question, the company’s most significant red flags might be found in the guts of the cash flow statement.
Snap has done just over $2 billion in revenue through six months of 2023 and has reported an operating cash flow of $69 million. However, the cash flow statement is filled with adjustments, including a whopping $632 million in stock-based compensation. That’s almost 32% of revenue.
That compensation isn’t a cash expense but still dilutes shareholders. Snap’s outstanding shares have grown by 27% over the past five years. If you back stock-based compensation out again, operating losses are still hundreds of millions of dollars.
Also, management has invested massive sums of money into research & development for years. That can be a good thing, but it’s become fair to question how effective these investments are considering Snap’s monetization challenges.
Investing is a long-term game, but what progress has Snap made since going public more than six years ago? Investors should see some return on all this investment, but the business is still losing money and issuing generous amounts of stock-based compensation.
Given my bearish view on the stock, the thesis risks include Snap demonstrating better spending discipline and reducing stock-based compensation and R&D spending as a percentage of revenue.
Additionally, Snap could show resiliency, stabilizing ARPU in North America while generating growth in its massive Rest of World segment, which has more than 200 million users.
Such fundamental improvements would be bullish for the stock and its shareholders.
Add it all up, and the jury is still out on whether Snap can be more than a good product with a lousy business model. At the very least, investors should scrutinize how leadership is deploying capital. I rate Snap stock as neutral after its drop. I would not be interested in upgrading until Snap’s financials dramatically improve.