How Risky Is Snapchat Maker Snap Inc?

Markets Motley Fool

Snap (NYSE: SNAP), the maker of the ephemeral messaging app Snapchat, has had a rough five months. Snap went public at $17 per share in early March, briefly surged to $27, then plunged to about $13 on major concerns about its growth plans, financial discipline, and its ability to survive a prolonged battle with Facebook (NASDAQ: FB).

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But as Snap searches for a bottom, contrarian investors might be tempted to pick up some shares. Let's take a closer look at this hated stock to see how risky that bet could be.

What's wrong with Snap?

At first glance, Snap's numbers don't look that bad. Its revenue surged 153% annually to $181.7 million last quarter, but that missed expectations by almost $5 million. However, its average revenue per user more than doubled annually to $1.05, while its daily active users (DAUs) rose 21% to 173 million. Users under 25 were spending over 40 minutes on the app per day, while users over 25 were using it for over 20 minutes daily.

Unfortunately, Snap's non-GAAP net loss widened from $107.4 million to $195.5 million, or $0.16 per share -- missing estimates by two cents. Its GAAP net loss looked even worse, widening from $115.9 million to $443.1 million during that period -- mostly due to stock-based compensation expenses, which gobbled up 135% of its total revenues.

Over the past 12 months, Snap spent a whopping $2.24 billion on stock-based compensation expenses while generating just $331.3 million in revenues. This paints a clear picture of insiders enriching themselves at the expense of investors. Snap's cash and equivalents rose from $150 million at the end of 2016 to $502 million at the end of last quarter (thanks to its IPO), but it also had a negative free cash flow of $229 million.

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Its inability to counter Facebook

Snap needs more cash to counter Facebook's Instagram Stories, which has added features that mirror Snapchat's popular ephemeral messages, camera filters, and "storytelling" features. In late June, Facebook revealed that Instagram Stories already had 250 million DAUs and a million advertisers.

Snap's response has been to buy smaller companies, like geofilter maker Placed and social map app maker Zenly, along with some geofilter patents. It's also reportedly developing a new version of its Spectacles smart glasses, but the devices remain niche "toys" that haven't really caught on among mainstream users.

Snap CEO Evan Spiegel liberally uses the term "growth hacking" -- the rapid use of experiential marketing techniques across multiple channels -- to explain how Snapchat can expand. Unfortunately, Snap doesn't seem to have the users or cash cushion to pursue that scattershot strategy. As a result, many analysts and investors simply see Snap as a deer caught in the headlights of Instagram Stories' stunning growth.

The fundamentals don't support anything

Even though Snap trades at a 24% discount to its IPO price, the stock remains extremely expensive. It trades at a whopping 24 times sales, compared to the industry average of 6 for internet information providers.

To make matters worse, Snap's sales growth is slowing down. Its triple-digit year-over-year growth last quarter looks impressive, but it only represents 21% growth from the previous quarter. The same goes for its DAUs, which rose just 4% sequentially. Those numbers indicate that Snapchat's DAUs might never catch up to Instagram Stories' numbers.

Some analysts suggest that Snap could be bought out, but its $15 billion market cap and lofty valuations indicate that it needs to fall a lot further before potential suitors will show up. Based on Snap's current P/S ratio and slowing growth rates, it's highly likely that the stock could be cut in half.

The verdict: It's not worth the risk

I've been bearish on Snap ever since its IPO, and the facts all indicate that the company should probably have stayed private until it figured out a long-term roadmap for growth. Instead, Snap looks like a company that rushed toward an IPO to enrich insiders, but failed to develop a cohesive defense strategy against behemoths like Facebook. Therefore, Snap still isn't a contrarian play -- it's a falling knife that should be avoided.

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Leo Sun has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Facebook. The Motley Fool has a disclosure policy.