BTIG Research: We Should Have Started Snap at Sell

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Earlier this week, BTIG Research made a confession: It should have started Snap (NYSE: SNAP) with a sell rating when it initiated coverage in April. Instead, BTIG had started the Snapchat operator's shares with a neutral rating back when shares were trading over $22. "With the stock down 28% in the past six months since our initiation at Neutral, we were wrong to not have a SELL rating," writes analyst Rich Greenfield.

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However, Greenfield is not downgrading his rating on Snap to sell now, but is sticking with a neutral rating, in part because shares have lost roughly 30% of their value since the initial call. "We missed that drop," Greenfield told Cheddar TV, and current levels of around $15 warrant a neutral rating until investors get more financial visibility into how Snap can improve monetization and execution of the ad business.

Engagement remains strong

Snapchat continues to enjoy very strong engagement within its daily active user (DAU) base, which totaled 173 million at the end of the second quarter. (Snap reports third-quarter earnings on Nov. 7.) Even though DAU growth is decelerating meaningfully, which is very likely related to Facebook's competitive aggression, engagement within the existing DAU base remains as strong as ever.

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Users spent an average of 30 minutes per day on Snapchat in the first quarter. CEO Evan Spiegel provided a little bit more granular detail on the second-quarter call: "On the time spent stuff, I think time spent's definitely [an] interesting metric because unlike daily actives, time spent is 0 sum. So for us, in Q2, we saw over 40 minutes spent per day for users under 25, and over 20 minutes per day for users over 25."

Snapchat has a respectable user base spending a significant amount of time on the platform every day -- there's no doubt about that. But there is doubt surrounding the company's ability to build a business on that engagement.

Monetization, not so much

Domestic average revenue per user (ARPU) grew just 9% sequentially in the second quarter to $1.97, below BTIG's estimate of 28% sequential growth when it initiated coverage. Greenfield has adjusted his estimates to incorporate slower ARPU growth in the years ahead, which directly reduces revenue estimates. For example, BTIG's estimate for 2020 revenue was cut "by nearly half." Greenfield poses a handful of questions that should be on investors' minds right now:

In turn, the unanswered question is why are revenues falling short of expectations? Is it simply taking longer for Snapchat to roll-out new advertising products? Are new ad products taking longer to gain traction? Are Snapchat's ad units underperforming advertiser expectations? Was management simply too optimistic? Or is it simply hard to model revenue growth, given how early Snapchat is in terms of trying to generate revenues (advertising only launched in Q1 2015)? Or most likely a combination of all of these issues?

Snap is a young company, but its ad business is even younger. That makes it incredibly difficult to model, since it will all boil down to execution, and a lot can change very quickly in this sector. For now, BTIG is recommending that investors stay on the sidelines.

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Evan Niu, CFA owns shares of FB and has the following options: long April 2018 $17 puts on Snap Inc. The Motley Fool owns shares of and recommends FB. The Motley Fool has a disclosure policy.