Should You Follow These Analysts Out of Snap Inc. Stock?

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Snap (NYSE: SNAP), the parent company of social media app Snapchat, was one of the most disappointing IPOs of the year. The company went public at $17 per share in early March, dipped below $12 in mid-August, then gradually rebounded to about $14.

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As a result, many analysts have been downgrading the stock. Three months ago, 11 analysts rated Snap as a "buy", 19 called it a "hold", and three called it a "sell". Today, only six analysts think it's a "buy", 21 analysts call it a "hold", and six analysts rate it a "sell".

We should always take analysts' upgrades or downgrades with a grain of salt. However, we should still take a closer look at Snap's business to see if their growing pessimism is justified.

What happened to Snap?

User growth is the key metric for a social media app's success. Snap's daily active users (DAUs) rose 17% annually to 178 million last quarter, but that represented a mere 3% growth from the previous quarter and fell short of the 182 million DAUs analysts had expected.

Snapchat's DAU growth is peaking because Facebook (NASDAQ: FB) added most of its defining features (disappearing messages, masks, and filters) to Instagram Stories. In early November, Facebook reported that Instagram Stories had 300 million DAUs -- up 20% from 250 million DAUs in June.

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Snap's revenue rose 62% annually to $207.9 million during the quarter, but that missed estimates by $29 million and represented just 14% growth from the previous quarter. On the bottom line, its loss more than tripled annually to $443.2 million.

That loss can be attributed to surging stock-based compensation expenses, rising operating expenses, and a $40 million inventory charge on its unsold Spectacles. Its hosting costs also rose 11% sequentially to $0.68 per DAU.

Snap finished the quarter with a negative free cash flow of nearly $220 million, compared to negative $229 million in the prior quarter. Its cash, cash equivalents, and marketable securities dropped by $500 million to $2.3 billion. Simply put, Snap is posting slowing user growth and widening losses as it faces Facebook's firing squad.

What the analysts claim

Many analysts became increasingly bearish after Snap's third-quarter report. Morgan Stanley analyst Brian Nowak noted that the weak numbers spoke "to the growing challenges" facing the company.

UBS analyst Eric Sheridan, in a note titled "Snap Crackle Flop", stated that "the long-term debates around user growth and ad business scaling were left unsolved." Sheridan also claimed that it was "very likely" that Snap would "continue to struggle on multiple fronts in the coming 12 months."

Piper Jaffray analyst Sam Kemp claimed that Snap had "poor leadership under a corporate governance structure that lacks accountability for senior executives." Stifel analyst Scott Devitt warned that the stock's current valuation (26 times sales as of this writing) was "difficult to justify, given the trajectory of the business."

But are investors too bearish on Snap?

It's easy to beat up on a struggling company, but investors might be overlooking some of Snap's strengths. First, Snapchat is still growing in popularity among teens, and the company is actively courting older users by redesigning the platform.

Snap unveiled its redesigned app in late November, which removed its "Stories" page and blended news stories with user posts and messages. However, some critics have noted that the changes didn't really make the app "easier" to use.

Nonetheless, Snap's average revenue per user (ARPU) is still growing, rising 12% sequentially to $1.17 last quarter. That figure fell short of analyst expectations of $1.30 per user, but it partly offset its aforementioned jump in hosting costs.

Lastly, there's the support of Chinese tech giant Tencent (NASDAQOTH: TCEHY), which bought a 12% stake in Snap in early November. That vote of confidence set a floor under Snap's stock, and could lead to the integration of Snapchat into Tencent's WeChat, the most popular messaging app in China.

The bottom line

I'm always looking out for beaten-down contrarian plays, but Snap just doesn't look appealing yet. Its price-to-sales ratio is astronomical, it doesn't have a plan to achieve profitability, and it lacks a meaningful defense against Instagram Stories. Therefore, I think the bearish analysts are right about Snap, and the stock won't rebound above its IPO price anytime soon.

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