Snap (NYSE: SNAP) investors are laughing all the way to the bank as better-than-expected first-quarter earnings send the stock flying by over 20% in after-hours trading on Tuesday. The long-suffering social media company now boasts a market cap of over $20 billion as user growth continues to surge.
But is all the optimism justified? Snap has a very high top-line valuation coupled with low-profit margins. The company also lacks a competitive moat and faces significant competition from rivals like Tik Tok and Facebook which offer similar platforms. Over time, the stock will probably give back most of its gains.
Snap has disappointed investors since its much-anticipated IPO in March 2017. The stock started trading at $17 per share before reaching an all-time high of $29.44 before falling below its original listing price to end up at $12.44 at the close of trading on Tuesday.
Snap’s problem has always been its extremely large market cap. The company IPOed at a valuation of over $20 billion which priced in a tremendous amount of growth that has been difficult to fulfill. Now, with Snap’s better-than-expect first-quarter results, the market is getting more optimistic about the company’s ability to meet its potential.
Snap generated revenue of $462.5 million which is a 44% year-over-year increase from the prior-year period. Most impressively, the company managed to increase its daily active users by 20% to hit 229 million . Management also claims that over 4 billion snaps were created every day in the first quarter. And daily time watching Snap’s Discover content rose by over 35%.
But behind all the positive facts and figures, Snap has a terrible problem: the company has terrible operating margins. And it is burning cash at an unsustainable rate.
Snap’s operating margin is negative 62% . While this has improved from the prior-year period’s negative 99%, it is still a terrible margin that results in an unsustainable cash burn. The company generated a net loss of $306 million in the first quarter while it only has $245 million in cash and equivalents on its balance sheet. The company also has $963 million in marketable securities that may need to be liquidated to fund operations.
To make matters worse, Snap’s user growth is slowing in the lucrative North American region. The company’s Daily Active Users (DAU) in North America only grew 10% compared to 45% growth in the rest of the world (excluding Europe). European DAUs grew by a modest 14%. The problem is that North American DAUs are much more profitable than their international counterparts. And a slowdown in this crucial region won’t do much to help Snap’s struggling margins.
Rest of World ARPU stands at just $1.00 — up 3% from the prior-year period . While North American ARPUs stand at $3.57 — up 27% from the prior-year period. European ARPU remains surprisingly low at just $1.09 which is a 41% increase from $0.77 in the prior-year period.
Snap’s good first-quarter performance might just be a fluke. Millions of people in the United States and Europe are currently on lockdown at home to slow the spread of the coronavirus pandemic. And this may have temporarily driven up demand for Snapchats mobile entertainment offerings. The company also has a very small moat and faces significant competition from competitors like Tik Tok and Facebook.
The market for video-based mobile social media is competitive, and the field is crowded with many similar apps. Vine, the pioneer of short-form internet videos, was acquired and shut down by Twitter because of its inability to make money. And Facebook’s Instagram and Byte Dance’s Tik Tok provide Snap with fierce competition in the crucial teen market.
Despite Tuesday’s rally, Snap is likely to give back most of its gains over the long term because the stock is still too overvalued in light of all these challenges.
Snap stock closed at $12.44 on Tuesday before rocketing 20.50% in after-hours trading to settle at $14.99. Investors can expect the stock to fall as the market comes to grips with the company’s poor fundamentals.