Snap Stock: Disappearing Messages, Disappearing Value

A Perfect Storm

Snap (NYSE:SNAP) is facing a problem – several, actually. We contend that the company has gorged itself on stock-based compensation, which has diluted class A shareholders tremendously. This dilution – combined with the always-nagging problem of Snap’s dual share class structure – and the rising costs of capital are driving institutional investors away from Snap. We hope to show that the best way forward for Snap is to focus more on profitability and reduce dependence on share-based compensation.

Not a Social Media Company

Snap, formerly known as Snapchat, was founded in 2010 and quickly became a “unicorn” – i.e., a private company with too many private equity Silicon Valley types throwing too much money at it. The company was valued based on the funding it took in at over $1 billion. SNAP went public in 2016 and since its founding has been helmed by Evan Spiegel. Snap made headlines when it went public because of its dual-class share structure. In essence, all shares traded publicly (class A shares) do not have voting rights, while the majority of the company’s class B shares, which retain the voting rights, are majority-held by Spiegel and Snap co-founder Bobby Murphy.

Along with the 2016 rebrand from Snapchat to simply Snap, the company’s leadership sought to change its image from being seen as a social media company to being viewed by the public as a “camera company.” Products such as Spectacles are now a key focus of the company, but its bread and butter remains the social media-esque app that generates essentially all of the company’s revenue, which is in turn generated almost entirely by advertisers.

The key differentiator of Snap to other social media sites is that content on Snap eventually deletes itself. As such, users don’t have to worry about content hanging around on the internet forever (although whether or not Snap actually deletes user post data is a point of debate).

Tale of the Tape

2022 has not been kind to Snap. Year to date the stock has declined more than 88%, compared to the broader market’s decline of 17.9%.

Despite this precipitous fall, Snap still maintains a hefty market cap of over $13 billion. You might also be surprised – based on the chart alone – to learn that Snap is on track to break revenue records, with its FY21 revenues coming in at $4.1 billion vs. FY20’s revenues of $2.5 billion. Next year is projected to be even better, with the company guiding to top-line revenues of $4.6 billion.

Daily active user (DAU) growth for the year has also been solid, posting a 19% year-over-year gain. The company has also tightened its belt financially and its efforts have been rewarded – average cost per DAU declined by 12% year over year. Additionally, Snap announced that it was planning to deploy $500 million in stock buybacks, which are expected to fully take place in Q4.

So, what gives?

Well, a couple of things. For one, those DAUs don’t fork over any money to Snap for the privilege of using the service. All revenue comes from advertisers just like any other social media – oops, I mean camera – company, and advertisers are pulling back on their average spends. On the surface, though, it doesn’t sound as if advertising budgets being on the decline should cause a stock to drop 88%. In fact, we believe that the core of Snap’s problems stems from a much deeper, more troubling problem.

Dilution in Action

For all the hype about A class shareholders being effectively frozen out of making any decisions about how the company is run, a far more sinister action is being taken by the company: excessive amounts of stock-based compensation. A quick look at Snap’s cash flow statements reveals the depth of the problem. In FY21, Snap doled out $1.09 billion in stock-based compensation. In FY20, the company paid out $770 million worth of stock-based compensation.

While some are quick to point out that stock-based compensation is a non-cash expense – and they are correct – it does have a dilutive effect, especially when used to this degree. Let’s take a look at Snap’s outstanding share count over the years:

In 2018, the outstanding share count for Snap stood at around 1.1 billion. As of the end of Q3 2022, the share count was around 1.65 billion. This 55% increase represents a direct dilution of each share held by each shareholder of the company (hence, the reason why Snap has been able to retain such a large market cap even as the price has fallen). The steady stair-stepping of the blue line up and to the right represents the total share count increasing through new equity issuance, but also through the exercising of stock-based compensation and options.

In other words, if you had bought a share of Snap in 2018 for $1 and the price never changed until today, your representative equity share in 2022 would be worth $0.45. Snap has really taken advantage of shared-based comp over the years, and its shareholders have been left holding the bag. It puts into perspective how minimal (hollow?) Snap’s recent announcement of a $500 million share buyback is – you can see it on the chart, the lone movement downward on the chart.

All of this is thrown further into relief by the fact that Snap has no plans to slow down its stock-based comp activity. Projections for the next full year show the company expending $1.2 billion on stock-based compensation – a 20% increase from this year.

No Rest for the Weary

Let’s say you’ve been a Snap shareholder for many years, and you’ve watched your proportionate equity in the company shrink – and then shrink some more. At least we’ve hit a reasonable price point at $8 per share, correct? Unfortunately, in our opinion, the answer is no.

We believed that the closest comparable company for Snap is Meta (META). Despite what their founders want to believe, both companies engage in a core, ad-spend dependent, social media business. Both companies have founders with aspirations far beyond the bounds of the app store. Both companies have launched expensive hardware with questionable public reception. Both companies have experienced precipitous stock price declines in 2022. And yet, only one seems to be somewhat fairly valued by the market at this point in time.

Meta’s stock is currently hovering around $120 per share and trades at a forward EV/EBITDA multiple of 6.4x. Snap’s forward EV/EBITDA multiple is 26x. Snap remains expensive with a forward P/E multiple of 31x vs. Meta’s 16.4x.

As a side note, we put more stock in the EV/EBITDA valuation as it takes more factors into consideration than a raw P/E multiple, and it better represents the price a true buyer of the company would take into account when evaluating the value of a company.

All of this illustrates that Snap is – even at $8 – a very expensive stock. Meta is expected to clock $116 billion in sales in 2022, while Snap is, as mentioned earlier, going to bring in less than $5 billion. Meta comprises an ecosystem of companies – Instagram, WhatsApp, Facebook, and the Metaverse (for what that’s worth) – compared to the more singular app product offered by Snap, supported by a set of AR glasses.

Given these different market positions, we find it difficult to justify Snap trading at any sort of premium to Meta. There doesn’t appear to be any competitive advantage, and in the war for economies of scale, even the most ardent Snap bulls would be forced to agree that Meta has the upper hand.

So why, we ask, would anyone pay such a premium for Snap? And furthermore, what is Snap actually worth?

Valuation, Snapped

As mentioned previously, our valuation metric of choice is EV/EBITDA, but it can be quite difficult to divine an appropriate price based on this multiple. For this reason, we’ll use both EV/EBITDA and forward price to earnings (P/E).

As we close out the bloodbath of a year for equity markets, Snap’s valuations are staggeringly high. Let’s compare them, again, to Meta.

As mentioned previously, Meta has a forward P/E of 15.8x, while Snap’s is 30.9x. We’re going to contend that Snap’s valuation should be less than Meta’s based on simple profitability – in FY21, Meta generated earnings before taxes (EBT) of $47.2 billion. Snap, meanwhile, produced an EBT loss of $474 million. If one agrees that Meta is competitively priced at these levels and multiples, it stands to reason that Snap should carry lower valuations.

The analysts estimate of Snap’s per-share earnings in 2023 is $0.36. If we target a forward P/E for Snap of 12x, we arrive at a target price of $4.32, a roughly 50% decline from current trading levels. Even this is somewhat generous, since Snap continues to compensate employees generously with stock, which we expect will dilute the earnings per share at a considerable rate into the future. Raising money for stock buybacks is also a proposition with diminishing returns as the Fed continues to raise rates and Snap’s cost of capital rises accordingly.

While it’s pretty easy to manipulate numbers to estimate P/E ratios, Snap’s EV/EBITDA valuation paints a pretty bleak picture as well. EV/EBITDA is a ratio of how many years it would take, with EBITDA being generated at constant levels, for a buyer of the company to earn back their investment if the company was purchased for its enterprise value (market capitalization + debt – cash on hand).

Snap has about $4.4 billion in cash and cash equivalents, a little over $4 billion in debt, and a market capitalization of $13.3 billion, which gives us an enterprise value of $13.1 billion. With a forward EV/EBITDA of 25.1x (for the sake of comparison, again, Meta’s multiple is 6.1x), Snap again appears to be wildly priced. The best way for a company to improve this multiple is to do things that are directly positive for shareholders and the company: eliminate debt and increase EBITDA. Neither of those things seems to be particularly attractive (eliminating debt) or easy (increasing EBITDA).

Assuming that Snap doesn’t continue to dilute shareholders, a price per share of $4.32 would give Snap a market cap of $6.95 billion. If we again assume a steady cash and debt position, at that point Snap would have an enterprise value of $7.2 billion. With its adjusted EBITDA analyst forecast of $617 million for the coming year, we arrive at a new forecast EV/EBITDA of 11.6x – which is still quite expensive.

The Bottom Line

Given that the macro environment is deteriorating rapidly for Snap with advertising budgets decreasing around the world, and given that Snap is also increasingly constrained by Apple (AAPL) and Google (GOOG) (GOOGL) on what user data it can harvest and provide to said advertisers, Snap is facing serious problems. In addition to these external factors, Snap’s management continues to make life difficult for itself and its shareholders by continually diluting the stock.

We believe that all of this constitutes something of a perfect storm for Snap. Tapping the debt markets for buybacks is no longer attractive as the cost of capital rises. Deploying cash for buybacks is also a bit like pouring money down the drain given the years the company has spent inflating the share count. The only option, it seems, is for Snap to turn its focus immediately to sustainable profitability.

We believe that $4.32 is a reasonable price target for Snap, even though we think that a stable market price could be materially lower than that. With this in mind, we believe that investors should steer clear of Snap at this time – it is very overvalued, and investors have little recourse against management if they believe their decisions to be unwise.

For now, we believe there are better investments to be had out there, and that investors who give Snap $8 for a share at this price shouldn’t be surprised if they’re soon left with half of their investment. Snap’s core business isn’t terrible, and it might be worth revisiting once the market reflects a more fair price for shareholders – but that day isn’t today.