Snap (NYSE:SNAP), the parent company of Snapchat, made its public debut on March 3, and the results were underwhelming. Snap made its public debut at $17, surged to nearly $30 on the first day, then tumbled back to just over $20 in less than two weeks.
Why did investors seemingly snub Snap, which some bulls have hailed as the "next Facebook (NASDAQ:FB)"? The answer is simple -- six red flags indicate that the stock could slide much lower before it's considered a bargain.
1. Slowing user growth
The decline of Twitter's(NYSE:TWTR) stock taught us that social networks live and die by their active user growth. Without active user growth, advertisers start skipping the platform in favor of faster growing ones. Snapchat's daily active users (DAUs) rose just 3% sequentially to 158 million last quarter, compared to 7% growth in the third quarter and 17% growth in the second quarter.
That slowdown was likely caused by the launch of new Snapchat-like features for Facebook's Instagram and Messenger apps -- which include Instagram Stories, vanishing Instagram photos, Instant Video for Messenger, and a Messenger Day app which deletes photos and videos after 24 hours. Instagram Stories, in particular, grew its DAUs from 100 million to 150 million between last October and this January.
2. Its cash burn rate
Snap's S-1 filing revealed that it finished fiscal 2016 with just $150.1 million in cash and equivalents -- a 77% decline from $640.8 million at the end of 2015. The company had a negative operating cash flow of $188 million in the fourth quarter of 2016, and it burned through $1.14 in cash for each dollar in generated revenue.
Snap will retain $2.3 billion of the $3.2 billion it raised during its IPO. That amount will help Snap tread water for a while, but it might not last long if its cash burn rate accelerates. Susquehanna analysts believe that Snap won't achieve positive free cash flow until fiscal 2020. However, that estimate could be far too optimistic if rivals like Instagram Stories continue throttling Snapchat's growth.
3. Widening losses
Snap's revenue surged 590% to $404.5 million in 2016. But on the bottom line, its net loss widened from $372.9 million to $514.6 million. The company's biggest expenses include multi-billion dollar cloud contracts with Alphabet's Google and Amazon.
If Snap can't narrow its losses with such massive revenue growth, things could get very ugly once its top line growth slows down. Snap has also warned in its SEC filing that it "may never achieve or maintain profitability."
4. Unrealistic revenue growth targets
Snap claims that it can generate $500 million to $1 billion in revenues in 2017. That's a very wide range, but analysts are modeling their forecasts on the high-end, with an average estimate of $1.04 billion. However, it's unclear how Snap plans to hit that target.
96% of Snap's revenue came from advertising in 2016. Snap's ad products include full-screen video ads, sponsored geofilters, and sponsored lenses. If Snap's user growth peaks, it could possibly boost its number of marketing partners to generate higher ad revenues per customer. But more than doubling its 2016 revenues to $1 billion in 2017 seems like a huge stretch.
Research firm eMarketer recently trimmed its 2017 ad revenue forecast for Snapchat from $800 million to $770 million. That reduction was modest, but it indicates that analysts aren't certain that it can hit its ambitious growth targets.
5. It thinks it's a "camera company"
Co-founder and CEO Evan Spiegel has repeatedly declared that Snap is different from other social networks because it's a "camera company." Tthat statement sounded reasonable because it produced special filters and lenses for smartphone cameras, but rivals like Instagram can easily make similar claims.
Spiegel didn't say that Snap would sell physical cameras anytime soon, but the company launched its Spectacles Snap-capturing glasses late last year. The devices attracted lots of shoppers, thanks to a clever marketing campaign featuring vanishing vending machines.
If Snap builds upon that idea, it could start selling other cheap image capture devices to build its brand and differentiate itself from Instagram. However, that move could cause it to burn through its cash even faster and weigh down its bottom line with a low-margin hardware business.
Should you avoid Snap?
Snap looks like a company that went public before it formed a coherent roadmap toward positive cash flows and profitability. Without the ability to reach those goals, Snap remains an incredibly overvalued stock at nearly 60 times sales.
To put that into perspective, Facebook had a P/S ratio of about 10 at the close of its first trading day. Twitter ended its first day with a P/S ratio of about 11. This means that Snap could easily plummet to the single digits if investors realize that this ephemeral emperor has no clothes.