Snap Inc. Earnings: What to Watch

Snap (SNAP 1.75%) will report its second-quarter earnings after the closing bell on Thursday. It's just the Snapchat operator's second earnings report as a publicly traded company, but it will be under intense scrutiny after failing to impress in the first quarter.

Investors have called into question Snap's ability to grow users on its Snapchat platform in the presence of intense competition from Facebook (FB 2.11%). Meanwhile, despite improving engagement metrics, increasing average revenue per user (ARPU) still remains a challenge. Snap investors should also keep an eye on Snap's cost of revenue and some key operating expenses when it reports.

Here's a more detailed look at what to watch when Snap reports its second-quarter earnings.

Image source: Spectacles

Analysts' expectations

Data sources: Yahoo! Finance and Snap financial reports. *Consensus estimate.

Wall Street analysts expect Snap to continue growing its revenue year over year as well as posting a sequential increase from the first quarter. The sequential increase, however, isn't unique to Snap; it's a seasonal effect of the advertising market. Facebook, for example, posted a 16% sequential revenue increase last quarter.

Snap, by comparison, is expected to grow the top line about 25%, which isn't much faster than Facebook considering the growth expectations for Snap just a few months ago.

Watch user growth

Snap's user growth has slowed considerably over the past year. The slowdown coincides with the release of Instagram Stories, which co-opts one of the core functions of Snapchat. Instagram is owned by Facebook. Snap said the slowdown is related to its feature release schedule, and investors should expect user growth to come in spurts. Not many investors are buying that, though, and the numbers aren't helping.

Last quarter, Snap added just 8 million daily active users to Snapchat, bringing its total to 166 million. This quarter, analysts are expecting even fewer. RBC Capital Markets analysts are predicting just 7 million net new users.

While user growth expectations aren't extremely high, it's still the most important metric investors need to watch. Growth in users shows improved potential for Snap to generate revenue and make a profit. And considering Snap doesn't currently make a profit, that's all its stock trades on -- potential.

Fueling the low expectations is the growth of Instagram Stories, which recently announced 250 million daily users. What's more, Instagram just announced its younger users spend 32 minutes per day in the app on average. Facebook users spend an average of more than 50 minutes per day across Instagram, Facebook, and Messenger. As Instagram continues to capture users' attention, they have less reason to download and use Snapchat.

If users don't grow, revenue per user must

In order for Snap to reach lofty revenue expectations for the next three years, it needs to start growing ARPU. Last quarter, Snap saw a decline in ARPU from $1.05 in the fourth quarter to $0.90. That decline is in line with seasonal trends, but Snap is still early in the monetization stage for Snapchat, so it doesn't bode well for its continued growth.

Look for ARPU to bounce back above the $1.05 Snap posted in the fourth quarter. There are some factors that could prevent that from happening, though. For example, the company aggressively pursued new advertisers by giving out coupons for its advertising. That said, the new self-serve platform may have brought on enough new advertisers to increase the ad load on Snapchat Stories and improve ARPU.

Mind the expenses

While the main focus for most investors when Snap reports earnings will be its top-line and user growth, don't ignore its expenses.

Snap's cost of revenue should benefit from its long-term cloud deals. Last quarter it reduced hosting costs by 13% over the fourth quarter despite adding more users and increasing engagement. Hosting costs are far and away the biggest portion of cost of revenue, so continued improvement should help improve gross margin.

On the other side, Snap's revenue-sharing expense may continue to grow as it looks to partner with more content producers to keep its audience engaged. If a significant portion of its revenue growth stems from its Discover platform, it'll be offset by the cost of its revenue-share agreements.

Meanwhile, Snap also has room to improve its operating expenses. It's been ramping up its sales and marketing expenses as it grows its top line, but the introduction of the self-serve platform last quarter could help produce some operating leverage. While the self-serve platform was only live for a month or so last quarter, watch for management's comments on the operating margin impact.

Overall, Snap's second-quarter results should prove extremely interesting.