Snap (SNAP -3.04%) decided to offer investors a closer glimpse at its advertising business in the third quarter. It disclosed the average ad price on Snapchat declined 60% year over year and 20% from the second quarter during its third-quarter earnings call.

The shift to Snap's API partners and its own self-serve platform led marketers to buy more ads via auction instead of directly from Snap's sales team. Snap sold 80% of Snap Ads via auction last quarter, up from 60% in the second quarter and 0% during the same period last year. As more marketers buy ads through auctions with lower minimum bids than reserved ad pricing, ad prices are declining.

Management believes the problem will sort itself out as more advertisers join the platform, but they're light on the details regarding when investors can expect the trend to turn around.

Snapchat logo

Image source: Snapchat

Low prices are attracting new advertisers

The new self-serve platform has done an excellent job of attracting new advertisers. Management says active advertisers on its self-serve platform increased by five times quarter over quarter.

Indeed, growing the number of advertisers on the platform is an essential part management's strategy to return ad prices to growth. Many of Snap's ad auctions had just one bidder, which meant minimum pricing. In contested auctions, average ad prices were 40% higher than uncontested auctions. Even still, prices in those auctions represent a steep decline from the average ad price last year.

Other platforms show that increasing the number of advertisers will increase average ad prices in the long run. Facebook (META 0.27%) saw the number of advertisers on its platform climb from 5 million to 6 million over the last six months. Its average ad price increased 35% in the third quarter.

But it's important to remember Facebook's ad prices are also impacted by supply constraints. Snapchat grew ad impressions 400% year over year last quarter, and CEO Evan Spiegel said, "Overall ad load remains very low," implying we could see impression growth for a long time still.

The big risk

The shift to nearly all Snap Ads sold at auction presents a major risk to Snap. Snap has been attractive to big brand advertisers looking to get in front of a young and engaged audience. These are the same companies that are buying television commercials, and looking for a replacement as time spent shifts from cable to digital media. Snap even pointed to this as its biggest opportunity in its S-1 filing in February.

These companies have lots of money to spend on advertising and were willing to experiment. The high minimum spending requirements for Snap Ads helped Snap capitalize on those large ad budgets. Where the minimums for Snap's direct-sold advertising are currently $100,000 to $200,000, small advertisers can get started on Snap's self-serve platform for just $100.

That's to say there's a big potential for some marketers to reduce their budget for Snap Ads by using the auction. When asked if marketers are maintaining their budgets for Snap Ads and buying more volume at a lower price or if they're lowering their overall spend, management dodged the question.

Lowering the threshold for advertisers to experiment can bring in a lot of advertisers, but it can also deteriorate Snap's existing revenue sources. That's the price to pay for better long-term growth potential. Considering expectations are still relatively high for Snap's growth over the long term, it's a necessary move. But Snap will continue to see its impact for a long time. Management wouldn't give any outlook for when investors can expect the auction format to become less of a headwind for ad revenue.