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Why I'm Not Buying Snap's "Strong" Earnings Report

By Jamal Carnette, CFA - Feb 13, 2018 at 10:13AM

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Snap Inc. exceeded low expectations in the fourth quarter but continues to hemorrhage cash.

It's been a rough ride in the public markets for Snap Inc. (SNAP -3.40%). In the three earnings reports after the company's highly anticipated IPO, shares have missed revenue expectations. As a result, the stock had found itself below its $17 IPO price coming into its fourth-quarter earnings.

This quarter was different: For the first time the company beat expectations by posting $285.7 million in revenue, a significantly higher figure than the Thomson Reuters' consensus estimates of $252.9 million. The company also beat analyst expectations on the bottom line by posting an adjusted EPS loss of $0.13, versus a $0.16 consensus.

Additionally, Snap outperformed expectations on supplemental metrics: Snap grew global daily active users to 187 million versus 184.2 million and reported $1.53 revenue per users versus $1.36. Shares initially climbed as much as 25% soon after the report, eclipsing its IPO price.

However, I'm still bearish on Snap, even after its strong earnings report.

Friends taking a selfie

Image source: Getty Images.

Free cash flow and adjusted EBITDA are moving in the wrong direction

In the company's prepared remarks, CEO Evan Spiegel notes (emphasis mine):

All this growth came at a lower cost than the previous quarter. Cash burn decreased 49% from the prior quarter, and gross margin increased 1,400 points sequentially to 36%. These are big improvements that show how quickly Snap can scale when our products and our ad business are working well together.

The first issue I have with Spiegel's comparison is one of seasonality. For advertising-based businesses like Snap, it's better to look at look year-on-year comparisons, especially during the holiday-laden fourth fiscal quarter. Unfortunately, Snap did not provide a year-on-year comparison for cash burn and made no mention of it in last-year's S-1 IPO registration statement.

However, free cash flow, defined as cash from operations minus capital expenditures, worsened this quarter, from a loss of $188.1 million in the fourth quarter of 2016 to a loss of $197.3 million in the current quarter, even with top-line growth of 72%. (On a sequential basis, the company did narrow its free-cash-flow loss from $220 million.) Finally, even though gross margin increased on both a sequential and year-on-year basis, adjusted EBITDA is still negative and worsened from the prior year's quarter.

Snap's plans to improve free cash flow are concerning

I'm unsure Snap has a concrete plan to reverse negative cash flow. In the fourth-quarter earnings slides, twice the company referenced how little it paid in capital expenditures, first noting that it spent less than $85 million in fiscal 2017 and the second noting that "modest capital expenditures will result in stronger FCF conversion over time." While I assume this is Snap's way of communicating that it's a highly scalable business, perhaps there are better ways to relay this message than highlighting that you're planning on not investing in property and equipment.

Snap had a better quarter than analysts had expected, but those expectations were rather modest. Even with all the good news, free cash flow and adjusted EBITDA continue to weaken. From a unit-economics standpoint, it's time for investors to ask if Snap can ever achieve the scalability it needs to break even on those metrics. With its shares trading at more than 20 times sales, I'm not willing to take a position until I'm sure the company can do so.

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