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3 Reasons to Sell Snap After That Awful Quarter

By Leo Sun - Updated May 4, 2018 at 1:42PM

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Teens still love Snapchat, but its business is a train wreck.

Shares of Snap (SNAP 0.30%) recently plummeted after the Snapchat maker released its first-quarter numbers. Its revenue rose 54% annually to $230.7 million, but it missed estimates by $12.9 million and marked its slowest growth since its IPO last year. It also represented Snap's first sequential revenue drop, with a 19% decline from the fourth quarter.

Snap's net loss narrowed from $2.21 billion in the prior-year quarter to $385.8 million, but that comparison was skewed by its post-IPO compensation last year. On a sequential basis, Snap's net loss widened from $350 million in the fourth quarter.

Snapchat's app.

Snapchat's app. Image source: Snap.

Those headline numbers indicate that things won't look brighter anytime soon. However, some contrarian investors might be wondering if Snap is a bargain at a near-30% discount to its IPO price. To those hopeful bulls, I offer three simple reasons for selling Snap instead of buying it.

1. Its user growth is peaking

Snap's daily active users (DAUs) rose 15% annually to 191 million, which seems decent but is actually its slowest year-over-year growth rate since its IPO. That also only represents 2% growth from the fourth quarter. Three main headwinds likely throttled Snapchat's growth.

First, Facebook's (META -0.76%) Instagram cloned most of Snap's unique features -- including its ephemeral messages, stories, and filters. Instagram hit 500 million DAUs last September, representing a five-fold increase from Oct. 2016.

Second, Snap shot itself in the foot with an app redesign that alienated many core users by splitting stories from friends from those from brands and celebrities. Celebrities like Kendall Jenner slammed the redesign, and irritated users petitioned Snap to roll back the update.

Lastly, Snap suffered a storm of bad publicity in late March when its automated ad platform ran an ad that asked users if they'd rather "slap Rihanna" or "punch Chris Brown." Rihanna responded to the controversy by asking her followers to delete Snapchat.

2. It's losing pricing power in ads

Snap's average revenue per user (ARPU) rose 34% annually to $1.21 during the quarter, but that missed expectations by six cents and represented a 21% drop from the fourth quarter. Snap attributes that decline to the automation of its ad buys -- which delivers more ads but generates lower revenue per ad -- the redesign of its app, and seasonal demand.

The first two reasons seem credible, but I don't think demand for social media ads is waning on a "seasonal" basis. After all, Facebook recently posted 50% annual sales growth in its ad revenues during the first quarter. A more reasonable explanation is that Snap's advertisers flocked to rival platforms like Instagram, and Snap started losing pricing power.

Meanwhile, Snap's cost of revenue per user rose 5% annually and 1% sequentially to $1.03. If Snap's ARPU keeps falling as its cost of revenue per user keeps rising, its sales growth will stall out and its losses will widen.

3. It has no vision for the future

During the conference call, CFO Drew Vollero warned that Snap's second quarter revenues would "decelerate substantially" from its first quarter levels. Vollero also expects "infrastructure costs to increase modestly in the short-term" as Snap tests and rolls out new changes for Snapchat.

This means that Snap will keep tweaking Snapchat, possibly alienating even more users, as it desperately tries to distance itself from Instagram. Meanwhile, Instagram will likely retain Snap's old features and lure away disenchanted Snapchat users.

Snapchat's Spectacles.

Snapchat's Spectacles. Image source: Snap.

The clearest sign that Snapchat is out of ideas is its plan to launch a new version of Spectacles. The new version adds incremental upgrades but costs $20 more than the original at $150, and it's unclear who will actually buy the new glasses after the first version flopped.

The discontinuation of the original Spectacles resulted in nearly $40 million in writedowns during the third quarter of 2017. Snap also lost $22 million on the 220,000 units it actually sold.

The key takeaway

Analysts expect Snap's revenue to rise 61% to $1.3 billion this year, but that represents a major slowdown from its 104% growth last year. Meanwhile, the stock trades at 13 times this year's sales -- which is a lofty premium for a company that is reporting slowing user growth, waning pricing power in ads, and widening losses.

This market is already a tough one, so investors shouldn't confuse falling knives like Snap with decent long-term plays like Facebook.

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