There was a time when social media company Snap Inc. (SNAP 12.70%) was worth about $30 billion. That valuation was based on a brand of optimism that makes cryptocurrency "investors" look like levelheaded realists.
Shares of Snap have since plunged around 75% -- that's a 50% decline followed by another 50% decline. There was no shortage of warning signs. The stock debuted at a price-to-sales ratio of roughly 60; publicly traded shares came with no voting power at all, putting complete control in the hands of an inexperienced management; user growth was already starting to slow; and the company was losing a staggering amount of money.
Those problems haven't gone away. Daily active users declined by 2% in the second quarter of this year from the first quarter, with the company's app redesign pushing users away. Free cash flow clocked in at negative $500 million through the first six months of the year, about $100 million worse than the same period in 2017.
And even after the steep decline, the stock price still doesn't make any sense. Neither does the company's strategy.
Image source: Snap Inc.
Communication, video, and profits?
Snap is refocusing on communication, according to a leaked memo from CEO Evan Spiegel to employees. The company wants Snapchat to be the fastest way to communicate. "If you miss a moment to communicate visually, then you have to explain it with words, which takes a lot longer," Spiegel wrote in the memo.
Snapchat is a time saver. Who would have thought?
This shift toward communication comes with a big problem: Monetizing messaging is hard. If the goal is to offer super-fast communication, ads would just slow things down.
So Snapchat is moving toward a business model that's inherently more difficult to monetize. It's also hurling money into original video content. The company is launching short-form scripted shows and docuseries, with five-minute-long episodes sprinkled with six-second ads.
Creating original content isn't cheap -- just ask Netflix. And how exactly original content meshes with the new communication strategy is unclear.
But don't worry, because heavy spending on content plus more difficult monetization equals profits! Spiegel wrote in his memo that the plan is to break even in the fourth quarter of this year and turn a profit in 2019. Snap posted a net loss of $739 million through the first six months of 2018 on less than $500 million of revenue.
Other than arithmetic and reality, one thing that will make turning a profit difficult is the company's cloud infrastructure agreements. Snap runs Snapchat on third-party cloud infrastructure, and agreements are in place that don't expire until 2022.
Snap is big enough that running its own infrastructure would be more cost-effective than using the public cloud. Other companies, including Twitter and Dropbox, made the switch to their own infrastructures and saw significant increases in their gross margins. Snap won't have that option anytime soon.
Long story short, it will take a miracle for Snap to turn a profit next year.
Still an expensive stock
Snap is now valued at about $8.6 billion. With revenue of about $1.15 billion expected in 2018, the stock's price-to-sales ratio is 7.5.
Twitter, another social media company with a stagnating user base, trades for about 7 times forward sales. But Twitter is profitable. It makes no sense for Snap to trade at a premium.
Beyond sporting a lofty valuation, Snap is in real danger of needing to raise money sometime next year. If the company can't drastically improve its cash flow situation, a liquidity crisis could be in the cards. Snap had about $1.57 billion in cash, cash equivalents, and marketable securities at the end of the second quarter, and it's burning cash at a rate of $1 billion per year.
Snap has no debt, but borrowing will be expensive given its gigantic losses. And selling new shares may not be doable if the stock continues to tank.
Snap has set profitability goals that are completely out of line with its new strategy. It's hard to see this story ending well.
