Where Will Snap Be in 5 Years?

Snap (SNAP 2.24%) has burned plenty of investors before. The Snapchat maker went public at $17 in March 2017, quickly soared to the high $20s, then slid to about $5 last December amid concerns about its slowing user growth, competition from Facebook's (META 2.98%) Instagram, and lack of profitability.

However, Snap's stock rebounded to the mid-teens this year as its user growth stabilized, its average revenue per user (ARPU) improved, and its losses narrowed. Snap also expanded Snapchat's ecosystem with new features to boost its ARPU. Those improvements indicate that Instagram wouldn't render Snapchat obsolete anytime soon. But will Snapchat still survive and thrive over the next five years?

Image source: Getty Images.

Snap's biggest challenges

Snap finished the first quarter with 190 million daily active users (DAUs), compared to 186 million in the fourth quarter and 191 million a year ago. That sequential stabilization indicates that its core users, most of whom belong to the coveted Gen Z demographic, aren't abandoning the platform.

41% of U.S. teens still call Snapchat their favorite social network, compared to 35% for Instagram, according to Piper Jaffray's latest "Taking Stock with Teens" survey. Furthermore, Snap consistently grew its ARPU by selling more automated ads at lower prices -- which offset its peaking user growth over the past year:

Data source: Snap quarterly reports.

In other words, Snap will keep prioritizing its revenue growth per user over its total user growth over the next few years. It will try to maintain that momentum by integrating more in-app games, original videos, augmented reality (AR) lenses, and other features to its ecosystem.

It's also expanding its ad network to third-party apps, making it easier for small businesses to launch ad campaigns through a partnership with Shopify, and it's encouraging developers to create more Snapchat features -- which will hopefully expand the app into a full-blown platform.

Image source: Getty Images.

A tough balancing act with unpredictable variables

However, it's still unclear if those new features can boost Snap's ARPU enough to offset its slowing user growth over the long term. eMarketer expects Snapchat's total monthly active users (MAUs) in the U.S. to decline 2.8% to 77.5 million this year, and only grow slightly to 28.1 million by 2023. The firm estimates that 39.9% of U.S. social media users used Snapchat last year, but that figure could drop to 37.9% this year, and 35.3% by 2023.

That decline can be attributed to tough competition from Instagram, which is expected to grow its U.S. MAUs 6.2% to 106.7 million this year. eMarketer also expects Instagram to add nearly 19 million new MAUs by 2023 -- which puts a lot of pressure on Snapchat to increase its revenue per user.

Snap reined in its spending over the past year, which narrowed its net loss from $386 million to $310 million between the first quarters of 2018 and 2019. Its negative free cash flow (FCF) of $78 million also improved significantly from a negative FCF of $268 million a year ago.

Snap finished last quarter with $246 million in cash and equivalents, but its negative FCF indicates that it could still run out of cash in the near future. This indicates that it needs to be cautious with its ecosystem expansion efforts and avoid wasteful projects like Spectacles in the future.

Trying to justify its premium valuation

Snap's stock trades at about 11 times this year's sales and 9 times next year's sales. Analysts expect its revenue to rise 35% this year and 31% next year, but its bottom line is expected to stay in the red.

Facebook trades at just 8 times this year's sales and 7 times next year's sales. Wall Street expects Facebook to generate revenue growth of just 24% this year and 21% next year -- but Facebook is also firmly profitable and trades at just 21 times forward earnings.

Facebook's growth is decelerating, but most investors believe the world's top social network will still exist in five years. Snap's outlook is hazier -- its business is stabilizing, but it will face more pressure to boost its ARPU and narrow its losses as its user growth tops out. Accomplishing that as it expands its ecosystem will be tough.

I think Snapchat will still be relevant in five years, since current Gen Z users won't simply stop using the app as they age. However, Snapchat isn't out of the woods yet, and it needs to prove that its new efforts -- which include targeting older users, expanding its walled garden, and attracting more developers -- can pay off.