Shares of Snap (SNAP 1.09%) recently popped after Evercore ISI analyst Kevin Rippey upgraded the social media stock from in line to outperform and boosted his price target from $18 to $20. The upgrade itself wasn't surprising, since Snap's fundamentals improved significantly over the past three quarters as it started gaining new users again.
However, Rippey's upgrade wasn't based on the growth of Snapchat's core advertising business, which he claims is already reflected in its current valuation. Instead, Rippey believes that Snap's gaming business could become its new growth engine by 2022 and generate about $350 million in annual revenue.
Investors should always take analysts' forecasts with a grain of salt when investing in stocks, but they should also understand the logic behind Evercore's forecast.
How much bigger will Snapchat grow?
Snap's total number of daily active users (DAUs) grew 8% annually to 203 million last quarter, while its average revenue per user (ARPU) surged 37% year over year to $1.91. Nearly all of that revenue came from ads. Wall Street expects Snap's top line to rise 44% to $1.7 billion this year.
Evercore didn't offer any long-term forecasts for Snap's overall growth, but UBS analyst Eric Sheridan predicts that Snap's DAUs will top 250 million in 2022 as its annual revenue reaches $2 billion to $3 billion. Sheridan also predicts that Snap will become profitable by 2021.
Based on Sheridan and Rippey's forecasts, video games could generate 12% to 18% of Snap's revenue by 2022.
What do we know about Snap's gaming plans?
Snap launched Snap Games in April, and the platform attracted publishers like Zynga (ZNGA), which launched a "bite-sized" battle royale game called Tiny Royale for the platform in June. Other launch titles include Bitmoji Party, Bitmoji Tennis, Zombie Rescue Squad, Snake Squad, and Alphabear Hustle. Snap also previously launched AR-based "Snappable" games, which let users perform camera-based tasks like "catching" fish in your mouth.
Snap hasn't revealed any user numbers for its gaming platform yet, but during last quarter's conference call, CEO Evan Spiegel stated that it was "off to a great start." Spiegel noted that Snap's gaming platform was designed for "gameplay with real friends" and that it was already seeing "a direct correlation between the number of friends playing a game together and their time spent playing games."
Spiegel noted that Snap was "just getting started" in gaming and that the platform would keep "evolving." Investors should recall that Tencent (TCEHY -1.45%), the largest gaming publisher in the world, is also one of Snap's biggest stakeholders. Therefore, there's a strong chance that Tencent will eventually release some of its top mobile games -- like Arena of Valor and PUBG Mobile -- on Snap Games.
Snap's gaming efforts complement the expansion of its ecosystem with new features -- which also include augmented reality (AR) lenses and filters, new Discover content, and original videos. That expansion could lock in more users while boosting its ARPU -- which could cushion any future slowdowns in its DAU growth.
Is the $350 million estimate realistic?
If Snapchat hits 250 million DAUs by the end of 2022 as its gaming business generates $350 million in annual revenue, it would indicate that its games are generating about $0.71 in annual ARPU. That's a realistic target. Zynga, for example, generated $0.61 in gross bookings per mobile DAU over the past four quarters.
Snapchat remains the most popular social networking app for teens in America, according to Piper Jaffray, making it an ideal platform for developers who are targeting Gen Z gamers. Snap Games will also likely remain less crowded than Apple's App Store and Alphabet's Google Play -- which makes it an attractive option for developers.
That all sounds promising, but Snap could still face competition from Facebook's Instant Games, which were originally embedded in Messenger but recently integrated into its main app. New platforms, like the Epic Games app store, could also lure away potential developers with promises of lower royalties and less crowded marketplaces.
The bottom line
I personally believe Snapchat's gaming business could become a pillar of growth in a few years, but it won't move the needle anytime soon.
For now, investors should focus on Snapchat's ability to boost its DAUs and ARPU as it expands its ecosystem and narrows its losses. If it accomplishes those goals, the long-term growth of its gaming business will merely be icing on the cake.