Snap's (NYSE:SNAP) stock surged nearly 40% on April 22 after the social media company posted strong first-quarter numbers. However, the stock dipped 6% the following day after the company announced a new debt offering.

Snap will offer $850 million in senior convertible notes, due in 2025 with an interest rate of 0.25%, in a private placement to qualified institutional buyers. Initial buyers will have an option to buy up to $150 million in additional notes; the notes can be converted to cash, Snap's Class A stock, or a combination of both upon maturity.

Snap plans to use the proceeds for "general corporate purposes," including working capital, operating expenses, and potential investments and acquisitions. The announcement wasn't surprising since Snap remains unprofitable and is burning through lots of cash, but the exclusion of those plans from its conference call might rub investors the wrong way.

Two young women take a selfie.

Image source: Getty Images.

Is the debt offering a red flag?

This marks Snap's second debt offering in less than a year. It offered $1.1 billion in notes last August (due in 2026 with a 0.75% interest rate), which saved it from running out of cash at the end of the year.

Snap's net loss narrowed slightly year-over-year from $310 million to $306 million in the first quarter. Its free cash flow and cash position both improved significantly, but that was mainly due to the proceeds from the debt offering last August:

Metric

2018

2019

Q1 2020

Net loss

($1.26 billion)

($1.03 billion)

($305.9 million)

Free cash flow

($810.2 million)

($341.4 million)

($4.6 million)

Cash and equivalents

$387.1 million

$520.3 million

$901.3 million

Marketable securities

$891.9 million

$1.59 billion

$1.18 billion

Source: Snap annual reports.

Snap's revenue rose 44% annually to $462 million during the first quarter, but its initial estimates for the second quarter, which bear the full impact of the COVID-19 pandemic, look worse. Its revenue rose 15% annually between April 1 and April 19, but dipped to just 11% growth over the past week, which indicates its loss could widen significantly in the quarter.

Snap clearly can't afford to keep losing over $300 million each quarter. That's why it's offering fresh notes, which could generate up to $1 billion in fresh cash if the initial buyers fully exercise their options for additional purchases.

Watch the debt-to-equity ratio

Snap ended the first quarter with a debt-to-equity ratio of 0.8. Adding $1 billion to its total liabilities of $1.77 billion (assuming that its total shareholders' equity remains constant) would boost that ratio to 1.3 -- which is alarmingly high for an unprofitable social media company.

Facebook (NASDAQ:FB) and Twitter (NYSE:TWTR), which are both consistently profitable, had debt-to-equity ratios of 0.3 and 0.5, respectively, at the end of 2019. Pinterest (NYSE:PINS), which isn't profitable, had a ratio of just 0.2. The higher Snap's ratio rises, the harder it will become to sell new notes with favorable interest rates.

Snap has repeatedly declared that it will achieve adjusted EBITDA profitability in the near future. However, that non-GAAP measure excludes two very important expenses: stock-based compensation and interest.

Last quarter, Snap paid out $172 million in stock-based compensation (SBC) expenses, which came from subsidizing employee salaries with stock bonuses, and $15.1 million in interest expenses on its outstanding debt. Snap might brush these costs off as "one-time" expenses, but they're clearly draining its cash reserves every quarter.

Snap's SBC expenses consumed 37% of its revenue in the first quarter. That's a staggering percentage compared to Facebook, Twitter, and Pinterest, which spent 6%, 10%, and 28% of their revenues on SBC expenses in their latest quarters, respectively.

Does Snap's growth potential outweigh those financial risks?

Despite those issues, Snap still generated impressive growth in the first quarter. Its daily active users rose 20% annually, marking its fourth straight quarter of accelerating DAU growth. Its average revenue per user (ARPU) also grew 20%, as its expanding ecosystem of videos, filters, and gamers locked in more users.

That growth indicates that Snapchat still maintains a wide moat against Facebook's Instagram, ByteDance's TikTok, and other rivals. Therefore, the concerns about its cash burn rate or its rising debt levels might be premature.

If Snap continues to grow its DAUs and ARPU as it scales up its ecosystem and reduces its expenses, its losses could gradually narrow and it could turn profitable before its long-term debt matures. Snap's latest debt offerings raise a few red flags, but I still believe that the potential gains outweigh the risks.