Snap (NYSE:SNAP), the parent company of Snapchat, recently posted its second-quarter earnings. Its revenue rose 17% annually to $454 million, beating estimates by nearly $10 million.

Its net loss widened from $255 million to $326 million, as its adjusted EBITDA loss widened from $79 million to $96 million. Its non-GAAP net loss widened from $0.06 to $0.09 per share, but still beat expectations by a penny.

Snap's headline numbers beat Wall Street's expectations, but its stock slid 6% after the report. That pullback wasn't surprising since Snap's stock had already rallied over 50% this year and was trading at 16 times this year's sales. But was it justified? Let's dig deeper to see if Snap still deserves its premium valuation.

A young woman takes a selfie.

Image source: Getty Images.

Another quarter of double-digit DAU growth

Snap's daily active users (DAUs) grew 17% annually to 238 million in the second quarter, marking its fourth straight quarter of double-digit growth. It also continued to gain users on a sequential basis:

DAU growth

Q2 2019

Q3 2019

Q4 2019

Q1 2020

Q2 2020

Sequential

7%

3%

4%

5%

4%

Annual

8%

13%

17%

20%

17%

Source: Snap Q2 2020 report.

However, Snap's DAUs slightly missed its own forecast of 239 million and analysts' expectations for 238.5 million. That miss was minor, but it likely contributed to the stock's post-earnings sell-off. On the bright side, Snap's DAUs grew sequentially and annually on both iOS and Android, as well as all of its global regions:

Region

DAUs (Q2 2020)

Sequential Growth

Annual Growth

North America

90 million

2%

9%

Europe

71 million

1%

12%

Rest of World

77 million

8%

37%

Source: Snap Q2 2020 report.

Snap also expects its streak of double-digit annual DAU growth to continue with 15%-16% growth in the third quarter. That's a deceleration from the second quarter, but Snap faces a tougher comparison to the third quarter of 2019, when it launched new AR lenses and games, and seasonally lower growth.

During the conference call, CFO Derek Andersen said that after "taking these factors into consideration," Snap's third-quarter forecast reflects a "continuation of the healthy underlying growth trends that we've observed in the business over the past year." In other words, Snapchat isn't losing users to Facebook's (NASDAQ:FB) Instagram or ByteDance's TikTok.

Slowing ARPU growth

Snap's slowing average revenue per user (ARPU) growth also likely spooked the bulls. Its ARPU dipped 5% sequentially and stayed flat annually at $1.91, marking a steep deceleration from its previous quarters. Double-digit declines in its Rest of World region overwhelmed its annual growth in North America and Europe:

Region

ARPU (Q2 2020)

Sequential Growth

Annual Growth

North America

$3.40

(5%)

8%

Europe

$1.10

(1%)

16%

Rest of World

$0.89

(11%)

(26%)

Total

$1.91

(5%)

0%

Source: Snap Q1 2020 report.

Andersen said the COVID-19 crisis throttled ad purchases in many overseas markets during the second quarter, but he noted its revenue had started to rebound in the third quarter and was "looking much better now."

Snap didn't provide exact revenue guidance for the third quarter, but it estimated its revenue had risen 32% annually through July 19. Andersen said Snap was "cautiously optimistic that these trends could sustain over time," but warned the conditions could "further deteriorate" with COVID-related losses of back-to-school, movie, and sports ad revenue.

Higher spending and widening losses

Over the past year, Snap attributed its robust DAU and ARPU growth to the expansion of its ecosystem with new Discover videos, AR lens, games, and its live Snap Map, which all widened its moat against Instagram, TikTok, and other challengers.

However, those investments boosted its total operating expenses 10% annually to $765 million, which more than wiped out its $454 million in revenue. Investors likely forgave Snap's losses when its DAU and ARPU growth rates were outpacing expectations, but that patience could wear thin as its growth stalls out.

Snap was still sitting on $1.25 billion in cash and equivalents, as well as $1.58 billion marketable securities, at the end of the quarter. Its free cash flow also improved slightly year-over-year, from negative $103 million to negative $82 million, so Snap won't run out of cash anytime soon. Snap believes it can eventually achieve profitability on an adjusted EBITDA basis, but it's unclear if it will ever generate a GAAP profit or a positive FCF.

Does Snap still deserve its premium valuation?

Snap's slower growth and wider loss likely convinced some investors to take profits in its high-flying stock. However, Snap's partial guidance for the third quarter indicates its platform is still growing, and its ad revenue could stabilize as more businesses reopen.

Snap's stock isn't cheap, but investors should recall it traded at over 30 times sales after its IPO three years ago. Snap's slowdown also seems temporary and caused by macro headwinds, instead of direct competition from Instagram and TikTok. Therefore, Snap remains a risky investment, but I believe its long-term growth potential still justifies its premium valuation.