Over the last four years, social media operator Snap (SNAP 0.26%) has seen a massive decline in its average ad prices on its Snapchat multimedia messaging app as it shifted to selling ads programmatically. The shift in ad sales allowed Snap to scale the ad business much more quickly, but it meant it wasn't necessarily maximizing the value of each ad impression.

However, Snap managed to turn the corner in the third quarter, with average ad prices climbing 20% year over year. It's the first time the company's reported an increase in average ad prices since going public.

Teens sitting on a couch staring at their respective smartphones.

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Three factors pushing Snapchat ad prices higher

Snap saw improvement in three areas that all contributed to higher average price per ad impression.

First, Snap saw a positive shift in ad impressions to higher-value ad products like its six-second Commercials. Commercials display during Snap's Shows in Discover, which continues to grow in popularity. Total time spent watching Shows increased 50% year over year last quarter. Revenue from Commercials more than doubled year over year.

Snap also saw strong adoption of its camera advertising products. Spend on the augmented reality advertising products also more than doubled year over year. Management called out its ability for advertisers to maximize reach and frequency with these ad products since Snapchat users spend a lot of time playing with lenses. 

Second, Snap experienced an increase in demand from both new and existing advertisers. Snap saw particularly strong demand with brand advertisers, who are more likely to purchase those higher-value ad products like Commercials and sponsored lenses. That was helped by a boycott early in the quarter of Facebook (META 2.67%) advertising from dozens of large brands. 

Finally, Snap has made continued improvements in its measurement and targeting capabilities. The ability to surface the right ad in front of the right person at the right time makes it that much more effective and that much more valuable to a marketer. Improving this technology is a big step toward increasing the price advertisers pay per impression.

Management noted that e-commerce advertisements on Snapchat that use its pixel to track purchases saw a 71% increase in price per impression. But even with the higher impression price, marketers paid just 1% more per sale.

Targeting technology alone isn't going to increase value, though. Snap also needs increased demand. Without a broad selection of ads to display, Snapchat is limited in its ability to maximize the value of its targeting capabilities. So, the combination of increased demand for its ad products with its improved targeting supercharged its ad prices last quarter.

Where Snap goes from here

With ad prices starting to trend in a positive direction, Snap will need to continue to manage its supply and demand going forward. To that end, Snap is favoring keeping supply low by limiting its ad load per user. While user growth will organically increase supply as users watch more Shows, play with Lenses, and share Stories, Snap wants to keep the user experience similar to today for as long as possible.

And with good reason. Users are more than fine with the number of ads they see today. That's evidenced by the strong user growth Snap's seen over the last year and a half. Daily active users are up 31% since March of last year.

Maintaining a lower supply will also allow the tech company to absorb negative changes in advertising demand. The third quarter was clearly helped by some advertisers shifting away from Facebook. It's unclear whether Snap will be able to hold onto that ad spend over the long run. Furthermore, management expressed uncertainty over fourth-quarter advertising demand amid the COVID-19 pandemic.

During Snap's third-quarter earnings call, CFO Derek Andersen said he expects fourth-quarter revenue growth of between 47% and 50%. He noted that's under the assumption that operating conditions remain the same and advertising demand trends are similar to the fourth quarter last year. That would be another strong quarter from Snap. Moreover, the long-term potential of sustainably growing the ad business is really starting to materialize with the positive trend in ad prices.