Why Snap's Valuation Warrants Caution

Shares of Snap Inc. (SNAP -2.37%) have performed incredibly well over the last 12 months -- delivering an almost 300% return -- outpacing its main competitors in the social media space. The company won the attention of investors as it delivered strong user and revenue growth in 2020, driven by the stay-at-home economy.

That momentum appears to have carried into 2021, with those key metrics still at elevated levels (but slowing) in the company's first-quarter earnings report. However, given Snap's struggle to turn big revenue gains into profits, there are some concerns about its current $92 billion valuation. Considering that number is 32 times full-year 2020 revenue, investors may want to proceed with caution. 

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Deceleration

Snap's first-quarter 2021 earnings report delivered some flashy numbers, compared to the 2020 equivalents. For example, revenue was up 66% versus the first quarter of 2020, and user growth was up 22%. At face value, these are impressive accomplishments, but when measured against the most recent fourth-quarter 2020 figures, there are notable signs of a slowdown. 

DATA SOURCE: COMPANY FILINGS.

Despite the stay-at-home tailwinds for Snap, revenue didn't start picking up until the second half of 2020. Now that vaccination programs are rolling out globally, economies are reopening, and it appears the company's revenue growth may have already peaked, with two consecutive quarters of deceleration. 

DATA SOURCE: COMPANY FILINGS

Daily active-user growth fared slightly better. The average quarterly growth for calendar-year 2020 was 5%, compared to 4% in 2019. So there's evidence that the pandemic resulted in more Snap users, and first-quarter 2021 growth of 5.7% was above the 2020 average. However, it's important that growth doesn't decelerate the same way revenue has, so investors should keep an eye on that. 

An innovation leader

Snap invests heavily in improving its platform with new features for users to engage with. The company shared some really impressive data points for specific augmented-reality lenses, which project scenery from various global locations via the smartphone camera. 

User interactions with this feature grew 40% in the first quarter, year over year. Over 260 million users engaged with Valentine's Day-themed Lenses over two weeks, and 125 million with Lunar New Year themes. This could be an important source of user growth for Snap, as this feature can be used to deliver new content by both users and the company itself -- in addition to being unique, with few social media players operating in augmented reality at this scale. 

Snap also built a new feature called Spotlight -- inspired by TikTok -- that's designed to aggregate some of the app's most viral content in one place. In March alone, the company says over 125 million people used the feature.

The company is making the right moves in keeping its platform fresh and engaging. However, it may take some time before investors see monetization from these new features hitting the bottom line in a material way. 

Still no earnings

Snap just boasted about a breakeven quarter, and the notable achievement of turning cash flow positive. The problem, though, is they've delivered positive operating cash flow before -- in the first quarter of 2020 -- and they followed that up with three consecutive quarters in negative territory, despite huge revenue increases. This time, they delivered significantly more operating cash flow, but the lack of consistency might concern some investors. 

DATA SOURCE: COMPANY FILINGS. *RECORD COMPANY REVENUE.

Regardless, this has not flowed through to the bottom line, and the company continues its struggle for earnings.

DATA SOURCE: COMPANY FILINGS.

The question for Snap -- and many other technology companies -- is whether 2020 was as good as it gets. It's difficult to determine whether these companies will ever experience a better environment for their platforms, given that consumers were confined to their homes with more screen time. 

To justify its current valuation, Snap may need to deliver more consistent quarterly revenue growth, halting the current deceleration. The company might otherwise struggle to maintain the current market cap at 32 times 2020 revenue, when investors could instead buy the enormously profitable Facebook (META -1.39%) at about 10 times sales. 

Above all, though, Snap needs to find a way to convert that revenue to the bottom line and deliver a full-year earnings result to show investors some substance for their money.