6 Red Flags for Snap's Future

Snap's (SNAP 6.70%) stock tumbled 27% during after-hours trading on Thursday, July 21, following the release of the social media company's second-quarter earnings report. Its revenue rose 13% year over year to $1.11 billion, which missed analysts' estimates by about $20 million.

Back in May, Snap had already warned investors its second-quarter revenue would come in "below the low end" of its prior guidance for 20%-25% growth amid tough macroeconomic challenges.

Snap's net loss also widened from $152 million to $422 million, while its adjusted EBITDA (earnings before interest, taxes, depreciation, and amortization) plummeted 94% to just $7 million. Nevertheless, its non-GAAP (generally accepted accounting principles) loss of two cents per share still beat Wall Street's expectations by a penny.

Image source: Getty Images.

Snap's daily active users (DAUs) still increased 18% year over year to 347 million, but its average revenue per user (ARPU) fell 4%. Those results look dismal, but six additional red flags indicate it's still too early to consider the beaten-down social media stock a turnaround play.

1. No more guidance

Snap usually provides guidance for its quarterly revenue and adjusted EBITDA, but it declined to do so for the third quarter due to "uncertainties related to the operating environment."

Specifically, Snap is still grappling with Apple's (AAPL -0.57%) privacy changes on iOS, headwinds from the Ukrainian war, and COVID-19-related disruptions in certain markets. Inflation and rising interest rates have been exacerbating that pain by throttling digital ad purchases worldwide.

Snap's cautious outlook isn't surprising, but it previously told investors it could achieve "50%-plus revenue growth" for "multiple years" during its investor day presentation last February. But this chart illustrates Snap's growth trajectory since it set that ambitious goal:

Data source: Snap. YOY = Year over year.

2. Refusing to abandon that 50% target

During the conference call, Snap was asked if that 50% target was still on the table. Instead of answering the question, CFO Derek Andersen said that while Snap faced near-term macro headwinds, it could still be "well positioned over time" as it rolled out new features and expanded overseas.

Analysts expect Snap's revenue to rise about 22% to $5.03 billion for the full year and another 32% to $6.63 billion in 2023, but those estimates will likely be reduced after its latest earnings report.

The responsible thing to do would be to simply walk back its 50% goal (and endure some pain now) instead of stubbornly maintaining it and undermining investors' confidence in its long-term plans.

3. Pausing its headcount growth

During the call, Andersen also said Snap would "effectively pause" its headcount growth. That decision could help it rein in its costs and expenses, which jumped 29% year over year to $1.51 billion during the quarter, as well as stock-based compensation expenses, which gobbled up 29% of its total revenue.

However, reining in its spending could also make it more difficult for Snap to roll out new features and keep pace with fierce competitors like ByteDance's TikTok and Meta Platforms' (META 1.54%) Instagram.

4. Deteriorating cash flows

Snap generated a negative free cash flow (FCF) of $147 million in the second quarter, compared to a negative FCF of $116 million a year earlier.

Snap won't run out of cash anytime soon, since it was still sitting on $4.9 billion in cash, cash equivalents, restricted cash, and marketable securities at the end of the quarter. But it's still bleeding out -- and its elevated debt-to-equity ratio of 1.6 doesn't give it too much room to raise fresh funds.

5. A $500 million buyback

It's a bright red flag when an unprofitable company with a negative FCF authorizes a big buyback. That's precisely what Snap did by abruptly authorizing a $500 million buyback for its Class A shares.

Snap says the buyback, which will last for the next 12 months, will offset a "portion of the dilution related to the issuance of restricted stock units to employees." Therefore, this buyback is actually a sign of weakness instead of strength -- and it won't actually make the company's shares any cheaper. 

6. A pointless stock split plan

Lastly, Snap pledged to issue a stock split in the form of a dividend of one Class A share for each then-outstanding share if the Class A share reaches $40 within the next 10 years. That decision, which is mainly aimed at letting its founders sell more Class A shares instead of their exclusive tier of Class C shares (which are worth 10 votes apiece), is meaningless and merely seems like a futile attempt to jump on the stock split bandwagon.

All these issues suggest Snap is in serious trouble. Investors looking for a more resilient social media play should take a fresh look at Meta, which might have a better shot at a long-term recovery.