It's been a bad year for mobile app company Snap (SNAP 4.71%). As recently as last September, Snap stock traded for over $80 per share. But it's now down almost 90% from its high.
Perhaps you've been told that a stock's price per share is unimportant, because in time, the stock price follows business execution. Therefore, you should watch the business, not the stock. And this is excellent advice -- most of the time. But every now and then, the stock price does affect a company's business.
Snap's deep sell-off is actually a problem, and management appears to be addressing this problem by staying the course.
Snap stock needs to more than double by 2025
Cheap debt defined the public markets in 2020 and 2021. As reported by The Wall Street Journal, during this two-year span, companies issued a record $57 billion in zero-coupon convertible notes, according to data from JPMorgan Chase. These notes don't pay lenders in principal and interest but in stock at predetermined prices.
Snap was just one company among many that availed itself of cheap debt. However, because shares are down nearly 90%, its convertible notes have conversion prices astronomically higher than where the stock trades today, as you can see below:
| Maturity date | Initial loan amount | Interest rate | Initial conversion price | Percentage gain from current price* |
|---|---|---|---|---|
| 2025 | $1.000 billion | 0.250% | $21.68 | 128% |
| 2026 | $1.265 billion | 0.750% | $22.81 | 140% |
| 2027 | $1.150 billion | N/A | $89.25 | 839% |
| 2028 | $1.500 billion | 0.125% | $56.34 | 493% |
Data source: Snap filings with SEC. Chart by author. *Calculated based on share price of $9.50 on July 28, 2022.
Snap's management already took care of some of its 2025 and 2026 notes when its stock price was still high. So it "only" has $3.7 billion in convertible long-term debt still outstanding. But that debt will only convert at prices much higher than where the stock trades right now. Unless Snap's stock recovers in time, it will be on the hook to repay the rest.
Why paying it back won't be easy
Snap could pay off its convertible notes in time by issuing new debt. However, the cheap debt era is over. Interest rates have surged in 2022, and I'd wager that interest rates from 2025 through 2028 will be higher than rates in 2019, 2020, and 2021. In other words, Snap might be forced to repay cheap debt with expensive debt -- less than ideal.
To avoid this scenario, Snap could use cash. After all, the company has almost $4.9 billion in cash, cash equivalents, and marketable securities right now on its balance sheet. However, Snap has historically burned cash and recently returned to burning cash. Therefore, it still needs its cash to fund operations, as the next chart shows.
| Quarter | Q3 2021 | Q4 2021 | Q1 2022 | Q2 2022 |
|---|---|---|---|---|
| Cash from operating activities | $72 million | $186 million | $127 million | ($124 million) |
Data source: Snap filings with SEC. Chart by author.
I don't think Snap's cash burn in the second quarter of 2022 is temporary. Management refrained from providing official guidance for the current quarter, but it expects flat revenue growth. And it plans "to slow the rate of operating expense growth," implying that operating expenses will still go up. If revenue stays the same but operating expenses increase, cash from operating activities will likely go down.
On its current trajectory, I believe Snap will need to pay back debt with more expensive debt. And this will negatively affect shareholder value, because higher interest payments leave less money to invest in the business.
Snap's $3.7 billion bet
If I were management, this entire scenario would motivate me to course-correct. But Snap's management is doubling down. Co-founders Evan Spiegel and Bobby Murphy will remain in their respective CEO and Chief Technology Officer roles through Jan. 2027. Therefore, shareholders can expect much of the same vision over the next five years as Snap has had since inception -- audacious goals with big spending.
Moreover, rather than conserving cash, Snap just initiated a $500 million stock repurchase plan. At first, this sounds good, because share repurchases can boost the stock price. However, in Snap's case, the buyback is just to offset ongoing dilution from stock-based compensation (SBC).
For the record, Snap's SBC was up 42% in 2021 and another 20% in the first half of 2022 on a year-over-year basis. If SBC remains elevated, more buybacks will be needed to offset dilution, requiring more cash. But if they don't offset it, it gets even harder for the stock price to bounce back to the conversion prices of its debt.
To be clear, in no way do I believe Snap is in danger of insolvency. I'm simply pointing out a big issue that could hinder future returns for Snap stock. By sticking with current leadership, repurchasing shares, and staying the course, Snap's management is essentially betting on itself.
However, with a price tag of $3.7 billion, that is a high-stakes bet -- shareholders need to be confident management is right.
