Snap (SNAP 0.19%) stock plunged 27% during after hours trading on Oct. 20 following the release of its third-quarter earnings report. The social media company's revenue rose 6% year over year to $1.13 billion, missing analysts' estimates by $10 million. Its net loss widened from $72 million to $360 million, while its adjusted earnings before interest, taxes, depreciation, and amortization (EBITDA) plunged 58% to $73 million. But on a non-GAAP basis, earnings of $0.08 per share still beat the consensus forecast.

Investors had already been bracing for a rough report following Snap's dismal second-quarter release in July, but the latest news seemed to extinguish any hopes for a near-term recovery. Should investors shun Snap stock at these depressed levels, or should they take the contrarian view?

A smiling person takes a selfie.

Image source: Getty Images.

What happened to Snap?

Snap's daily active users (DAUs) grew 19% year over year to 363 million in the third quarter. However, that growth was largely offset by an 11% decline in its average revenue per user (ARPU). Besides ongoing headwinds for the ad market, stiff competition from rivals like TikTok, and Apple's privacy-oriented changes for its iOS, stronger growth in the company's "Rest of World" segment put pressure on ARPU since it still contributes much lower revenue per user than the more saturated North American and European markets.

Period

Q3 2022

Q2 2022

Q1 2022

Q4 2021

Q3 2021

DAU Growth (YOY)

19%

18%

18%

20%

23%

ARPU Growth (YOY)

(11%)

(4%)

17%

18%

28%

Revenue Growth (YOY)

6%

13%

38%

42%

57%

Data source: Snap. YOY = Year-over-year.

The slowdown over the past year indicates Snap overestimated its own growth potential when management boldly told investors in Feb. 2021 the company could grow its annual revenue by 50% or more for "multiple years."

As Snap's revenue growth cools off, its operating and adjusted EBITDA margins have collapsed. The latter improved sequentially in the third quarter after Snap laid off 20% of its workforce and scrapped several of its non-core projects, but it still seems highly unlikely operating margins will approach breakeven levels anytime soon.

Period

Q3 2022

Q2 2022

Q1 2022

Q4 2021

Q3 2021

Operating Margin

(39%)

(36%)

(26%)

(2%)

(17%)

Adjusted EBITDA Margin

6%

1%

6%

25%

16%

Data source: Snap.

Snap ended the third quarter with $4.43 billion in cash and marketable securities, so it still has the resources to sustain a turnaround. However, with $3.74 billion in convertible senior notes on the balance sheet as well, the company has only so much room to raise fresh funds at reasonable rates if its liquidity dries up.

That's why it was baffling when Snap authorized a $500 million stock buyback for the next 12 months. Management likely wants to capitalize on the low stock price to offset the dilution from stock-based compensation (30% of third-quarter revenue), but it's still a bad look for a company that lost $1.14 billion in the first nine months of 2022 and just laid off a fifth of its staff.

What are Snap's plans for the future?

Snap stopped providing guidance earlier this year, but CEO Evan Spiegel claimed the company could eventually reaccelerate and diversify its long-term revenue growth by investing in new augmented-reality (AR) features. However, TikTok and Instagram have launched similar AR features.

TikTok also continues to pull users away from Snapchat and Instagram. In its semi-annual "Taking Stock with Teens" surveys, Piper Sandler found TikTok overtook Snapchat as the top social media platform for U.S. teens for the first time this spring, and that lead continued to widen in the fall.

Snap believes Spotlight, the short video platform it launched in late 2020, can fortify its defenses against TikTok and Instagram Reels. It pointed out that its users spent 55% more time year-over-year watching Spotlight content during the third quarter, but that still represented a deceleration from its 59% growth in the second quarter and didn't meaningfully boost its ARPU. That's not too surprising since Meta previously warned the expansion of its short video ecosystem through Instagram Reels and Facebook Watch would curb its near-term growth in ad revenue.

On the bright side, Snap continues to gain more DAUs even as its ARPU growth dries up. Therefore, revenue growth could recover quickly once macroeconomic headwinds wane, and it fully overcomes Apple's iOS changes.

Is Snap too cheap to ignore?

Analysts believe Snap's revenue will increase about 12% to $4.63 billion this year and maintain that pace in 2023. Adjusted EBITDA should decline 44% to $346 million this year before doubling to $675 million in 2023. Based on that outlook, the stock looks cheap at 2.5 times sales and 19 times adjusted EBITDA for 2023.

However, we shouldn't put too much faith in those estimates as a recession looms on the horizon. Investors should keep a close eye on Snap, but they shouldn't buy in until the company exhibits clearer signs of a long-term turnaround.