Snap (SNAP 6.70%) has fallen off a cliff since the end of 2021, despite being the sixth most popular social media application in the U.S., and the most popular among teens. However, even if you are a big fan of the company, management highlighted several things in its recent earnings that could change a die-hard optimist into a pessimist.
Here are three risks investors should think about before investing in Snap stock.
1. Deteriorating revenue
Although investors were aware since the company's second-quarter earnings that revenue was decelerating and would likely continue slowing, the market was still shocked by the rate of revenue decline in Snap's third-quarter 2022 results.
Snap's revenue only grew 6% year over year to $1.12 billion, its slowest-ever quarter for revenue growth as a public company. Investors responded to the lackluster growth by sending the stock down 28%.
In addition, the market is apprehensive about a recession further deteriorating Snap's revenue. In early October, the Conference Board, a global, nonprofit think tank that delivers business insights and forecasts, pegged the probability of a recession at 96% within the next 12 months.
Considering that Snap has fewer resources to withstand a recession and further revenue decline than its larger, more well-known competitors, 2023 could be very rough for its investors.
2. Layoffs and reorganization
Snap CEO Evan Spiegel sent a note to Snap employees on Aug. 31, telling them that for the company to safely maintain enough cash to operate in a low-growth economic environment, it needed to lay off 20% of its workforce -- a demoralizing scenario for workers. Also, layoffs send a message to the market that a company is in crisis, which is terrible for attracting and retaining its advertising clients.
After announcing the layoff decision, management projected that most of the negative impact from reorganizing the business would occur in the third quarter of 2022 in severance costs, contract termination costs, and other impairment charges. When the company finally reported its third quarter, the damage was a net loss of $360 million, 400% below the prior-year period. Furthermore, the company expects an additional negative impact on net income in the fourth quarter.
SNAP Net Income (Quarterly) data by YCharts
Spiegel also said the company was restructuring its business, using its limited funds to prioritize three areas: growing the community of users, monetizing users, and developing augmented reality. As a result, initiatives outside those areas have been either phased out or are receiving reduced investments.
Some of the projects Snap phased out could hurt its long-term competitive position, as Snap is said to have canceled many promising apps and initiatives. For instance, the company axed its entire Web3 team. Web3 is the next-generation version of the internet and includes blockchain technology. Should Web3 evolve into a fundamental technology, Snap could be at a competitive disadvantage to its peers still working on it.
3. Its ad business is risky
Another risky aspect investors need to consider is the company's reliance on ad revenue. First, consider that Snap derives approximately 99% of its revenue from advertising, yet its ad business is still relatively young and unproven. Therefore, most advertisers have not established long-term advertising commitments with Snap, and some view its ad products as experimental. In a fiercely competitive online ad market, the risk is high that Snap could ultimately fail.
Second, in June of 2021, Apple rolled out iOS 14.5 with a new user tracking opt-out feature. The iOS changes hurt Snap's ad business by crippling how ad effectiveness is measured. As a result, when Snap released its third-quarter 2021 earnings, it missed the lower end of its guidance by $3 million. Since then, the company has been altering its advertising formats, optimization, measurement, and delivery tools -- a critical time of technological change with high execution risk.
Third, two senior Snap ad executives, Chief Business Officer Jeremi Gorman and VP of Ad Sales for the Americas Peter Naylor, left the business in August to join Netflix. These executives leaving the company is terrible news considering that Snap cannot afford to lose top advertising talent during this crucial period.
Last, the weakening macroeconomy has negatively impacted online ad sales; even Meta Platforms and Alphabet have seen slowing ad growth. As a result, Snap's revenue and profitability will likely remain weak until the economy recovers.
Should you buy Snap?
Snap sells at a price-to-sales (P/S) ratio of 3.49, compared to the Internet Services & Social Media Industry P/S ratio of 2.03. Despite the stock's 79% fall year to date, many investors might still consider it overvalued, especially considering all of Snap's risks.
Although the company has a high upside should it succeed, only those comfortable investing in high-risk companies should buy Snap stock.
