Not much is going right for Snapchat parent Snap (SNAP 6.70%) these days.
The stock sank on its fourth-quarter earnings report as revenue growth was just flat in the quarter at $1.3 billion. The company also said that revenue was down 7% quarter-to-date in the first quarter, and it continued to post a wide GAAP loss on the bottom line.
On a GAAP basis, the company posted a loss of $288.5 million, a far cry from the $22.6 million in profit it had in the year-ago quarter. With adjustments, Snap gained $214.5 million, or $0.14 a share.
Image source: Getty Images.
One way to compensate
Often, financial reporting adjustments are based on one-time events like restructuring charges or tax benefits, but tech companies like Snap adjust for share-based compensation as well. However, the social media company has taken this to an extreme level.
In the fourth quarter, the company spent $450.6 million on share-based compensation, most of which comes in the form of restricted stock units. That's equal to more than a third of its revenue, which is up 50% from the year before. Tech companies prefer to compensate employees with equity, when possible, rather than cash because these companies are often unprofitable and see the upside potential in equity as a powerful incentive.
There's nothing wrong with that in principle, and share-based compensation is often an effective tool for employee retention and motivation. Snap argues that it "fosters ownership culture across the entire term." However, it can also mask a more fundamental weakness in a business, and Snap appears to be struggling to bring its stock-based compensation under control.
SNAP Average Diluted Shares Outstanding (Quarterly) data by YCharts
As you can see, Snap's diluted shares outstanding count is up by more than 50% since its 2017 IPO. The figure has come down a bit over the last year, but that decline is misleading.
Snap isn't lowering its share count by reeling in share-based compensation. It's just gotten aggressive with buying back stock. In the fourth quarter, it repurchased $500 million in stock, just as it did in the third quarter.
In other words, the company is spending nearly 40% of its revenue on share buybacks. Share repurchases can be a good thing when used appropriately, but they're generally best suited for stable, profitable companies that believe their stock is cheap. Snap stock may be cheap, according to some metrics, as it's down nearly 90% from its peak, but the company is far from profitable when you include share-based compensation.
Additionally, this strategy simply isn't sustainable. Snap's cash balance fell by nearly $500 million in the fourth quarter, and it's likely to decline again in the first quarter if it maintains that pace of repurchases, especially since the company expects revenue to drop in the first quarter and it's a seasonally slower period than the holiday quarter when revenue generally peaks. If the stock rises from here, the buybacks will only become more expensive, making them harder to justify.
What it means for investors
Despite its weak financials, Snap still has the potential for recovery as revenue growth should return when the economy rebounds and the ad market improves. The company also continues to grow its user base with daily active users up 17% to 375 million, a sign that the product is resonating with users even if the business is weak due to a lack of interest from advertisers.
Still, the excessive share-based compensation remains a problem even if the company has found a way to control the share dilution. Buybacks aren't sustainable for an unprofitable company in Snap's position, and investors shouldn't be fooled. In fact, they could be making its long-term financial position even worse by depleting its cash balance.
