Last week, Snap (SNAP -4.59%) reported positive results for the third quarter as it beat Wall Street's expectations on both the top and bottom lines. But there are still plenty of problems under the hood that make this a risky stock to own.
Here's why investors should think twice about buying Snap despite the seemingly improved quarterly numbers.
1. Free cash flow can't seem to stay positive
A key number that growth investors should monitor when looking at a business is free cash flow. It can help indicate whether the company is self-sufficient from its operations or if it'll need to rely on stock sales or debt to raise cash in the future. In Snap's case, the business has struggled to keep free cash flow positive.
Data by YCharts.
Free cash flow is arguably more important than net income because it excludes non-cash items and often better reflects how the business is doing on a day-to-day basis. While there have been periods when Snap has generated positive free cash flow, it has been on a downward trend over the past few years.
2. ARPU has been declining this year
Snap reported 406 million daily active users (DAUs) for the most recent quarter, up 12% year over year. But despite the double-digit increase, the company's top line rose just 5% because average revenue per user (ARPU) declined 6%.
Through the first three quarters of 2022, ARPU was above $3. But the company hasn't been able to reach that threshold year to date. This latest quarter, ARPU came in at $2.93, down from $3.47 a year earlier.
Without stronger ARPU, it will be difficult for any increase in users to translate into significant revenue growth for Snap, which is why DAUs on their own aren't all that helpful in determining if the company is moving in the right direction.
3. Operating expenses as a percentage of revenue are too high
Snap still has a lot of work to do in order to get anywhere near profitability. Last quarter, its net loss totaled $368.3 million, which was slightly worse than the $359.5 million loss a year ago.
The problem is the company's operating costs remain too high as a percentage of revenue, making it nearly impossible to find a way to stay out of the red.
| Item | Third-Quarter Amount | Percentage of Revenue |
|---|---|---|
| Revenue | $1,180 million | 100% |
| Cost of revenue | $556 million | 47% |
| Research and development | $494 million | 42% |
| Sales and marketing | $297 million | 25% |
| General and administrative | $221 million | 19% |
Data source: Snap Q3 2023 earnings release. Table by author.
The above operating expenses totaled $1.57 billion, or about 132% of revenue. Until those numbers come down significantly, the bottom line is likely going to remain negative.
However, like many growth-focused companies with no GAAP profits to report, Snap provides investors with an alternative profitability metric, adjusted EBITDA. After stripping out certain line items, the biggest by far being stock-based compensation, Snap generated $40 million in adjusted EBITDA last quarter. Unfortunately, even this figure is down 45% year over year. And through the first three quarters of 2023, adjusted EBITDA has plummeted 98% to $2 million.
Snap is too volatile a stock to buy
Year to date, shares of Snap have risen 10%, trailing the tech sector overall. The launching of its own chatbot, My AI, has failed to help the company cash in on the market's artificial intelligence hype.
So as Snap's growth rate has fallen over the years and it remains deeply unprofitable, the stock is no longer as attractive to growth investors. In three years, the stock has declined 75%, and there's unfortunately little reason to expect a turnaround anytime soon.
TikTok is the hot new social media platform for teens and young adults, and Meta Platforms has the more established platforms in Instagram and Facebook, leaving Snap somewhere in-between.
Investors should wait until the company can either revitalize its growth or drastically improve its cost structure before taking a chance on this struggling stock.
