Snap has a rock bottom valuation of 4 P/S and the stock has not traded here in the entirety of its public market history.
In fact, this is nearly 50% lower than the March 2020 Covid low when it traded at 7 P/S. The Covid March low matches the previous low from Q4 2018.
I believe Snap is oversold and we hope to capture this opportunity.
Q2 2022 Earnings
As long as the FED is raising rates, then the primary reason to close a position will be due to a company’s declining cash profile and/or declining margins. Snap provided a shocking report on the bottom line in Q2 and we had no choice but to exit and regroup.
We covered this briefly here when we said: “The other negative to Snap’s report included more losses on the bottom line. Free cash flow is at ($147) million in the most recent quarter. Adjusted EBITDA fell from +$117 million to +$7 million. GAAP net losses went from ($152) million to ($422) million.”
Some of this is driven by the company’s generous stock-based compensation which totaled $1.2 billion over the trailing twelve months, or about $300 million per quarter. That’s 50% of the company’s gross profit.
There was a $500 million stock repurchase announcement in July with 3% of outstanding shares purchased as of August 31. This helps to offset SBC dilution.
However, there is new information regarding Snap’s bottom line as of August 31 and September 6th:
In August, Snap announced a 20% reduction in work force and will reduce operating expenses through restructuring its products to cut back on Other Bets, such as drones and Originals.
This will result in a $500 million operating expense reduction relative to Q2 2022 which includes $50 million from content costs and $450 million from personnel and opex cost reductions. Of the total $110 to $175 million in transition costs, the majority will be reflected in Q3 2022 with $95 million to $135 million incurred as an adjusted operating expense.
Snap stated this will result in “adjusted EBITDA and positive free cash flow at current revenue levels” which will “drive meaningful operating leverage when revenue growth accelerates.”
One week later, there was an additional leaked memo on September 6th where the CEO stated his 2023 goals are for $6 billion in revenue, adjusted EBITDA above $1.5B and free cash flow above $1 billion. This would represent 20% growth on the top line. The memo also pointed toward 30% growth in DAU to 450M, up from the 352M the company reported last quarter.
My interpretation is that DAU will outpace revenue growth because DAU growth will come from Rest of World where users are monetized at a lower rate than North America and Europe. This has been the trend over the past year in Snap’s key metrics.
Of the $6 billion in estimated revenue for 2023, Snapchat+ will contribute $350 million in revenue next year. The premium subscription currently has 1 million subscribers and is expected to reach 4 million by the end of 2022.
Following the announcement, analyst Mark Mahaney stated he is modeling an EBITDA margin of 17% for FY2023 up from 9% in FY2022.
“Evercore ISI analyst Mark Mahaney raised the firm's price target on Snap to $17 from $14 and keeps an In Line rating on the shares as he is "modestly increasing" his FY22-FY23 revenue estimates and also raising his EBITDA estimates following the company's intra-quarter update on August 31. He is now modeling a meaningful EBITDA margin expansion to 17% next year from his estimate of 9% margin in FY22, driven by cost reduction initiatives and scaling of the business, Mahaney noted.”
Morgan Stanley is in line with Mark Mahaney with a 9% margin this year to $670 million and $919 million for FY2023.
“Morgan Stanley analyst Brian Nowak raised the firm's price target on Snap to $10 from $8 following Snap's recent better than expected August ad update and announcement of a $500M cost reduction plan. Nowak has raised his FY22 and FY23 revenue estimates by 9% and EBITDA forecasts to $670M and $919M, respectively, but keeps an Underweight rating citing low near-term visibility and still-high execution risk.”
That would put Snap back on track for a H2 profile similar to 2021 for adjusted EBITDA of about $118 million in Q3 and $229 million in Q4. I’m basing this off 2021 when Q4 was roughly 2X the profitability of Q3.
Perhaps most importantly, if Snap does achieve the $6 billion, then Mark Mahaney is modeling $1 billion in adjusted EBITDA. In 2021, Snap had adjusted EBITDA of $617 million. If we go with $1 billion conservatively and $1.5 billion for a high estimate per the leaked memo, then this will be 1.5X-2X adjusted EBITDA in 2023 compared to 2021.
Overall, there has been a rapid turnaround in 30-day analyst EPS revisions that show Snap as the leading stock in the tech universe for 72K% change on the bottom line for FY2022.
What this means is that instead of Snap reporting ($0.09) EPS, the company is now expected to report $0.05 EPS.
The estimates for FY2023 are at $0.33 EPS, up from $0.16 EPS for FY2023 consensus before the announcement.
Regarding free cash flow, to put this in perspective, the company had negative FCF of negative ($147) million last quarter. The company will now be positive $1 billion in FCF for FY2023 compared to FCF of $126 million in FY2021. That’s a 8X improvement in two years. Assuming this happens, Snap is guiding for a remarkable turnaround in the cash profile of the company — which is the reason we are attracted to the stock once again.
Notably, it was not only Netflix’s entry into CTV ads that made the stock attractive in July/August, but the improving free cash flow guide from 2022 to 2023.
When the headcount reduction was announced, the CEO also disclosed that Snap was losing two of its top ad executives to Netflix. This is seen as a negative yet we are also keen on the Netflix opportunity and imagine the executives see what we see, which is global streaming juggernaut + CTV ads = (likely) a new trajectory.
The CTV ad opportunity is our top trend in media but we also like Snap at this valuation (both things are true). Snap’s audience is especially interesting for advertisers, but ultimately, product takes a back seat when there is a hawkish Fed. As we are seeing with MongoDB, the cash margin is too critical right now to move from a positive FCF to a negative FCF.
Revenue Growth and DAUs:
In a rising rate environment where cash is rerated with each Fed announcement, the bottom line is arguably more important than the top line (within reason). If Snap had not provided a significant improvement to the bottom line, then we would not be re-evaluating the stock.
Regarding the top line, Snap stated in the Investor Update on August 31st that “quarter to date” they are tracking 8% revenue growth for Q3.
What the CEO said in the September 6th memo regarding inflation and how he looks at revenue growth is important so I’ve pasted it verbatim here:
“In this inflationary environment, we need to adjust the way that we think about our revenue growth. With the U.S. Consumer Price Index at 8.5% growth year-over-year in July, and our Q3 QTD nominal revenue growth rate disclosed on August 31st at 8%, our revenue is growing -0.5% in real terms.
In short, if we are growing revenue below the rate of inflation, our business is actually shrinking. Meta’s revenue, in real terms, shrunk by nearly 10% in Q2, while our Q2 revenue grew approximately 4% in real terms. As we think about our revenue goals for next year, we need to consider the rate of inflation and factor it into our ambitions.
Our goal for 2023 is $6 billion in revenue, of which we will generate $5.65 billion of advertising revenue, and $350 million of revenue from Snapchat+.
Assuming that $5.65 billion of advertising revenue represents approximately 20% growth year-over-year, and assuming an 8% inflation rate, we would be generating approximately 12% year-over-year inflation-adjusted advertising revenue growth.
That’s a far cry from the 50%+ year-over-year average annual revenue growth we’ve generated over the past five years, but we believe it’s an appropriate goal in this environment. If we can generate $6 billion in revenue in 2023, we should be able to generate at least $1.5 billion in Adj. EBITDA and $1 billion of free cash flow.”
I believe the market has not moved much on this news because it requires a Q3 report and a Q4 guide to show if there’s any near-term acceleration from the paltry 8% growth. Essentially, the market will be looking for a sign that September was stronger than August. There is risk it September won’t be stronger than August and/or Q4 won’t be stronger than Q3, yet I/O Fund is subjectively comfortable with the risk as I believe the 4 P/S valuation is pricing in the worst case scenario.
We need DAU to remain strong, but judging by the CEO’s comments, that shouldn’t be a problem as the company provided the forecast of 35% growth over the next 18 months when the CEO said in the memo the goal was to: “Increase Daily Active Users to 450 million in Q4 ’23.” This is up from 352 million DAU in Q2.
Risks:
Snap’s management has struggled to provide accurate guidance in H2 2021 and H1 2022. This twelve-month period has seen (40%) drops in price and +58% gains in price in one day.
This is a volatile stock particularly because management’s guidance has been wrong. We have to take that into consideration when relying on management’s guidance for H2 2022 and FY2023. Morgan Stanley called it “execution risk” when referring to CEO Spiegel’s inability to guide correctly and navigate the many headwinds his company faces.
However, institutional analysts agree with the bottom line and the improvements that $500 million reduction in opex will lead to, including those that are underweight, so that’s helpful. The 8% revenue growth seems reasonable and not an over-promise compared to the 50% revenue growth that had been provided in 2021.
There is a risk that DAU misses as the 35% growth over 18 months is a strong guide.
The stock based compensation is high and viewed as a negative in this macro environment. This weighs on GAAP operating margin.
Conclusion:
Our decision to look for an entry is based on the stronger bottom line, the anticipated full 8X growth in FCF over two years coupled with a rock bottom valuation.