Why Recent Weakness in Snap Stock Could Be an Opportunity

While the S&P 500 has surged to record highs over the past few weeks, one of the market’s hottest stocks of 2019 – Snap (NYSE:SNAP) – hasn’t participated in the record rally. Instead, SNAP stock has dropped 17% over the past three months, and presently trades about 20% off its 2019 highs.

Source: Ink Drop / Shutterstock.com

Why has SNAP struggled over the past few months despite broader market strength?

In short, SNAP just got too hot for its own good. I warned about this in September, that SNAP had come so far, so fast, that it needed perfection to head higher, and perfection would be hard to come by.

Indeed, Snap’s third-quarter earnings report wasn’t perfect. It topped Street estimates on users, revenues, and profits, but included a light fourth-quarter revenue guide which implied that the growth narrative here is slowing.

At $18, SNAP stock wasn’t priced for slowing growth. So, shares have retreated to below $15 over the past few months. What’s next?

A rally back above $15. Sure, Snap’s third-quarter report wasn’t perfect, and it showed that SNAP doesn’t deserve an $18 price tag today. But it was good, and broadly showed that below $15, SNAP stock is undervalued relative to its realistic long term growth prospects.

The implication? It may be time to buy the dip.

Snap Has Good (Not Great) Prospects

Snap is a communications platform built for young consumers and not much more than that. For the platform’s core audience (mostly Generation Z-ers and some Millennials) Snapchat is the de facto communications and entertainment platform. For everyone else, though, we don’t really need Snapchat.

We already communicate with friends and family through various other channels, and the Snapchat form of ephemeral communication doesn’t really appeal. At the same time, we already get a wealth of entertaining content from various other platforms, and the content populated in the Discover channel is mostly geared towards Millennial/Generation Z consumption in its presentation.

Sure, Snapchat could evolve over time and broaden its value prop to be more attractive to consumers outside its core youth demographic. But, at present, Snap is a “kids app”, and not much more.

Some could argue that Facebook (NASDAQ:FB) was also initially just a “kids app” and then became an “everyone app,” but Facebook was birthed in an era with no global social media incumbents. Today, the social media landscape is very crowded, and in order for Snap to become an “everyone app,” they have to convince people to leave other apps. That is something Facebook didn’t have to do.

Net-net, then, Snap projects as an app that will be used heavily by kids everywhere, and not used at all by everyone else. Given that, user growth potential is good, but not great, and revenue growth potentially is similarly good, but not great, because this demographic has lower purchasing power than peer demographics and therefore attracts less ad dollars.

Snap Stock Deserves to Trade Above $15

Given that Snap’s long term growth prospects are good but not great, SNAP deserves to trade above $15, but not at $20 just yet.

The math is pretty simple. Roughly 15% of the world’s population falls in Snap’s core demographic of 15-to-24-year-old consumers. There are roughly 2.1 billion people in the world that use either Facebook, Instagram, WhatsApp, or Messenger once a day. That number can broadly be used as a proxy for the total global addressable market for social media platforms. Assuming so, then Snap’s serviceable addressable market is about 15% of that, or about 315 million users.

Snap has 210 million users today. They project to add five million new users next quarter. It seems reasonable that Snap adds roughly 10 to 20 million new users per year over the next several years, pegging the 2025 user base at 300 million monthly active users.

At that point in time, Snap’s ad business will be much more mature. It will look a lot like what the ad business at Twitter (NYSE:TWTR) looks like today. Twitter’s quarterly average revenue per user rate is roughly $6. Snap should get there by 2025, up from $2 last quarter. That implies $7.2 billion in revenues by 2025.

Gross margins will rise towards Facebook-levels of 80%. The opex rate should fall with scale towards 40-50%. Assuming so, then 2025 earnings per share will likely come in around $1.30 to $1.50.

Taking the midpoint and applying a growth stock average 20-times forward earnings multiple, you arrive a 2024 price target for SNAP stock of $28.

Discounted back by 10% per year, that equates to 2019 price target of roughly $17. Thus, below $15, SNAP looks undervalued.

Bottom Line on SNAP Stock

Snap is widely considered a battleground stock, with bulls saying that it’s the next Facebook, and bears saying that it’s worthless.

Neither of those statements are true. In reality, Snap is a “kids only” social media platform that will monetize those kids at high rates, but fail to attract and/or monetize users outside of that core demographic. Given this reality, Snap’s multi-year growth prospects are good, but not great.

Good, but not great, growth prospects means that SNAP is undervalued below $15 today, and overvalued at levels closer to $20.

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