Reduced Target Price, Reiterating Hold –

Premise – We Got Snap Wrong, At Least For Now; The Business Has Moved Right Into the Danger Zone

Snap (NYSE:SNAP) shares are down ~83% off their highs now, as the valuation bubble has burst. We’ve rode the decline while being in the neutral to bull camp for a while, though since the start of the year we’ve been neutral on the name with a small long position.

As of right now, it’s clear to us that we likely got the story wrong, at least for now. Management’s 50%+ revenue CAGR target for the next few years was clearly too ambitious, and considering the state of the broader economy, the business has moved into the danger zone.

As revenue growth rates have slowed materially, competition has ramped, and we have opened our eyes to structural issues with engagement and ad targeting, we have decided to remain in the neutral camp.

Our long position in the stock remains, though we own puts that mostly hedge the position. Nevertheless, we see some promise in the business.

As of right now, looking at it objectively: revenue growth is materially slowing, the business will struggle to generate meaningful cash flow, and the valuation isn’t barebones enough to be in the bargain camp.

We’re at Hold.

8-K Bombshell: A Meaningful Decel Slams Snap

Since we issued guidance on April 21, 2022, the macroeconomic environment has deteriorated further and faster than anticipated. As a result, we believe it is likely that we will report revenue and adjusted EBITDA below the low end of our Q2 2022 guidance range. We remain excited about the long-term opportunity to grow our business. Our community continues to grow, and we continue to see strong engagement across Snapchat, and continue to see significant opportunities to grow our average revenue per user over the long term. – Snap 8K Filing

There it is: The 8K seen ’round the market. And really it was the shock felt ’round the ad business. Snap, a company that just a year ago was loosely targeting 50% revenue CAGR for the next few years, without any new incremental engagement.

Here we are now, with Snap struggling to hit even 20% y/y growth. Perhaps, in spite of all management has done to scale this business meaningfully, we should’ve taken this comment with a grain of salt.

Management’s commentary implies <20% 2Q revenue growth and negative EBITDA and that’s it. We don’t have any guardrails on this comment. We just don’t know how low the growth rate and EBITDA will go.

Additionally, we don’t know how long headwinds will last, and how much of the headwind mix really is macro versus company specific. The indicators, at least right now, are that it’s both, but that management is understating company-specific headwinds.

Oppenheimer’s checks at a Las Vegas conference indicate to them that agencies and their clients continue to spend big in advertising more broadly. This is important because it is contrary to management’s callout of a vastly deteriorating macro environment.

Additionally, a fellow digital ad play, The Trade Desk (NASDAQ:TTD) reiterated their guidance for the quarter basically saying they don’t see the same macro picture Snap is seeing. While we’ll get more details on Snap’s 2Q call, it seems like there is potential management is shifting blame off company specific issues and towards the macro environment. If this is the case, it’s a massive blow to management credibility, credibility that has been built up over the last two years of consistent beat-and-raise quarters and guides.

Overall, the 8-K filing and the ripple effects since have done more damage to management’s overall credibility than can be repaired in the short-term.

Structural Impacts Underestimated – What We’re Watching: ATT Signal Loss, TikTok Competition, Engagement Patterns

This 8-K, and the subsequent digest of the potential reality that Snap’s growth slowdown is an effect of company specific trends has led us do to a meaningful re-evaluation of the risk profile of the business. Right now, in this environment, we think large advertisers would look to cut Snap from budgets ahead of almost any other competing platform.

And we suspect that’s what’s happening. The macro environment is beginning to deteriorate, and management is right on that callout. The problem is, we think that advertisers, in order to reflect this, are budgeting cautiously. They’re ‘sticking to their guns’ so to speak. So this means trim brand spend, and cut the fat off lower ROI direct response budgets, and stick with what has worked for generating ROI in digital: Alphabet (NASDAQ:GOOG) (NASDAQ:GOOGL) and Meta (NASDAQ:FB) (more-so Alphabet). Google Search and FB/IG Feed ads have worked for years, and even through recent headwinds, they are a lot safer to lean into than a Snap. So we think macro fears aren’t taking down broad-based ad spend yet, but they are leading to a mix shift towards more established players. Additionally, we think that macro deterioration (our base case) will lead to continued reductions in brand spend.

So we think what’s probably going on is macro is forcing advertisers’ hand to flee to safety. Now, why is Snap not part of ‘safety’? That’s the structural problem.

We think the problem is three-fold:

• competition with TikTok
• ATT signal loss
• chat-centered engagement

First you have TikTok competition. Per Piper Sandler’s recent survey work, TikTok is now the most popular social media app among teens, outpacing both Snapchat and Instagram. TikTok, as a platform, is much larger in terms of pure engagement and demographics. Additionally, their content recommendation engine is one of the best on the internet. While for much of the pandemic it seemed Snapchat was the shiny new toy for advertisers, we think TikTok is taking that experimental budget share now. Targeted vertical short-form video is a format that TikTok simply dominates, even as Reels, YouTube Shorts, and Snapchat Spotlight play catch up. We think that because TikTok has better demos at scale, they’re taking the ‘fluff’ part of advertisers’ budgets from Snapchat. We think this is a structural challenge. Snapchat needs to adapt fast to keep user engagement high and diversify away from core use cases (more on that later).

The next headwind is ATT-related signal loss. Snap has adopted their own first-party measurement solution (90% of Snap advertisers are now using) called CAPI (Snap’s conversions API). Additionally, they are using this in tandem with Apple’s (NASDAQ:AAPL) 3rd party limited signal SKAN tool. In terms of first party, we think signal is much more limited on Snap than it is for Meta. Meta has better workarounds and can track across three 1b+ user networks (Instagram, Facebook, and WhatsApp/Messenger). We think this is a potential structural headwind for future adoption of Snap’s ad platform among direct response advertisers and exacerbates that flight-to-safety effect described earlier. We think that continued targeting pressure could lead to a reversing mix shift back to brand advertising if Snap cannot pick up ROI.

And finally, there are broad engagement patterns. This might be our number one structural reason for pessimism. The vast majority of engagement on Snapchat is done on the Chat side (low to no monetizable inventory) and Stories posting/scrolling (where inventory appears saturated). We think Snap will continue to struggle to drive engagement to Spotlight and meaningfully Discover until content selection improves on both.

In essence, we see macro headwinds combined with company specific headwinds creating a perfect storm of negativity and uncertainty for the business through 2022-23.

How Low Can Ya Go? – Is 2Q The Bottom For Growth Rates? Uncertainty Profile Hasn’t Been This High at Snap Since 2018

The fundamental problem with Snap right now is nobody really knows how low growth can go. In the short-term, we don’t know how much of a swan-dive revenue growth is going to take. All we know is that revenue was growing 30% in April, and that they won’t grow at 20% for the full quarter. And that’s as of May data. We don’t know how much of a deterioration took place in June.

There-in lies the problem. Management has lost credibility, growth rates are plunging, and with a continuously devolving macro backdrop (rising rates, high inflation, and decelerating payrolls growth) we can’t confidently say when or where growth rates bottom.

The only confidence an investor can have is in trailing numbers, which is why we’re pulling back our valuation models to trailing numbers. More on that later.

The problem is simple: uncertainty hasn’t been this high on Snap since the company was a penny stock in 2018. Back when users were continuously negative quarter after quarter, and Instagram was eating Snap’s lunch. Back when cash burn was high, and some didn’t know if the company was going to survive.

Now, we simply don’t know what short, medium, and long-term growth trajectories look like. And without cash flow, you don’t have fundamental valuation support, you have relative valuation support on sales multiples.

The water has been muddied, uncertainty is high, and we don’t see catalysts for alpha unless you have (low probability) a soft landing for the economy.

Every Cloud Has It’s Silver Lining – Engagement Is Strong With A Decent Runway; High Upside If Engagement Patterns Transition

Implicit in the 8-K was that engagement remains on track. This is important, and a meaningful silver lining. If you believe that when the economy gets back on track that advertisers will once again follow eyeballs, Snap’s continued ability to sustain ~10m+ users/quarter of growth is impressive.

You don’t have a dead platform on the user end, and we think that Snap can continue to grow the platform meaningfully especially in Latin America, India, and Southeast Asia. The ceiling on the user base is high, and Snap continues to execute on growing up this ceiling.

Things will really devolve if core use cases reach maturation or if mature geographies start to witness some churn.

Additionally, we believe that if management can successfully transition engagement off of core chat and stories and towards more broad-based engagement (Maps/Spotlight/Minis/increased Discover traction), revenue growth could reaccelerate as advertiser demand across different ad formats and use cases increases. For example, on Snap Map, local SMB advertiser demand could pick up to place ads if engagement on that part of the platform follows through. Additionally, if content curation improves on Discover and Spotlight, and incremental engagement improves, ad dollars will follow.

We think that if Snap’s user base can diversify to where monetization potential is higher, which is a relatively big ‘if’, you could see ARPU growth reaccelerate.

Valuation

BASE CASE:

We are changing our base case valuation methodology to track value of the company on ’21 numbers. We’re doing this for a number of reasons. Chief among them, is we cannot confidently predict the remainder of full year (how low does 2Q go, does 2H reaccelerate). Additionally, we have difficulty predicting out-year numbers because of existential and company-specific risk.

Our base case multiple is 5.5x EV/’21 sales. We think this is fair considering historical multiples in peer group, the uncertain forward profile, and the stickiness of risk associated with the business. On $4.12b of 2021 revenue, that puts our fair enterprise valuation at $22.66b. With $4.22 billion in debt, and $5 billion in cash, that loosely gets us to a market cap of $23.44 billion. On a share count of 1.636 billion, that gets us a valuation of ~$14.33/share.

BEAR CASE:

Our bear case is at the low end of historical multiples. We’re electing to use a 3.5x EV/’21 sales, getting us a valuation of ~$9.29/share.

BULL CASE:

Our bull case assumes a growth multiple of ~8.5x sales. While that is well below historical highs, we think that considering the environment, uncertainty, and decelerating growth rates, we think the bull case multiple is likely justified. This gets us a valuation of ~$21.88/share.

Conclusion – Uncertainty Is Too High To Recommend, Sticking To Hold

In the face of the uncertain 8-K announcement, and with high pressure existential and company specific headwinds of uncertain duration, we’re keeping the stock at Hold, and cutting our target materially. Our long position is a small holding and is mostly hedged anyways through a rolling put position.