Brief Breakdown of 3Q

Snap (SNAP) recently reported Q3 earnings, which led to an incredible reaction in the share price.

Data by YCharts

The stock swiftly rose in a matter of days from the mid-$20s to the low $40s on the back of this quarter. So, what all drove this reaction? Before we break down the conference call, let’s look at the quarterly numbers themselves.

  • ARPU: $2.73 vs. $2.27 expected (20.3% BEAT)
  • DAU: 249 million vs. 243.7 million expected (2.2% BEAT)
  • Revenue: $679 million vs. $551.83 million expected (23% BEAT)
  • non-GAAP EPS: $0.01 vs. -$0.06 expected

The biggest beat here is likely from the ARPU part of the print. Analysts across the sell side and buy side had widely anticipated no serious return in ad spend until next year. Christmas arrived early, with strength from both direct response and brand advertising spend. In addition, Snap mentioned that it saw tailwinds from brand advertisers pulling spend and “boycotting” Facebook (FB) for social justice initiatives. How big of an impact this had on the quarter remains unknown, but it seems that the majority of the beat was generated the general recovery in advertising budgets.

The next part of the beat was the usage of the platform. Snap added 11 million new users in the quarter on a sequential basis. This growth was incredibly strong, considering that the guidance was only for ~4-6 million new users. Despite mostly easing lockdowns and somewhat of a return to normalcy across the U.S. and Europe, we still saw strength in usage. The caveat is, the vast majority of the beat came from the “Rest of the world” segment, where Snap’s Android update is beginning to just pick up steam.

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The combination of extremely strong usage and monetization progress led to a massive revenue beat. In addition, with continued gross expense discipline, Snap hit 58% gross margins. In spite of increasing operating expenses, the company’s improving operating leverage trends led to a breakthrough, finally: non-GAAP profitability in Q3. Increased fiscal discipline is yet another reason to be bullish.

Conference Call Commentary

This section of the report will break down Snap management’s conference call commentary. Here is the first mentionable quote from the call:

As brands and other organizations used this period of uncertainty as an opportunity to evaluate their advertising spend, we saw many brands look to align their marketing efforts with platforms who share their corporate values.

This quote indicates that the company could have seen somewhat of a tailwind from brands pulling advertiser spending in the quarter. Obviously, I am referring to the advertiser boycott. The real question is, how big of an impact did this have on the quarter and quarters in the future?

As businesses adapted and began to look for opportunities to increase their marketing budgets in Q3, we were pleased to see existing advertisers resume and even increase their budgets, as well as new advertisers allocate spend to drive real business value via our self-serve ad platform. The success we saw in our business in Q3 is the result of many long-term investments we have made to improve our sales and marketing functions, drive ROI through measurement, relevance, and optimization, and build innovative ad experiences through video and AR. It was our continued focus on these three priorities, along with our unique reach and growing global audience, which allowed us to accelerate our growth as more of the world opened up and brands returned to marketing.

Management is essentially saying here that big budgets returned in Q3, and that the innovations in their automated bidding platform have driven better advertiser experiences. Snap’s continued focus on this should lead to continued improvements in ROI and ARPU.

For the first time as a public company, we observed a rise in overall eCPM in Q3, driven by a combination of mix shift towards higher eCPM products such as Commercials, as well as a rapid rise in overall demand. Average eCPMs increased 20% year-over-year. However, we believe our eCPMs remain well below market rates for our audiences and ad units. The ongoing growth of our community, as well as deepening engagement within our app, continues to add more inventory opportunity to our ecosystem over time. In addition, we continue to make improvements to our targeting and optimization capabilities that allow us to show more relevant ads to Snapchatters and utilize our inventory more efficiently. For example, while eCPMs for inventory monetized via Pixel Verified Purchases rose by 71% sequentially in Q3, the cost per purchase for our advertising partners rose by just 1% over the same period. Consequently, we believe that we will be able to deliver attractive returns on ad spend to our advertising partners as eCPM grows over the long term.

Snap also observed a rise in eCPMs for the first time since listing as a public company in March 2017. This was driven by a stronger mix to higher-value, higher-priced products. In addition, Snap believes ad inventory can grow in value over the long term. Effectively, the company’s ad pricing has plenty of headroom over the years to come. In addition, Snap is showing that it is driving value to advertisers. As eCPM grows, so will ARPU most likely, driving even stronger growth in revenue.

Gross margins were 58% in Q3, up 7 percentage points year-over-year. We continue to make significant progress against our goal of driving down our underlying infrastructure unit costs over time. In Q3, our efficiency improvements fully offset the year-over-year increase in user activity, resulting in infrastructure costs per DAU of $0.70.

This is another big deal. Snap’s ability to be efficient with gross costs will enable greater operating leverage. This improvement in managing infrastructure costs led to improved gross margins. Improved gross margins led to better operating leverage, and the non-GAAP profit we saw in Q3. As ARPU continues to scale, I would anticipate continued scaling of gross margins.

Assuming that the current favorable operating conditions persist, and that the holiday season materializes in line with what we have experienced in prior years, we believe that year-over-year revenue growth of 47% to 50% is attainable in Q4.

Snap provides a general commentary in terms of what it is seeing in revenue for Q4. This would mark a slight deceleration, but was well ahead of analyst expectations going into the print. It also signifies that there is not expected to be a dip in advertiser demand sequentially – a very good sign for the company and the overall industry.

Consequently, we expect that year-over-year expense growth is likely to be higher in Q4 than we have observed year-to-date.

Turning to OpEx, Snap anticipates that operating expense growth that exceeds what they have seen year to date. Year to date, Snap has seen ~21% OpEx growth Y/Y. Assuming an acceleration to ~25%, I’m modeling OpEx of ~$339 million in Q4, essentially flat Q/Q.

In addition, we are pleased with the growth trends we have observed in our Snapchatter community and believe that momentum will continue into Q4 with DAU of approximately 257 million, implying year-over-year growth of approximately 18%.

Additionally, the company anticipates 257 million DAUs, an addition of ~8 million users in the quarter. While this is a slight slowdown compared to 3Q’s ~11 million additional users, it is still a very strong number considering the fact that 2Q and 3Q pulled forward usage of technology in general. Snap’s ability to keep high growth in the user base shows strength in the product, another reason to be fundamentally bullish here.

Rating and Target

My rating on the stock is based on my view of the narrative, as well as the price target I have assigned. For Snap, I use a discounted cash flow model to value the business and assign a valuation to the stock.

I’m using a WACC (weighted average cost of capital, or my discount rate) of 8.67%. This is based on a beta (i.e., the volatility of the stock) of 1.52, 52% more volatility than the market as a whole. In addition, for my risk-free rate, I am using the ten-year treasury bond, which currently yields 0.874%. Combined with an equity risk premium of 5.25% (per Damodaran), Snap’s cost of equity is 8.85%. Then, factoring in a 15% tax rate, a cost of debt of 4.04%, and Snap’s market capitalization and debt load, Snap’s WACC comes out to 8.67%.

Then, we have to take into consideration expectations for the business long-term.

Here are my current business model forecasts for Snap from here to FY2029.

This obviously is not the complete extent of my projections, but I really wanted to start with revenue, as it is one of the most relevant metrics to look at considering how early-innings Snap is in terms of becoming a mature business.

On the ARPU side of things, I would anticipate that Snap will continue to grow into a ~$30+/user annually business. Why? Keep in context that Facebook is monetizing at ~$40+/user already. While Snap is no Facebook, the company has some defining characteristics that differentiates it from other advertising competitors. Augmented reality, in particular, offers a unique way for advertisers to interact with Snap’s coveted, young user base. This, combined with the general transition I have been talking about for years now, from traditional advertising mediums (print, radio, TV) towards higher ROI (digital), will also benefit the company. And finally, as the young user base Snap has such a lock on ages and enters the job market and general economy, it will have greater purchasing power, which will drive advertiser demand. All of these factors combined lead me to believe the company can scale to ~$30/DAU annually in revenue.

In addition, as Snap scales ARPU, I believe it will be able to generally tame infrastructure and revenue sharing expenses, leading to further gross margin development as well as improved operating leverage trends. This combination likely leads to increasing profitability. Now, I must note that I could be conservative on the OpEx side, as we haven’t gotten much commentary on Snap’s long-term spending plans. For now, I can model ~$3+ in earnings power as we enter the late 2020s.

Combined with steadily growing CapEx, here is what I’m looking at free cash flow-wise.

While these 2020 numbers are certainly banking on a big Q4 breakthrough, I believe it is plausible that Snap begins pumping out a large amount of cash as soon as next year and rapidly scales in the years to come. At the end of the day, cash flow is going to drive the valuation here. Bringing it back to the overall valuation:

Now, factoring in the discount rate, a terminal growth rate slightly above inflation, and Snap’s cash/debt profile, we get to a valuation of ~$55 billion. This brings me to a price target of $37/share. In addition, this is a premium of ~17x my FY’21 revenue projection. Now that we have the price target, why am I giving Snap a Hold rating if the stock has ~17% downside to fair value?

First of all, there are very few fundamental long-term headwinds for the company. With the disproportionate amount of tailwinds relative to the few headwinds, this leaves us with a positively skewed fundamental backdrop. Second of all, the stock clearly has momentum going for it. I am not going to put myself in front of a speeding train of momentum unless there is a clear, timely, identifiable catalyst for downside. Right now, such a catalyst doesn’t exist. And finally, I have been long Snap for a little while now. While I have drastically reduced my position in the company, I will likely continue to hold it for the long term. That said, if I’m looking to raise cash for something else, Snap would be one of the first names I would pull out of.

Conclusion

All in all, Snap’s quarter was ridiculously strong and continues to assert the bullish narrative on the company. While I remain long, it would be one of the first names I would sell if I were to sell a stock, as the valuation has gotten fairly stretched.

Disclosure: I am/we are long SNAP. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: This is not financial advice. I am not a financial advisor. Please do not interpret this as financial advice. Do your own due diligence before initiating a position in any of the aforementioned securities.