Social media company Snap (NYSE:SNAP) was once one of the most hated stocks on Wall Street. Then, seemingly overnight, Snap stock has become a Wall Street favorite.
From Christmas Eve 2018 to today, SNAP stock has essentially tripled, while Wall Street has gone from overwhelmingly bearish on the stock, to constructive on the company’s long term growth potential.
Why the change of heart from investors and analysts? A few positive developments materialized in early 2019 and have continued over the past several months. These developments include reinvigorated user growth, continued healthy revenue and margin ramp, and expansion into shopping, shows, and gaming.
In sum, these positive developments have breathed life back into the company’s long term bull thesis of becoming an important social media platform alongside Facebook (NASDAQ:FB) and Twitter (NYSE:TWTR).
They’ve also essentially torn apart the bear thesis, and paved a path for SNAP stock to head substantially higher in the long run.
Does that mean it’s time to buy into the SNAP stock rebound?
No. Sure, the fundamentals here are improving. But, if you look out long term, it seems that SNAP stock is pretty fully priced considering its multi-year growth prospects.
As such, while I don’t think bearishness is the right sentiment here and now, I do think that caution is warranted on SNAP stock going forward. At $15, valuation friction is a big enough problem to potentially short-circuit the big 2019 rally.
Three Potential Long Term Outcomes for Snap
In the long run, there are three potential outcomes for Snap stock. Those outcomes are as follows.
Number One: Bear Case (flat user growth, pedestrian ARPU growth, Twitter-like profitability)
The Android app reboot fails to re-accelerate international user growth. Instagram continues to dominate the social video sharing market. Snap’s user base plateaus around 200 million daily active users.
Quarterly ARPU climbs ~15% per year to around $5 by 2025. Gross margins rise towards Twitter-like 70% levels. The opex rate falls towards Twitter-like 50% levels. EPS settles around $0.50 by 2025. Based on a digital ad average 25-forward multiple and 10% discount rate, that implies a 2019 price target for SNAP stock of roughly $8.
Number two: Base Case (tepid user growth, healthy ARPU growth, mix of Twitter and Facebook profitability)
The Android app reboot re-accelerates international growth. But, Instagram’s global incumbency in the social video sharing market ultimately keeps user growth stuck at a pedestrian rate.
Snap adds about 5 million new users per user. Daily active users measure around 230 million by 2025. Quarterly ARPU climbs towards Twitter-levels of $6. Gross margins rise towards Twitter-like 70% levels.
The opex rate falls with scale towards a Facebook-like 40% level. EPS settles around $1, which given the same parameters listed above, equates to a $15 price target.
Number Three: Bull Case (healthy user growth, robust ARPU growth, Facebook-like profitability)
The Android app reboot re-accelerates international growth. Gaming, shopping, and shows initiatives reinvigorate growth for the next several years, too. Snap adds around 10 million new users every year. The user base measures 250 million daily actives by 2025.
Quarterly ARPU skyrockets alongside robust user growth. It settles around $8 by 2025 (roughly in between present Twitter and Facebook levels). Gross margins rise towards Facebook-like 80% levels. The opex rate drops to 40%. EPS settles around $1.60, equating to a $25 price target given the same parameters.
The Current Valuation Is not a Steal
Given how young Snap is, the potential outcomes for SNAP stock span a wide range. The aforementioned three cases arrive at price targets between $8 and $25. Thus, the best way to value SNAP stock today is to incorporate probabilities for each potential outcome.
Given recent positive developments, the bear case ($8 price target) seems increasingly unlikely to materialize (probably around 10% likelihood).
The bull case ($25 price target) seems equally unlikely given that Snap faces intense competition from Instagram, has a niche demographic and addressable advertiser market, and will have trouble reaching Facebook-like profitability without Facebook-like scale.
Realistically, the bull case also has just a 10% chance of panning out, leaving the base case ($15 price target) with an 80% chance of materializing.
Now, let’s do some math. We have a 10% likelihood associated with an $8 price target, a 10% likelihood associated with a $20 price target, and an 80% chance associated with a $15 price target. Summing all that up, a reasonable probability-adjusted 2019 price target for SNAP stock is around $15.
Bottom Line on SNAP Stock
Things are undeniably improving for Snap. But, they are not yet improving in a way which warrants an extension in the currently rally towards $20-plus prices.
As such, unless user, revenue, and margin trends all come in far above expectations over the next few quarters, the best of the 2019 SNAP stock rally is likely in the rear-view mirror.
As of this writing, Luke Lango was long FB and TWTR.