Snap Inc

Snap reported second-quarter results, including sales of $1.60 billion, up 19%, and an adjusted EBITDA margin of 16%, up 13 percentage points. The firm's digital advertising business got a boost from the World Cup this summer. Shares rose sharply after the earnings report.

Why it matters: As we have seen in prior quarters, Snap's top line is being driven by its growing subscription business, with users paying for premium Snapchat features and storage. Subscription revenue grew 85% to $316 million, now accounting for 20% of total revenue, up from 13% a year ago. While they're not driving the top line currently, we were encouraged to hear how Snap is leveraging artificial intelligence to boost its advertising products. We see AI-driven advertising and content recommendation as a key part of Snap's plan to rejuvenate advertising growth, which was merely 9% this quarter. On the user front, after losing users in both North America and Europe over the past few quarters, Snap stemmed losses in both regions, with user counts remaining flat sequentially.

The bottom line: We maintain our $7 fair value estimate for no-moat Snap, with shares modestly undervalued after the after-market pop. For investors looking for digital advertising exposure, we'd recommend they consider wide-moat Meta, a name that trades in the 4-star range.

Coming up: Management expects revenue growth to slow to 14% next quarter, citing tougher year-over-year comparisons and the removal of the World Cup catalyst as the main cause of this deceleration. The 14% growth estimate is slightly ahead of our prior forecast.

Between the lines: Management noted that industry app-based penetration rates of paid-to-total users typically range between 7% and 12%, with Snap's 3% penetration rate implying plenty of headspace for Snap's subscription business to grow into.

Our fair value estimate for Snap is $7 per share, implying a 2026 enterprise value/adjusted EBITDA multiple of 11 times.

We forecast Snap’s sales to grow at a 9% compound annual growth rate for the next five years, primarily driven by user base expansion and supported by a gradual increase in average revenue per user across geographies. We expect the company to further penetrate markets in Asia and Europe, spearheaded by the growing content creator community. We also expect the firm to continually improve its ad-targeting algorithms, enabling advertisers to improve their return on ad spending on Snap’s platform, improving Snap’s overall value proposition to its customers.

On the profitability front, we project gross margins to rise as the firm continues to scale. We expect Snap to hit operating profitability by 2028, with near-term profitability unlikely due to the firm’s continued investments in product improvements, new features, and more nascent technologies, including AI. As the company grows, we expect these investments to decline as a percent of sales, allowing for an improved profitability profile in the medium and long terms.

We assign Snap a no-moat rating. Although Snap has moaty characteristics, including the foundations of a network effect, we lack confidence in the firm’s ability to effectively monetize its user base and generate excess returns on capital over the next 10 years. While Snap boasts a large user base of more than 450 million daily active users, or DAUs, with particularly impressive user penetration among Gen Z and millennials, the firm faces stiff competition from the likes of Meta, TikTok, and YouTube in the social media market, which contributes to our lack of confidence in the firm’s ability to generate excess returns.

Snap has established itself as a significant player in the social media industry. Its flagship app, Snapchat, is renowned for its ephemeral messaging feature, which automatically deletes Snaps and messages after 24 hours, simulating the transience of real-life conversations. The app is particularly popular among 18 to 34-year-olds. Users can send Snaps via private chat or upload them as “Stories” for friends to view. These Snaps and Stories can be enhanced with creative tools, including augmented reality lenses.

Despite Snapchat’s popularity, heavy competition in the social networking industry has hindered its ability to establish a network effect around its user base. Incumbents and emerging platforms alike compete for users’ attention, and advertisers tend to allocate their budgets based on scale, user engagement, and ultimately the return generated on ad spending. Given Snap’s limited ad inventory and user count compared with rivals like Meta and Alphabet, advertisers have diverted additional dollars to applications such as Facebook, Instagram, and YouTube. Although Snap regularly releases new features to drive engagement, users still prefer spending more time on Facebook, Instagram, and TikTok, creating more headwinds for Snap’s competitive positioning. Consequently, sandwiched between large incumbents and strong upstarts, Snap is left with a small portion of the overall social media ad spending, rendering it unlikely to catch up with its competitors any time soon. This dynamic within the social media ad market, in turn, limits Snap’s capacity to invest in its business, both via research and sales efforts.

As Snap has played catch up in the social media space, the firm has spent heavily to develop new features and acquire new users. While these investments, on balance, have helped Snap improve ad monetization and improve user growth/engagement, they have also materially depressed profitability. Further, as we have seen with Meta’s Reels and Stories, which are TikTok and Snapchat copy-cat features, respectively, any creative idea that appeals to customers can be quickly copied by competitors with large user bases. This copy-cat competition dynamic ends up diluting ad dollars that may chase users enjoying that new feature, depressing returns on the investments required to create those features.

A social media platform has two primary levers of providing value to advertisers. One, the firm can improve ad-targeting, making its ads more effective, pushing the return higher. In return, the social media firm can command higher prices per ad. Two, the social media platform can increase ad inventory, providing advertisers more real estate on which to leverage different ad types. Both of these actions by social media firms have the same net result—an increase in the firm’s average revenue per user, or ARPU, as more ad dollars flow to its platform.

As we look at Snap’s monetization of its user base, its ARPU numbers are materially below competitors like Meta. Again, the firm will likely have to spend billions of dollars in the coming years to improve its ad-targeting capabilities and create new features to increase its ad inventory. We believe these investments, while required to remain competitive, will keep Snap’s returns depressed, not allowing the firm to generate excess returns.

With 450 million daily active users already, Snap has a large user base to build on with investments in new applications and features.

As digital spending continues to grow, Snap can reap the benefits by attracting advertisers that seek to target younger audiences.

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Alternative revenue streams like Snap+ and Spectacles could gain traction and drive revenue growth.

Snap’s continued spending on user acquisition and improved engagement will limit profitability for the foreseeable future.

Snap may struggle to compete for both advertising dollars and users’ attention against established players like Meta and larger emerging rivals like TikTok.

By issuing only nonvoting shares for public trading, Snap’s management retains complete control over the firm, potentially limiting accountability.