Snap's Earnings Report Was Better Than You Think

Snap (NYSE:SNAP) shares were getting shellacked after the social media company turned in a disappointing third-quarter earnings report.

Shares plunged more than 20% Friday morning after the company missed revenue estimates for the third quarter and offered underwhelming guidance for the current period. Q3 revenue increased 57% to $1.07 billion, but that was short of the company's guidance and the analyst consensus of $1.1 billion, while management guided for Q4 revenue of $1.165 billion to $1.205 billion, or just 30% growth at the midpoint. That was well short of analyst expectations of $1.36 billion.

The culprits weren't a big surprise. Snap noted headwinds from Apple's new ad-tracking policies as well as the global supply chain disruptions and labor shortages, which are impacting ad spending because businesses are reluctant to spend to increase demand if they can't fulfill it. Despite the stock's post-earnings tumble, there were a number of positives to come out of the report, showing that the pullback may be just a blip.

Of all the major publicly traded social media platforms (Snapchat, Twitter, Facebook, and Pinterest), none is growing as fast as Snapchat. Daily active users in the third quarter exceeded the company's own guidance, increasing by 23% to 306 million, which marked its fourth consecutive quarter of at least 20% year-over-year user growth. Snap is also experiencing user growth in all three of its geographies: North America, Europe, and Rest of World.

That's important because it shows Snapchat continuing to resonate with its audience and drive increased adoption. The business' growth is ultimately tied to its user base, and the more users it has to monetize, the greater its potential revenue is.

The company is also winning with the most valuable demographic -- users aged 13 to 34 in developed countries. In its core markets in the U.S., U.K., France, Australia, and Netherlands, 90% of the 13-to-24 population and 75% of the 13-to-34 population uses Snapchat. Piper Sandler's survey of American teens found that Snapchat was the most popular social media platform with a 35% share this fall, up from 31% in the spring.

For the fourth quarter, the company expects robust user growth to continue, forecasting DAUs of 316 million to 318 million, or up 19% to 20% from the year-ago quarter.

As long as user growth is solid, the growth story is intact.

For a long time, Snap looked like a money pit, burning cash to fund its operations, but that's changing as the business scales. Now, it's starting to enjoy some of the same unit economics that have made digital advertising platforms like Facebook so profitable.

In the third quarter, the company posted adjusted earnings before interest, taxes, depreciation, and amortization (EBITDA) of $174.2 million, more than tripling from the year-ago quarter and representing a margin of 16.3%. Free cash flow turned positive at $52 million, compared to a loss of $70 million in Q3 2020. On an adjusted basis, the company reported a per-share profit of $0.17, up from just $0.01 in the year-ago quarter.

On a GAAP basis, the company is still losing money as it spends aggressively on share-based compensation, with $300 million in that category in the third quarter, but GAAP profitability should soon follow the other key metrics.

Snap's gross margin is also improving in line with its goals. It noted on the earnings call that gross margin reached 60% in Q3, up from 58% in Q3 2020 and from 56% in the second quarter. That should give investors more confidence that profitability will continue to scale as the company grows. Considering the margins of larger peers like Facebook and Alphabet's Google, the profit ceiling for Snap is a high one.

Snap's focus on innovation also distinguishes itself from other social media platforms . Rather than functioning as a forum for posting, Snap's builds unique and creative tools for users to connect directly with each other. It invented Stories, which was copied by nearly every other social media platform, and has added unique features like Snap Map, which shows users where their friends are and what they're doing (with permission), and Spotlight, which highlights the most popular Snaps of the day, making Snapchat both a source of entertainment and a way of connecting with friends. Submissions to Spotlight more than doubled from Q2, showing the feature is reaching a wide audience.

The company has also invested in augmented reality tools and continues to see strong engagement with them. More than 200 million people engaged with AR every day on Snapchat, and the company used AR tools for unique applications like teaching users sign language and allowing them to experience the artists Christo and Jeanne-Claude's rendering of the Arc de Triomphe.

Issues like the supply chain disruptions and even Apple's advertising changes are short-term challenges. The uncertainty around those events explains why the company's guidance was so weak, but investors are better off ignoring those factors as they are not meaningful to the long-term trajectory of the business.

Snap is executing in the areas it can control, driving user growth, improving profit margins, and innovating with new products. The business remains healthy. The stock, however, was priced dearly coming into the report, so a sell-off makes sense. Still, long-term investors may want to seize this moment as a buying opportunity as these headwinds will ultimately be fleeting.