Snap’s Earnings Remind Us Of The Growth-Profitability Tradeoff

Morning Markets: Snap reported earnings yesterday. The public social media company’s results contained some useful lessons for later-stage, private companies. Let’s explore the public market’s current views on profits versus growth.

Snap, parent company of the popular Snapchat application, announced its third-quarter results yesterday after the bell. As a company Snap has been on a well-documented rebound for some time; the company has traded for under $5 per share inside the last year despite being worth over $14 per share during yesterday’s regular trading.

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Its latest numbers paint a picture of a company still struggling with its cost structure, recapitalized with debt, and growing its revenue at a good clip.

To back that up, let’s peek at the numbers. Snap’s revenue grew 50 percent in Q3 2019 compared to the year-ago period, from $297.7 million to $446.2 million. Over the same time period, its net loss fell 30 percent from $325.1 million to $227.4 million.

Other negative metrics also improved, including its free cash flow (from negative $158.8 million in Q3 2018 to negative $84.1 million in the most recent quarter) and adjusted EBITDA (from negative $138.4 million to negative $42.4 million).

Wall Street had expected a larger adjusted loss, and revenue of $437.9 million. On the back of that double-beat, you might expect that Snap’s stock is up today. It isn’t.

After Snap reported its results, its shares fell. Why? Because the deeply unprofitable company isn’t projecting the sort of growth that Wall Street expected, as MarketWatch explains:

Snap said that it expects to report adjusted Ebitda of up to $20 million on revenue of $540 million to $560 million in the holiday quarter, which is typically its largest of the year thanks to increased advertising budgets; analysts on average were projecting a break-even quarter on an adjusted basis with sales of $555 million, according to FactSet.

If Snap manages to land at the top of its revenue forecast, then, it will only beat expectations by a smidge. At the low end of its range, it would miss by three times that amount. So, despite Snap’s strong Q3, its slower-than-expected Q4 forecast cost it dearly.

Let’s parse that a bit, and relate the lessons to the private companies that make up our regular fare.

Growth

In the past, companies that went public were usually profitable. In recent years, with the private market flush with cash, companies going public have been majority unprofitable, though often growing extremely quickly. There’s a bit of a trade off: a company going public today tends to be either a high-growth company, or profitable-ish.

And as most startups in today’s market select the high-growth model (venture capitalists often advise startups to focus on growth), you can see how the IPO market has shifted towards that choice.

Snap focused on growth over turning a profit before and during its IPO; it has yet to break even as a public company. Things haven’t changed since. Snap has had to raise debt, and has a long way to go to reach free cash flow breakeven, let alone adjusted profit or GAAP net income.

As we saw above, Snap posted good growth momentum in Q3. But if the company posted strong revenue expansion, why are investors trading its shares down? Because slowing growth makes its current lack of profits less palatable. Investors are now accustomed to Snap’s quick revenue growth and clearly aren’t happy to see it fall under their expectations; slower growth means lower implied future cash flow and profit, let alone a longer ramp to gross profit covering costs. And when cash flows and profits are lower, investor returns tend to be lower as well.

No Rest For The Glow Up

So even Snap, on one of the biggest public market glow-ups of last year, is still on a knife’s edge. It can’t afford to post slower growth if it wants to be valued as highly as it was this summer, given its losses.

Maybe this is all to say, if you’re going to grow fast and go public, you’ll need to keep the growth up if you aren’t cleaning up your losses at the same time. Growth stocks tend to have volatile stocks. Why? Becaused missed results can sternly correct investor expectations; Snap has seen that happen to its benefit and detriment during its life as a public company.

For startups, perhaps we can take this as a lesson to lower your burn a bit while keeping growth as high as possible. Investors like to see more-than-tidy revenue expansion (at this point, they’ve been conditioned to) but they’ll be less than thrilled if the consequences of growing fast catch up with you.

And that’s as true today for private companies as it is their public siblings.

Illustration Credit: Li-Anne Dias