Snap’s Horrible Guidance Isn’t Its Worst Problem

Bad guidance is one thing. But social media company Snap (SNAP) has a bigger problem…

Let’s deal with the guidance problem first…

The company expects to miss the lower end of its previous guidance. But that shouldn’t shock anyone. After all, as I said on July 13, advertising – even the digital kind – is cyclical.

And yet, market commentators still tripped over themselves to see who could spin the most negative adjectives after Snap’s recent earnings report. And the stock fell 39% on July 22.

That’s rough, of course. However, it’s even worse for Snap…

The entire business isn’t economically viable.

Let me show you what I mean…

In short, we need to talk about “stock compensation expense” (“SCE”).

This a non-cash expense for companies. It’s the economic value of stock given by them to employees.

Importantly, we aren’t talking about gifts. It’s compensation for services rendered.

Startups can persuade employees to accept lower cash salaries in return for a chance to participate in the company’s growth.

If all goes well, the company will grow. And in turn, the value of the employees’ stock will grow, too.

But as always, great tools can be destructive if they’re misused…

That’s the basic reality of SCE. The more stock (often options on day one) that a company issues this way, the higher its shares outstanding can climb.

That’s because the company simply creates new shares to fulfill its obligations.

And it’s a vicious cycle… The more shares outstanding in the future, the more dilution.

As you might know, dilution happens when more and more shares grab a piece of the available capital. That dilution cuts everyone’s per-share values.

And of course, this process hurts employees who gave up chances to work for more cash elsewhere. The value of their SCE will be less than they expected – sometimes by a lot.

It hurts investors, too. Their stakes also get diluted.

But employees at least know up front they’re getting less cash in exchange for stock. If they don’t like what they see, they can quit and find another job.

However, SCE isn’t at the top of investors’ minds…

It’s not usually listed in a company’s “Income Statement” (which is the first place astute investors usually check). Instead, it typically appears on the “Statement of Cash Flows.”

Many companies – especially emerging firms that are a long way from sniffing profitability – prefer to strategically rearrange their financials. Businesses like Snap offer management-created “Non-GAAP” items in their investor presentations. (GAAP means “Generally Accepted Accounting Principles.” Auditors must approve those items.)

On slide 48 (out of 49) of its most recent investor presentation, Snap buried a darn important footnote…

First, on that slide, you’ll find the company’s “Adjusted EBITDA” (which is like what I call “operating profit”). And it looks good… This metric shows that the company lost $720 million in 2017, but it earned nearly $617 million in 2021.

However, the second footnote accompanying the adjusted EBITDA line is a killer. It’s hiding in light-gray, nano-sized font. Here’s the relevant text…

We define Adjusted EBITDA as net income (loss), excluding… stock-based compensation expense and other payroll related tax expense…

Snap isn’t doing anything illegal. The company is defining the numbers it presents with the footnote. And the table discloses SCE.

But the company can only do so much.

Here’s what Snap’s adjusted EBITDA would be if SCE didn’t exist. By that, I mean if the company paid its employees conventionally, with full-cash salaries. Take a look…

(By the way… don’t panic if you see different numbers elsewhere. Creativity rules in the non-GAAP world. Everybody computes things their own way.)

As you can see, Snap is still in the red in this metric. That means it’s what I recently referred to as a “failure to launch” company. And the bottom line is simple…

It wouldn’t be economically viable if it had to pay its employees with full-cash wages.

The bad guidance report earlier this month might seem like Snap’s biggest problem. But when we consider SCE, it’s clear that the company is in much worse shape than believed.

Good investing,

Marc Gerstein

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