Snap Finds It's Not That Easy to Operate Profitably in Emerging Markets

Much of the Snapchat parent's user growth is now coming from India and other emerging markets, where average ad prices tend to be lower.

Following Snap’s  (SNAP) - Get Report Q2 report, a lot of attention has been given to how the company’s Q2 user growth fell short of what some investors were expecting.

Less attention, however, has been given to where Snap added the lion’s share of its new users last quarter, and what impact that has on its bottom line.

To recap: Snap, whose stock is down over 7% post-earnings, reported its average daily active users (DAUs) rose by nine million sequentially and 35 million annually in Q2 to 238 million. Sequentially, the company saw DAUs rise by two million in North America (defined as the entire continent of North America) to 90 million, one million in Europe (defined as including Russia and Turkey) to 71 million and six million in all other regions -- places grouped by Snap into a segment it calls “Rest of World” -- to 77 million.

On an annual basis, 21 million of the 35 million DAUs Snap has added have been in “Rest of World” countries. And from all indications, a healthy portion of these new users are in India, where Snap opened its first office last year and has been putting a lot of effort into doing things such as partnering with smartphone OEMs and supporting a number of local languages.

Snap's DAU growth by region. Source: Snap.

Snap's DAU growth by region. Source: Snap.

On Tuesday’s earnings call, CEO Evan Spiegel said that Snap’s Indian DAUs more than doubled annually in Q2. And with the Indian government having banned TikTok near the end of Q2, odds are good that the company will also see strong Indian DAU growth in Q3.

Also: In addition to India, Snapchat has substantial user bases in “Rest of World” countries such as Brazil, Saudi Arabia and the Philippines.

While it’s generally a good thing for a social media platform to add users, having to support a large number of new emerging markets users poses financial challenges for Snap, since due to lower average incomes, ad impressions and clicks generated in these markets tend to carry lower prices than impressions and clicks generated in developed markets.

These monetization challenges are part of the reason why Snap’s Rest of World revenue rose only 2% annually in Q2 to $69 million (15% of total revenue), even as its Rest of World DAUs rose 37%. As a result, its Rest of World average revenue per user (ARPU), which is likely boosted some by developed markets such as Japan and Australia, fell 25% to $0.89.

For comparison, Snap’s North American ARPU rose 9% to $3.40, and its European ARPU rose 16% to $1.10.

Snap's ARPU growth by region. Source: Snap.

Snap's ARPU growth by region. Source: Snap.

Admittedly, CFO Derek Anderson said on Snap’s call that Q2’s Rest of World revenue was “more significantly impacted by several COVID-related factors” than North American and European revenue, such as “restrictions on cash transactions and interruptions to supply chains that impacted both physical and e-commerce retail.” He added that the region’s revenue growth rates have been rebounding in Q3.

But as far as ARPUs go, there is a clear trend afoot here, as Snap’s prior earnings reports drive home. From Q2 2019 to Q1 2020, Snap’s Rest of World ARPU growth gradually slowed from 25% to 2%, as the region’s DAU mix shifted more towards emerging markets users.

And regardless of where in the world new users reside, supporting them requires Snap to incur (via cloud providers Google  (GOOG) - Get Report and  (AMZN) - Get Report) substantial cloud hosting expenses.

The company’s infrastructure costs totaled $163 million in Q2, flat sequentially but up from $146 million a year earlier. These expenses are a big reason why -- in spite of strong North American and European ad revenue growth -- Snap is still cash-flow negative. Free cash flow was negative $82 million in Q2 and stands at negative $247 million for the last 12 months.

With more than $2.8 billion in cash in the bank at the end of Q2 and more than a billion in credit facility funds available if needed, Snap has plenty of time to figure out how to profitably support a large and growing base of emerging markets users. But as the company’s latest numbers show, this isn’t an easy nut to crack -- particularly when it’s  relying on Google and Amazon’s data centers, rather than its own, to help support them. And with Snap currently possessing a $34 billion market cap, investors aren’t just betting that the company will be cash-flow positive in time, but that its cash flows will be substantial.

Alphabet and Amazon are holdings in Jim Cramer’s Action Alerts PLUS Charitable Trust Portfolio. Want to be alerted before Cramer buys or sells these stocks? Learn more now.