Why Are Analysts Suddenly So Bullish on Snap?

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For the first three weeks or so following Snap‘s (NYSE:SNAP) IPO, almost no Wall Street analysts gave the stock a buy rating. The company suffers from a ton of uncertainty around the high-growth expectations of investors. Of the first 19 analyst opinions to come out on Snap, just three said the stock is a buy.

That changed this week when analysts representing the banks that underwrote Snap’s IPO issued their own ratings. Those banks were overwhelmingly positive on the stock; nine of the 10 analysts from underwriting banks that issued notes earlier this week gave it a buy rating.

While there are regulations in place to keep the research and investment banking divisions of these banks separate, there is clearly some consistency from the firms that helped bring Snap public.

"Snap Inc." on a yellow background

Image source: Snap

What the bulls are saying

I’ve been rather negative on Snap since it filed its S-1, but here’s what analysts with buy ratings have to say about it.

RBC Capital’s Mark Mahaney was most bullish with a $31 price target. “We believe SNAP has taken steps to ensure robust product innovation going forward,” he wrote. “And we see the company’s current limited DAU [daily active user] base (158MM or ~1/10th the size of FB) and its current low ARPU [average revenue per user] ($1.05 or ~1/7th that of FB) as creating substantial growth opportunities.”

There’s plenty of room to grow ARPU if Facebook‘s (NASDAQ:FB) numbers are any indication. Marketers spent over $19 per monthly Facebook user in the U.S. and Canada last quarter. That number goes up if the denominator is just daily users versus monthly users. By comparison, Snap generated just $2.15 per daily user in North America last quarter.

Jefferies analysts also point to ARPU as the main factor driving robust revenue growth over the next few years. Morgan Stanley suggests that could come from increasing the ad load — the number of ads users see per hour of engagement. Facebook and Instagram have significantly higher ad loads than Snapchat, and engagement remains strong for both properties.

Cowen and J.P. Morgan analysts expect robust user growth from Snapchat as current users get older and more teenagers get smartphones. J.P. Morgan expects 299 million daily users by 2020 (up from 158 million today) and Cowen expects 378 million users by 2022.

A lesson for investors

The analysts with buy ratings on Snap have valid points and may turn out to be right. But it’s important for investors to be mindful of the considerations that might have influenced their opinion. It’s not very smart to bite the hand that feeds you, so analysts from banks to which Snap just paid millions in fees are unsurprisingly bullish.

I’m guilty of similar behavior. I may be overly bullish on stocks that I own in my personal portfolio. (You can see them in my Fool.com profile, and if I own a particular company I’m writing about, you’ll see it in the disclosure at the bottom of every article.) To be sure, in the case of my own stockholdings, I had a reason to invest in these companies and be bullish on them before I owned them.

In the case of the analysts from the underwriting banks, they don’t actually own shares, but they’re still inclined to provide bullish notes. That may be due to working alongside the people that built the books for Snap’s IPO and spent months speaking positively about the company. It’s easy to hop on the bandwagon when everyone around you thinks this is the next great IPO.

Confirmation bias

It’s human nature to interpret evidence in a biased manner to support our pre-established opinions of something. That’s especially true in emotionally charged scenarios, and few things are as emotionally charged as money. It’s a phenomenon called confirmation bias — we look for evidence to confirm our beliefs and ignore contradicting evidence.

You are probably guilty of confirmation bias yourself. You may prefer reading articles and ideas that confirm your beliefs rather than those that contradict them. But if you read opinions on both sides of the coin and really try to understand their arguments, you’ll generally make better decisions.

While I have some reservations about Snap’s ability to grow users, the analysts offer some very good arguments around Snap’s ability to grow the monetization of its current user base. Still, most analysts seem to conveniently ignore Snap’s extremely poor profit margins as they would rather focus on the company’s opportunity to grow the top line.

Remember to take all of these opinions with a grain of salt. Even mine.

Adam Levy has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Facebook. The Motley Fool has a disclosure policy.