Reddit: Don’t Buy The Hype (NYSE:RDDT)

On Friday, Reddit (NYSE:RDDT) rallied 7.02% from its closing IPO price in a single trading day. The rally was likely brought on by a surprise earnings beat from Snap Inc. (SNAP), which itself booked a staggering 27.6% gain the same day. In the chart below, you can see the price action in the two stocks from Thursday’s close to Friday’s close. Both booked phenomenal one-day gains, with Snap being the really big winner.

I don’t have much to say about SNAP. I never used the service, so I can’t analyze the products–those being pivotal to understanding consumer tech stocks. Reddit I have extensive experience with. Over the years, I’ve had four or five Reddit accounts, one of which (since deleted) had tens of thousands worth of Karma. I still maintain a smaller account to this day. On the basis of this experience, I can bring product insights to bear on my analysis.

One of those insights is that Reddit isn’t the easiest kind of platform to monetize. It is not very similar to other social media apps–those typically have some element of connection to the user’s real-world identity, such as personal feeds, real names, and location-based features. Reddit does not have a Twitter/Facebook style feed, it doesn’t have a TikTok/Instagram-style focus on images or videos, it does not particularly encourage you to use your real name, and it does not have many features that integrate with your physical location. In these ways, it is much more like a forum site than a modern social media app. More to the point, these features show that Reddit collects nowhere near as much data on you as the big social apps do. While this is a virtue from a privacy standpoint, it is a hindrance from a monetization standpoint: user data is what social media apps rely on to show users targeted ads.

A quick look at Reddit’s privacy policy shows that it does attempt to collect a fair amount of user data. Specifically, it automatically collects login data, referring websites, and location data. Some of this is good data: referring websites can tell you what kinds of products a person likes, while location data can help you serve ads for local businesses. The problem is that Reddit’s user interface (“UI”) does not encourage you to actually provide such data. When you visit reddit.com, you’re first greeted with a post feed like the one below:

Notice that nowhere in this list of posts do you see a username or anything encouraging you to “socialize” with other users. Instead, you are shown a list of posts from subreddits, which are like sub-forums.

Finally, we get the page you see when you click on a user’s profile. This is without a doubt the most “social” aspect of Reddit’s UI, featuring a “follow” button and a somewhat larger profile picture. But again, you do not see these kinds of profiles when you first visit Reddit, you see a list of posts with no usernames, then when you click on those posts, you only see usernames displayed in very small font next to profile pictures that all look the same. In a word, you are not encouraged to look at Reddit user profiles–yet those profiles are just about the only thing on Reddit that is truly social!

This entire UI is very forum-like, and forums are not known for monetizing successfully. The problem is that they run enormous server costs, but unlike social apps, they do not have the trove of user data to make up for that. Also, as many Redditors have pointed out, Reddit does not appear to be very well run. Many people have developed third-party Reddit apps, some of which were considered better than Reddit’s own app. When Reddit bought one such app, rather than using its features in its own proprietary app, it simply killed the project! So, it does not appear that much effort is being spent on making Reddit the best product possible.

Financials

Digging into Reddit’s financials, we spot three clear trends:

1. Revenue deceleration.

2. Consistent (though not widening) losses.

3. Low average revenue per user (“ARPU”).

First, the revenue deceleration. In 2021, Reddit’s revenue grew 111% from the 2020 level. In 2023, it grew just 20.5%. This is a very rapid pace of deceleration.

Second, the consistent losses. Reddit lost money in all of the four years reported in its IPO filing. On a more positive note, the net loss did shrink in 2023, especially as a percentage of revenue, so the current trend has Reddit turning profitable eventually.

Finally, the low ARPU. Reddit had $804 million in revenue in 2023. It had 267.5 million weekly average users in the same period. This is ARPU of just $3. For reference, Facebook’s ARPU is $40.5, while even chronically unprofitable Twitter managed $24.65 before Elon Musk bought it.

Discounted Cash Flows

The above points lead into my discounted cash flow valuation–the theoretically correct way to value a stock, much more rigorous than multiples.

Observing the financials and trends seen in Reddit’s business, I came up with the following DCF model assumptions:

• Revenue decelerates from 20.5% to 10% over the course of five years. This ends up being equivalent to a 14% CAGR growth rate, which is what I’ll use in my model.

• COGS grows at the same pace as revenue: 14% CAGR.

• The company slows down the growth in operating expenses to 10%. The historical growth rate in such expenses is much higher, but investors will likely start demanding profits, and SG&A is usually an easy line item to cut from.

• Interest expense continues to be $0.

• The tax rate in profitable years is 10%.

Based on these assumptions, I created the model below:

Click to enlarge

As you can see, in this model, it takes six full years for this $45.43 stock to get to $0.67 in per-share profit! And this is with extremely generous assumptions like continued double-digit growth, no dilution and no interest expense!

I will just count the unprofitable years as being worth $0, because shareholders in corporations have limited liability; they don’t have to pay in to a company they own when it loses money.

Using 10.6% as the discount rate (the current 10-year yield plus a 5% risk premium), that $0.67 in year six EPS is worth $0.360. This figure is arrived at by adding one to the discount rate and raising all of the aforementioned to the power of six. If we keep the 10.6% discount rate for the perpetual growth period, assume that Reddit grows at 8% per year in perpetuity, then we get a $27.83 terminal value. The present value of the terminal value is $15.20, for an overall price target of $15.56. This is the price I’d need to see before I’d consider buying Reddit.

Bright Spots

Despite considering Reddit to have a fair value far lower than its current stock price, I do acknowledge that it has some things going for it. One of the biggest would have to be its balance sheet. Reddit is definitely quite solvent, with a ton of balance sheet cash and no shortage of liquidity. It also has basically no debt (to be specific it has $25 million worth, but that’s compared to $804 million in revenue, so it’s negligible in the context of the whole company). So, it can ride out a few more quarters of negative earnings without being seriously harmed by it.

Also, Reddit’s multiples are arguably not terrible on a sector-relative basis. For example, the stock trades at 3.5 times sales and 3.56 times book. The Magnificent Seven stocks generally have higher multiples than this, while having less growth than Reddit has. So if management can get costs under control, it may get to positive earnings faster than my model has it doing, and then have a modest earnings multiple. In such a scenario, my DCF model would be proven wrong.

Nevertheless, I consider Reddit just a hold. The assumptions in my DCF model are very generous, including things like 14% CAGR revenue growth, yet it still ends up with a fair value estimate about one third of the stock price. Of course, this is a relatively small-cap stock with the Reddit army behind it–I can’t rate something like this a sell, you never know when a WallStreetBets army will rally behind this stock and burn those shorting it. But it’s certainly not a buy based on fundamentals.