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That Giant Snapping Sound is MiFID II

By Linda McDonough on July 19, 2017

I’ve never been a big fan of Snap’s stock. I reviewed it back in May after it reported its first quarter earnings and came away underwhelmed. But last week’s downgrade by its lead underwriter was unlike any I’ve seen in my 27 years following stocks. I’m suspicious that a new industry regulation named MiFID II may be at the root of the downgrade and inspire more bearish calls.

Snap, which just went public last March, was downgraded by Morgan Stanley, the lead underwriter on the deal. Typically the analysts of the underwriting brokerage firms are the stock’s biggest cheerleaders. Although they formally operate separate from the “banking” side of the firm which orchestrates stock deals, it is an unwritten tradition that these analysts support their bank’s deal with favorable ratings.

Snap’s relationship with most of its underwriting analysts began that way. Snap went public with a whopper of a deal. Two hundred million shares were priced at $17 in early March. With perfect punctuality, the analysts who worked for the underwriting banks trotted out buy recommendations on the exact day the company’s quiet period ended.

Morgan Stanley issued a buy rating with a $28 price target. Of the other six underwriters, all but two issued Buy ratings with price targets ranging from $27-$30.

Many other analysts who were not involved in the IPO rolled out coverage of the stock in the next month. Interestingly enough, almost every one issued a cautious rating on the stock.

What’s particularly curious about Morgan Stanley’s downgrade of the stock is its timing.

As I noted in my May recap of Snap’s IPO, the company’s fundamentals were already wilting before the deal was priced. Growth in daily active users and revenue per user was slowing markedly. When a company is losing as much money as Snap is, the only saving grace is geometrically expanding revenue.

Even after Snap reported a disastrous quarter in mid-May, Morgan Stanley analyst Brian Nowak kept his overweight rating and his $28 price target.

Snap’s first quarter as a public company showed an acceleration in the decline in revenue per user. In what should have been a glaring red flag to investors, CEO Evan Spiegel blithely ignored analysts’ concerns over the growth, noting that he instead focuses on “growth in creation”.

Since that time, analysts not involved in the IPO have been ringing increasingly loud alarms about Snap’s deteriorating business model. Instagram, Snap’s primary competitor, is owned by deep-pocketed Facebook, who is spending money hand over fist developing short video features to keep users from straying from its social media circle.

Analysts at Oppenheimer and Nomura are particularly vocal about advertisers’ hesitation to shift ad dollars away from Facebook toward Snap. In the past few months both offered a pile of data showing increasing growth in Instagram’s downloads, and slower growth of new advertisers for Snap.

Industry source Digiday called out problems for Snap in late May. The site quoted several media buyers who were offered discounts, coupons, and media credits by Snap if they purchased ad dollars before quarter end.

Even still, one wonders if this incremental data is enough to justify Morgan Stanley lowering its price target to $16, one dollar below the $17 price it offered to investors on the IPO just a few months ago. Knowing the rigor of the analysis and energy spent attempting to choose the perfect IPO price, you’d be suspicious of Morgan Stanley’s sudden change of heart.

A draconian cut to estimates coincided with the downgrade. It seems that after further analysis, Morgan now thinks Snap will lose $815 million next year, $214 million or 36% more than it thought four months ago. Estimates for losses in 2019 ballooned as well. The analyst believes Snap will lose half a billion dollars that year, $350 million or triple, the amount it originally penciled in.

Even for a cynic like myself, these numbers are shocking. While it’s possible the wheels are falling off Snap’s growth model, I think this sudden change of heart may be linked to new industry regulation that will put analysts’ research under a microscope.

MiFID II, a new regulation being enacted in Europe in January 2018, will require asset managers to pay for the equity research they’ve been receiving from brokerage firms. Currently, most firms paying a base level of commissions receive a full suite of research from brokerage firms.

The new rule will put a firm price on the research and analysts who can’t justify their salary will be out of a job. Although the regulation is only being instituted in Europe, most asset managers are global companies and will follow the rule with their U.S. based trading partners.

Look for more bearish and honest stock research as analysts attempt to prove their worth with buy side asset managers instead of towing the company line on banking clients. While many research departments will shrink, I think it’s a healthy move for the market and an opportunity for bearish calls to play out more quickly than they would in the past.

At my Profit Catalyst Alert service, I often issue bearish trades for subscribers and will be increasing my focus on these trades to capitalize on this shift in the market.

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