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Snap Plunges to New Low on Morgan Stanley Downgrade

After sinking below its IPO price of $17 for the first time yesterday, shares of Snap (NYSE: SNAP) are under even more pressure today, falling by 8% to trade below $16. The big catalyst is a brutal downgrade from Morgan Stanley -- notably the lead underwriter in the IPO, a role that earned the investment bank $26 million in fees.

Analyst Brian Nowak has cut Snap's rating from overweight to equal weight, while dropping his price target from $28 all the way down to $16 (via Tech Trader Daily). Ouch.

Image source: Snapchat.

Snap's challenges are mounting

Nowak believes that Snap's ad business is facing a handful of hurdles. Chief among them is poor return on investment (ROI) for ad campaigns, and Snapchat ad ROI is lower than Facebook's (NASDAQ: FB) Instagram, to boot. Advertisers are hesitant to open up their wallets even more in the face of low ROI, and Snap has dragged its feet in actually improving its ad products as it struggles in trying to break out of being an "experimental" ad platform.

Snap's new automated ad platform, which is critical to its ability to scale, is not growing as quickly as expected, either. Nowak doesn't think it will begin to scale until late 2017, or potentially even early 2018.

Instagram is only getting more aggressive, undercutting Snap pricing on similar ad products like "lenses," the live video filters that helped popularize Snapchat; Instagram is offering sponsored lenses to advertisers for free. Instagram doesn't disclose daily active users (DAUs), but Nowak believes the platform has over 450 million DAUs. Instagram has disclosed that it has 700 million monthly active users (MAUs) and its Stories feature has 250 million DAUs, compared to Snapchat's 166 million DAUs.

Third-party estimates also suggest that user growth is stagnating, citing SensorTower data that other analysts have also pointed to as cause for concern. Snapchat download rates are only getting worse, which doesn't bode well for DAU figures, at least directionally. The analyst is modeling for Snapchat to finish out the year with just 182 million DAUs (down from a prior estimate of 185 million).

A change of heart

Shorty after Snap went public, Morgan Stanley was among the firms issuing bullish ratings after the 25-day quiet period. At the time, the analyst believed that Snap had potential thanks to its ability to reach younger demographics, combined with possible upside for ad load. Morgan Stanley even assigned a bull case price target as high as $40.

It looks awfully bad when one of your lead underwriters downgrades your stock just months after helping you go public. There's a Chinese wall that separates investment banking operations from research operations, and the downgrade suggests that this Chinese wall remains properly intact, which is bad news for Snap, as it just lost one of its bulls.

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Evan Niu, CFA owns shares of Facebook. Evan Niu, CFA has the following options: long January 2019 $20 puts on Snap Inc. and long January 2018 $120 calls on Facebook. The Motley Fool owns shares of and recommends Facebook. The Motley Fool has a disclosure policy.