To The Moon

$Reddit(RDDT)$

Reddit shares have been more volatile than usual recently, reflecting broader market fluctuations, especially on Tuesday, March 11. That day, Reddit stock surged by double digits following an upgrade from a Wall Street analyst, who suggested that the stock had been overly beaten down in recent times. I've considered Reddit stock a buy for a while now, and in general, I am optimistic about the social media sector. The business model is highly profitable, as seen in larger companies like Meta Platforms. The profit margins, cash flow, and returns on investor capital that grow with scale are impressive, and the foundations of the social media business model often lead to strong long-term profits.

To assess Reddit’s stock further, I’ll review the company’s recent revenue growth, cash flow, and returns on capital. I'll also look at Reddit's recent expansion in daily active users, its AI integrations, and how these are benefiting the company. After considering all of this, I'll evaluate its discounted cash flow valuation and review key metrics like price-to-earnings and price-to-free-cash-flow ratios. I'll then update my recommendation on Reddit stock—whether it remains a buy or if I’m adjusting my view.

Earning Overview

Reddit's revenue growth has been accelerating since January 2023, with a steady increase in figures. In the latest quarter, they reported a 71% year-over-year growth in revenue for Q4 2024. Operating revenue, specifically from ads, grew by 59.83%. Daily active users increased by 39% year-over-year, and the platform now has 1 million daily active users. Impressively, Reddit is growing in North America, where other social media companies have struggled to expand.

Fundamental Analysis

Another important factor is Reddit’s second derivative growth, meaning the rate of growth itself is increasing, which is highly valuable when evaluating a business. Few companies are able to scale their growth rate while remaining profitable, but Reddit is one of those rare businesses. Its revenue growth is impressive, particularly at 60%, making it attractive to investors.

Although Reddit’s net income is currently negative at 32%, the trend is improving. The company is still losing money at the bottom line, but it is generating positive cash flow. This shift to positive cash flow is an important turning point because it means Reddit no longer needs to rely on investors for cash—it can sustain itself. While it’s a valid concern for investors to worry about companies losing money on the bottom line, if those companies are generating consistent positive cash flow, it mitigates the risk. In such cases, the losses don’t necessarily signal a crisis that would force the company to seek money from investors, which could lead to higher capital costs or a “desperate” situation.

Guidance

Revenue Growth: Reddit has demonstrated strong revenue growth, with a 71% year-over-year increase in the most recent quarter. The company’s ad revenue is a key driver, and it is expected to continue growing as Reddit expands its advertising capabilities, particularly in North America. Given the 60%+ revenue growth it’s been achieving, it’s likely that Reddit will continue to show positive revenue performance in the near future, provided it maintains its user base and engagement.

User Growth: Reddit has been seeing strong growth in daily active users, particularly in North America, where other social media platforms are struggling to expand. The company reported a 39% year-over-year increase in daily active users. Continued growth in this area will likely be a key part of its guidance, as the more users engage on the platform, the more revenue Reddit can generate from advertising and other monetization strategies.

AI Integration: Reddit's efforts to incorporate artificial intelligence to improve user experience and content discovery are expected to continue driving engagement and efficiency. AI-driven features could further enhance the platform’s monetization and user experience, aligning with broader trends in the tech industry.

Free Cash Flow

Speaking of profitability, Reddit's cash flow from operations to sales ratio has risen to 17.1% and continues to grow. This demonstrates how social media companies, as they scale, can become highly profitable due to network effects. The more users on the platform, the more valuable it becomes, creating a self-perpetuating cycle of growth and engagement. Reddit benefits from this network effect, driving organic growth with minimal additional costs—just maintaining the platform to ensure smooth operations. This contributes to the impressive cash flow and returns on capital we’re seeing.

Cash Flow: Reddit’s transition to cash flow positive is a critical development. As the company has achieved positive cash flow from operations, it is no longer dependent on external funding from investors. This financial stability should help Reddit in the long run, reducing concerns over profitability and its ability to self-sustain.

Technical Analysis

If the Stock Drop below $105 support level we could see further decline to challenges $80 level.

Risks and Challenges

For Reddit, this isn’t a concern because its positive cash flow from operations means it doesn’t need to ask for funds. A company like Reddit can operate with negative net income yet remain cash flow positive due to non-cash expenses like stock-based compensation. This compensation, used to pay employees in the form of stock rather than cash, helps maintain positive cash flow and keeps employees engaged, as they benefit from the company’s performance.

Profitability Concerns

Net Income Losses: Although Reddit is cash flow positive, it continues to report negative net income. Persistent losses at the bottom line, even as cash flow remains strong, can concern investors. If Reddit does not reach profitability soon, its ability to scale and reinvest in growth could be constrained.

Cost Structure: Reddit's reliance on stock-based compensation, a non-cash expense, can help maintain cash flow, but it also dilutes shareholder value over time. This could be a concern if it continues at high levels without a clear path to profitability.

User Growth and Engagement

Saturation in North America: While Reddit has been growing in North America, the region is also highly competitive, with platforms like Facebook, Instagram, and Twitter already established. If Reddit struggles to maintain or expand its user base in this key market, its growth potential could be limited.

User Retention: Attracting new users is important, but maintaining engagement and retaining existing users are equally critical. If user engagement levels stagnate, it could impact Reddit’s ability to monetize effectively.

Content Moderation and User Experience: Reddit faces ongoing challenges with managing content moderation and balancing freedom of speech with the need to prevent harmful or inappropriate content. Poor moderation can lead to user dissatisfaction and potentially alienate advertisers.

Economic Factors

Interest Rates and Cost of Capital: With interest rates influencing the broader market, Reddit’s ability to raise funds or refinance existing debts at favorable terms could become more challenging if rates rise. As Reddit transitions to greater reliance on internal cash flow, any fluctuations in the cost of capital could impact growth strategies.

Recession Risks: In the event of an economic slowdown or recession, advertising budgets typically shrink, which could reduce Reddit’s ability to generate ad revenue. Additionally, consumers may spend less time on the platform, impacting user growth and engagement.

Valuation

Now, looking at Reddit’s valuation, on a forward price-to-earnings basis, it’s trading at 28.7, which seems very cheap considering its 60%+ revenue growth and expanding cash flow from operations. On a price-to-free-cash-flow basis, Reddit’s valuation at 85 looks more appropriate, indicating that it is trading at a premium, but this is justified given the company's strong fundamentals.

Reddit’s accelerating revenue growth, improving cash flow, success in North America, and adoption of artificial intelligence are all solid growth indicators. Now, based on my discounted cash flow valuation, the intrinsic value per share is $156.60, while the current market price is $122. This indicates that the stock is undervalued. After updating my valuation with the recent decline in the 10-year government bond rate (which has dropped from 4.75% due to reduced economic growth prospects), the intrinsic value per share rises to $170.

Market sentiment

Market sentiment around Reddit has been mixed, driven by a combination of its growth potential and the volatility of its stock price. On the one hand, there is optimism due to Reddit’s strong revenue growth, increasing daily active users, and profitability in terms of cash flow. The company is benefiting from network effects and its ability to monetize its platform more effectively, which appeals to investors looking for high-growth opportunities in the social media sector.

However, there are concerns about its net income, which remains negative. While Reddit is cash flow positive, some investors are cautious about its lack of profitability on the bottom line, especially as it faces competition from other social media giants. Additionally, fluctuations in its stock price, driven by broader market trends and investor sentiment around tech stocks, add to the volatility.

The sentiment has also been influenced by Reddit’s efforts to integrate AI and expand in North America, where other social media platforms have struggled. These efforts have been well-received, but questions remain around how effectively Reddit can scale its business and whether it can maintain its current momentum.

Overall, the market sentiment around Reddit appears to be cautiously optimistic. While there are risks, the company's growth prospects, strong cash flow, and strategic initiatives give it a solid foundation for long-term success, which continues to attract investors.

Conclusion

With this lower risk-free rate, the cost of capital (WACC) decreases, which in turn increases my valuation for Reddit stock. Given the favorable metrics from both the forward price-to-earnings and discounted cash flow perspectives, Reddit stock still looks undervalued. Based on this analysis, I continue to believe that Reddit is a buy, and my opinion hasn't changed.

Disclaimer: I want to make it clear that I am not a financial advisor, and nothing I say is intended to be a recommendation to buy or sell any financial instrument. Additionally, it's important to remember that there are no guarantees or certainties in trading or investing, and you should never invest money that you can't afford to lose.

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