The stock market has gotten off to a sizzling start in 2024. Euphoria surrounding artificial intelligence (AI) is bringing the S&P 500 and Nasdaq Composite to record highs, and the momentum doesn't appear to be slowing down.
Unsurprisingly, some businesses are taking advantage of the ripe market conditions as 2024 has featured a number of high-profile initial public offerings (IPO).
Social media platform Reddit (RDDT 3.59%) recently began trading on the New York Stock Exchange. While shares briefly surged over 120% from their offering price, reality may be setting in as they've already retreated more than 30% from their peak.
Prospective Reddit investors should understand the major risk areas for the company and how they can affect its long-term outlook.
1. Social media is fiercely competitive
The social media industry is jam-packed with competition. While platforms may specialize in different areas such as product reviews, peer-to-peer communications, or image and video sharing, the underlying goal is always to build a large, engaging community.
This makes sense from a business perspective. If you can attract more users to your platform, then you have a bigger monetization opportunity. And the most common way to monetize users on social media is through advertising.
With 73 million daily active users, Reddit clearly has some brand appeal. Moreover, in 2023, the company generated $804 million in revenue -- up 21% year over year. Similar to its competitors, Reddit's primary source of revenue stems from advertising.
On the surface, this might appear to be a pretty solid business. However, Reddit is fighting with companies like Meta Platforms, Alphabet, Snap, X (formerly Twitter), Pinterest, and others for engagement.
Meta Platforms owns Instagram, Facebook, and WhatsApp, which combine for over 3 billion daily active users. Meanwhile, Alphabet is home to the world's most visited websites -- Google and YouTube -- with over 100 billion site visits each month.
Reddit's management clearly understands it has an uphill battle when it comes to competing with these larger behemoths. The company's average revenue per user declined 7% year over year in Q4 2023 after falling flat the previous quarter.
But the company's plan to grow beyond the typical advertising business model is puzzling, and even more concerning, it's very much unproven.
2. Reddit's growth path is puzzling
In Reddit's S-1 filing, the company describes two other areas it's exploring as revenue opportunities: e-commerce and artificial intelligence (AI).
E-commerce can complement Reddit's existing advertising operation. However, the intersection of Reddit's specific brand of social media and e-commerce can be a challenge given existing players in the space.
Meta has been able to penetrate e-commerce successfully thanks to the rise of small businesses on Instagram as well as the marketplace on Facebook. But while smaller platforms like Snap are also experimenting with e-commerce, their success has been much more limited. Average revenue per user has continued to trend lower for Snap, hinting at the challenges for social media companies looking to expand their sources of revenue.
As far as AI goes, the company has signed data licensing deals worth $203 million -- notably including a $60 million partnership with Alphabet.
Given Reddit's vast library of user data, there is merit to the idea the platform's content can be scraped to help train generative AI models. However, the risk here is that those same models could eventually poach the company's user base and engagement as people turn to AI for the discussion and answers they previously sought on Reddit.
3. The stock's premium is too high
Reddit has a market capitalization of $7.5 billion as of this writing, putting its price-to-sales (P/S) ratio at about 9.3.
That matches Meta's P/S ratio, while coming in higher than the likes of Pinterest and Snap. This premium valuation is hard to justify given the question marks surrounding its growth prospects.
Data by YCharts.
Andrew Freedman, an analyst at Hedgeye Risk Management, recently called the stock "grossly overvalued" in a short report published last week, according to Bloomberg. Freedman believes the stock will retreat closer to its IPO price of $34 per share, which would benefit short sellers who profit when a stock's price falls.
Once Reddit begins hosting earnings calls, investors will learn how much success the company is having with its pursuits in e-commerce and AI. But for now, I'd steer clear of Reddit and let the current hype surrounding the stock play out. There are other opportunities in social media from larger, more established businesses.
