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Forget Snap: Facebook Is a Better Growth Stock

Let's face it, Facebook (NASDAQ: FB) is a mature business -- the social network's user base includes nearly one out of every three people on Earth, based on its monthly active user numbers. Meanwhile, Snap Inc.'s (NYSE: SNAP) Snapchat could lay claim to less than 200 million users at the end of the third quarter -- a respectable figure, to be sure, but one that leaves the upstart app with a lot of room to expand. Indeed, analysts expect Snap to grow its earnings per share at an annualized rate of 40% on a long-term basis -- a full 16 percentage points ahead of their consensus estimate for Facebook. Obviously, Snap is the better growth stock.

There's only one problem: The same analysts also expect Snap to produce annual losses through 2021, at least. That 40% EPS growth forecast ought to come with a warning label, because the uncertainty around the figure is stratospheric -- and it's weighted to the downside. Facebook's long-term growth is by no means certain, but it is much more so than Snap's. The difference between the two largely comes down to a crucial concept in business and investing: the economic moat. Facebook has one, Snap doesn't. That makes the former a superior growth company, in my opinion.

Sign at Facebook's Menlo Park, California headquarters depicting a large
Sign at Facebook's Menlo Park, California headquarters depicting a large

Image source: Facebook, Inc.

What is Snap's "economic moat"?

At the end of September, Snap CEO Evan Spiegel wrote a 15-page memo to his employees in which he described Snap's competitive advantage this way:

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Warren Buffett introduced the concept of "economic moats" to describe a competitive advantage in business, playing off the idea of medieval castles protecting themselves from rampaging invaders.

Snap's moat is comprised primarily of network effects, economies of scale, and our brand... The network effects of our product will make it harder for other companies to compete by copying our core product value. That's because the value to the incremental user of Snapchat is a direct function of the users already on Snapchat. Put simply, if a competitor made an exact copy of Snapchat (like Poke or Instagram Direct) it wouldn't be able to offer as much value as Snapchat because there wouldn't be anyone using it.

But if that's true of Instagram with its 186 million daily active users, it's exponentially more so for Facebook with its 1.49 billion. In fact, Spiegel knew that Snap's moat was far from unassailable when he wrote that memo -- he had just a few months earlier suffered a stinging demonstration of that fact. At the end of June, Instagram, a unit of Facebook, announced that its Stories feature had grown to 400 million daily active users -- more than twice the number of Snapchat users -- from its launch just two years earlier.

In creating Stories -- slideshows into which users post photos and videos that disappear after 24 hours -- Instagram had directly copied Snapchat.

Smiling woman holding a smartphone displaying multiple notifications from social networks
Smiling woman holding a smartphone displaying multiple notifications from social networks

Image source: Getty Images.

The argument that a Snapchat clone wouldn't offer as much value as the original "because there wouldn't be anyone using it" might be valid for new entrants trying to build their user bases, but the same logic turns against Snapchat when one tries to apply it to Facebook, which already has a larger user base and, therefore, more powerful network effects. It's surely no coincidence that Snapchat's user base has fallen in each of the past two quarters, the first declines in Snap's history.

The importance of a moat: A lesson from Web 2.0

Here's a historical comparison that I think is relevant: To label Snap a better growth stock than Facebook today would be akin to someone having described Groupon as a better growth stock than Google (now Alphabet) just after the daily deals company went public in October 2011. At that time, Groupon had just closed a quarter in which revenues had more than quintupled year over year, whereas Google, with trailing 12-month revenues of around $28 billion, had managed to grow quarterly revenues by only 22.6%.

Since then, over a seven-year period, Groupon's quarterly revenues have grown just 38%, while Alphabet's have expanded by about 247%. Alphabet has a massive competitive advantage that has enabled it to become one of the two dominant companies in the global digital advertising market -- the other being... Facebook.

(Incredibly, Google itself nearly fell for Groupon's rearview growth illusion -- it reportedly offered $6 billion to acquire it in 2010; today, Groupon sports a market cap of $1.8 billion.)

Facebook vs. Snap: The consensus is wrong

Facebook's moat eclipses any that Snap might have -- that much is clear. There are nonetheless risks to Facebook that could put the brakes on its growth. The company has been plagued by multiple scandals linked to user privacy and the persistence on its platform of false, manipulative or objectionable content. The responses to these problems from CEO Mark Zuckerberg and Chief Operating Officer Sheryl Sandberg have been oblivious, dawdling, or passive-aggressive. Still, Facebook's potential downside is not, in my opinion, as concerning as Snap's.

The consensus expectation among analysts is that Facebook's revenues will grow at an annualized rate of 20.9% over the next three years, versus 29.7% for Snap. For the reasons I've outlined above, I believe the consensus view is wrong, and that Facebook will instead post higher revenue growth than Snap, all the while remaining highly profitable. Snap, on the other hand, will struggle mightily over that period to achieve any sort of profitability. If this is a story of David versus Goliath, get ready for new ending that's more in line with the Philistines' original expectations: Facebook is a better growth stock than Snap.

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Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool's board of directors. Alex Dumortier, CFA has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Alphabet (A shares), Alphabet (C shares), and Facebook. The Motley Fool has a disclosure policy.