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In another, less ebullient market, a profitless Snap wouldn’t even have tried to come public. The parent of Snapchat, the popular service that allows users to share disappearing messages, photos, and videos, is nowhere near break-even. It racked up large losses in 2016 and warned in its S-1 filing on Thursday that it expects “to incur operating losses in the future and may never achieve or maintain profitability.”

The five-year-old company lost $514 million last year on revenue of $404 million, and the red ink got worse by the quarter. Snap lost $169 million in the fourth quarter on $166 million in sales. Growth in users is slowing, perhaps due to competition from Facebook (ticker: FB).

None of this probably will matter as Wall Street prepares for the hottest initial public offering from an Internet company since Twitter (TWTR) made its debut in November 2013. Investors are eager for the next exciting social-network story, and Snap, with its large, young demographic, seems to have it. But slowing growth raises questions about the ease with which it will be able to monetize this opportunity.

It is also possible that Snap’s founders and controlling shareholders, CEO Evan Spiegel and Chief Technology Officer Robert Murphy, might decide to sell the business to Facebook or Google parent Alphabet (GOOGL) down the road. (For more on Snap and other social-media stocks, see Tech Trader.)

Investors who get an allocation of shares in the $3 billion IPO—mostly institutions—are likely to score when Snap comes public, probably next month. The shares are expected to rise in secondary trading. But investors who buy shares after the IPO could pay an especially eye-popping valuation.

The risk is that the Venice, Calif.–based company turns out to be a Twitter-like disappointment, rather than a Facebook-style winner. Like Twitter, Snap is more of a niche business operating in the red pre-IPO. Twitter went public at $26 a share, popped to $44 on the first day of trading, and has sunk to $17 as sales growth slowed, big profits never materialized, and a strategic buyer didn’t step forward.

It isn’t easy to predict where Snap will be priced. A pricing range will be included in a subsequent filing closer to the IPO date. The S-1 states that Snap valued its shares at $16.33 at the end of 2016, giving the company a market value of $17 billion based on just over a billion outstanding shares. That $16.33 price undoubtedly is low relative to where the IPO will be priced.

Reports that Snap is seeking a $20 billion to $25 billion valuation would suggest an IPO price of $20 to $25. But Snap could trade up considerably from there, given likely investor enthusiasm and expectations that the company might become the next Facebook, now valued at nearly $400 billion.

Snap looks exceedingly rich based on one traditional measure: price to sales. At $25 billion, the company would be valued at 60 times trailing revenue. Facebook fetches 14 times sales and Twitter, six times. It would take enormous growth in revenue and the generation of significant profit to justify an even higher post-IPO valuation.

Given the red ink, investors will be looking for any guidance on 2017 revenue—and future profitability—during Snap’s coming roadshow. There is speculation that Snap is targeting $1 billion in sales this year and $2 billion in 2018.

Bulls say Snap is early in user monetization, having started to post meaningful revenue only last year. Fourth-quarter revenue per North American user was $2.15, versus $20 at Facebook. Most of Snap’s user base is 18 to 34—a demographic that traditional consumer-products advertisers are eager to reach. Snap says users under 25 check the app an average of 20 times a day and spend 30 minutes a day on the service.

SNAPCHAT USERS send photos and videos to friends, often decorating them with text, cartoon characters, and goofy graphics like mustaches. The images disappear on a recipient’s screen after they are viewed. Users often chronicle their lives in a separate “stories” section, with “streaks” involving daily communications between users that extend back months or even years.

Snap’s average daily active users increased by 3% sequentially in the fourth quarter of 2016, versus 7% in the third quarter and 17% in the second. The slowdown coincided with Facebook’s rollout in the third quarter of its Snapchat-like Stories service on Instagram. TechCrunch wrote last week that the growth slowdown “aligns with our report that multiple analytic providers and social-media talent managers saw a big decline in Snapchat usage after Instagram Stories came out.”

In addition to a rich price, IPO investors will have to accept nonvoting stock, perhaps the first such instance in an IPO. This will perpetuate control by Spiegel and Murphy, who each own stakes worth $1.8 billion at the pre-IPO price of $16.33.

There are other risks to Snap. Snapchat users’ network of contacts usually is smaller than their Facebook “friends” list, making the service less sticky. A younger demographic also is more fickle. It is unclear whether others will gravitate toward a service that is harder to use than Facebook. Advertising accounts for nearly all of Snap’s revenues, leaving the company vulnerable if its ads don’t resonate with users.

The higher Snap’s post-IPO stock price, the greater the risk that any misstep could clobber investors. This looks like a deal to avoid.

Additional reporting by Mohammed Kabir

Email: editors@barrons.com

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