Reddit Ad Revenue Is Soaring. That’s Not Good for RDDT Stock. Here’s Why.

As expected, Reddit’s (NASDAQ:RDDT) plan to flood the comments section of its platform with advertising is having the desired effect. Ad revenue surged 42% in the second quarter t0 $253.1 million. While that’s nothing compared to rivals like Facebook which brought in over $38 billion in ad sales, it is a marked improvement that helped boost Reddit’s financials for the period.

I’ve previously noted the plan would likely result in higher sales for the social media site.

“While Reddit’s plan could initially boost revenue as advertisers try to reach a new and different audience, more ads also raise the risk of users ignoring them,” I wrote in pointing out that long-term effects could be negative.

There could be a backlash amongst’s Reddit’s notoriously volatile users. Moreover, because Reddit is forced to spend a lot of money to attract new users, degrading the experience by more ad placements could make it harder — and more expensive — to gain new users.

The short-term effect is positive and Reddit’s stock soared 8% on the earnings release. Longer term this could be negative. It’s why I think investors should take their profits and sell.

The Rising Tide Lifting Reddit’s Boat

Reddit reported a 54% increase in quarterly sales to $281.2 million on a 57% jump in weekly active users. The social media site now has over 342 million users. Most of Reddit’s revenue comes from advertising, or 90%. That’s the case with most social media platforms that need to monetize their users.

The site continues to lose money, but it significantly narrowed those losses. It reported net losses of $10.1 million, a substantial improvement over the $41.1 million it lost in the year ago quarter.

It did turn in adjusted EBITDA of $39.5 million compared to an adjusted loss of $35.4 million last year. Most of that gain, however, came from backing out the stock-based compensation given to executives. Over $66 million was awarded to executives this quarter versus $10 million last year.

Yet, it shows the benefit of bringing in more ad revenue. Because although its expenses surged in the quarter, no doubt partially a result of its going public back in March, Reddit was able to offset that growth by selling ads.

A Tsunami of Advertising

The presence of ads is going to grow significantly going forward. Reddit will be further integrating advertising in its unique communities, allowing for more targeted marketing to occur. It typically makes sense to put ads relevant to the communities that will view them.

Reddit has an opportunity to increase ads in search, too. It touted its acquisition of Memorable AI to assist marketers and advertisers in placing ads on the site. That will also help when it comes to expanding search capabilities across the platform.

“For many users, they’re literally typing into a box exactly what they’re interested in,” Chief Executive Officer Steve Huffman told analysts on the earnings conference call.

But, it is the quality of the user that matters most to Reddit, its biggest vulnerability.

A Lack of Engagement

As fast as Reddit is growing, it is not attracting users who are engaging with the site. Reddit admits its business built on and relies upon user engagement. But fewer and fewer users of the site are actually logging in.

While daily average users grew 51% for the period, the number of those who actually logged into Reddit continues to decline. Only 46% of users logged in compared to 53% last year. It is also down from the first quarter when 48% logged in.

Logins are essential because users can’t comment on or create posts without doing so. It means a growing number of users are just skimming the site and not engaging with it. That means their value for advertisers is less.

The Bottom Line for Reddit Stock

What this points to is Reddit may grow revenue from putting more ads on the site but the users who are most important may not like it. And as a smaller and smaller percentage of them actual engage with the Reddit platform, it could be an overall negative effect for its stock.

On the date of publication, Rich Duprey did not hold (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.

On the date of publication, the responsible editor did not have (either directly or indirectly) any positions in the securities mentioned in this article.