Why shorting Snap Inc. is a bad idea
Great investments happen when the crowd is convinced on a narrow range of outcomes, while the hero investor believes in a different and correct outcome. Thus there are two requirements at play, namely 1) the width of the range of outcomes the crowd expects and 2) contrarianism. If different players believe in vastly different outcomes, the wisdom of crowds arises and averages the general expectation to a level quite close to the actual outcome. Yet if everyone seems to be convinced on a narrow range of outcomes, there is potential for a profitable mismatch between expectations and reality. Secondly, contrarianism is crucial since if you do what everyone else does, you get what everyone else gets. But simply going against the tide for its own sake is a stupid strategy — the crowd tends to be right. Be contrarian but most importantly, be right.
How do these criteria fit Snap’s upcoming IPO? Everyone seems to be excited to participate in the largest tech IPO since Alibaba. General expectations seem to be that the IPO will be a success at a $19.5–22.2 billion valuation, and everyone will make money. Yet the hero investor correctly believes that Snap is heavily overvalued and will profit handsomely when the chasm between flowery expectations and business reality is bridged. My question is whether this chasm can arise in the first place.
Why is Snap Overvalued?
If we define value as current and future owner earnings (free cash flows that can be taken out of the business without affecting its future cash producing capacity), Snapchat’s value is derived entirely from future owner earnings as currently they are not producing any (positive ones). Let’s look at how does Snap currently generate revenue to base our expectations as to how Snap will generate owner earnings in the future. Taken directly from their S-1 filing all revenues come from advertising, and in 2 ways:
- Sponsored Creative Tools. Creative tools refers to corporate sponsored lenses and location-based geofilters. See below.
- Snap Ads. These are regular ads, and they play in between user generated content.
Sponsored creative tools are interesting because they are currently a unique product with no direct competition. Yet being a monopolist in itself is not special if the underlying market is not valuable. Even though it costs Snap to design these unique filters and they depend on users choosing to apply them, I’m willing to agree that larger firms may see value in the filters and pay.
Unfortunately, the S-1 doesn’t segment what portion of Snap’s revenues of 58.7 million (2015) and 404.5 million (2016) came from Sponsored Creative Tools and what portion from Ads. We can safely assume that Ads make the bulk of the revenue, as the the creative tools cannot be scaled (you cannot offer a user hundreds of lenses). Regular video ads are the revenue driver of Snap, and there is large potential value in video ads.
In simple terms, video ads play in between stories which are 24-hour photo or video content shared by a user’s Snapchat contacts. Attention is derived from this rich user-generated content, and snapchat sells that attention to advertisers interested in the demographic. The costs Snapchat incurs is in maintaining the platform and hosting the content, and scale is supposedly achieved as more users adopt the platform. This is exactly the social media business model that Facebook is executing extremely profitably. Create a platform to generate content and reward creators with non-monetary social feedback (likes, reactions, views, upvotes) and sell for cash the attention to advertisers.
Differently from Facebook, Snap does not own its own servers. This converts Snapchat’s largest cost driver from fixed to variable, limiting economies of scale. This cost is very large, Snapchat has made 5-year contracts for cloud services with Google and AWS for 2 billion and 1 billion, respectively. This comes out to 600 million a year, which compared to their 2016 revenues of 404.5 million, raises a serious question mark over profitability. To keep in mind, Snap’s total costs for 2016 were 924.9 million, resulting in a net loss of 514.6 million. If Snap were so certain in their staying power and growing user base they should have invested in their own infrastructure and take advantage of scale.
Even with high costs, Snap has a potentially strong value driver with stories in the large and growing mobile advertising market which can lead to handsome future owner earnings. Yet very unfortunately for Snap it is not the monopolist in this area anymore. The introduction of Instagram stories has up-ended Snap’s largest opportunity and with that has captured a large value away from Snap.
Since launching in August 2016, Instagram stories have achieved 160 million daily users, which is equal to Snapchat’s daily users. Instagram is also popular with Snapchat’s key demographic, with 60% of Instagram’s 600 million users being in the 18–30 age range. In the quarter after the introduction of Instagram stories, Snapchat active daily user count grew by a paltry 3.27% , compared to 6.9% the previous quarter (Q3 2016) and 13.8% in the same period in 2015. Snapchat’s explanation is that problems in their android app limited use, which is both ridiculous and inexcusable if it was the real reason. Finally to add my own anecdotal experience, my Snapchat stories have experienced a stark decline in views and this has been the case with all Snapchat power users I interviewed. Moreover in the university environment I inhabit, most phones are viewing endless Instagram stories rather than Snapchat stories.
How did Instagram stories successfully capture users away from Snapchat stories?
- More feedback. What concurrent users of Snapchat and Instagram discovered is that uploading stories on Instagram nets them more views than on Snapchat, since people tend to have more followers on Instagram than on Snapchat, due to the openness of the platform (easy to search users, likes, comments and public on Instagram and private on Snapchat).
- Better product. Instagram stories feature higher quality video and photo, because Facebook, the parent can afford the hosting of larger files on its own servers. Snapchat cannot afford this, since its already paying billions for cloud services. In addition, many users are reporting superior user experience on Instagram.
- All-in-one experience. Instead of switching platforms, now Instagram users can only focus on growing and sharing with their larger Instagram followership, and do not need to switch apps.
As a last note, content creation is one thing and the number of people to whom the content is distributed is another key variable. On Snapchat people tend to include friends and acquaintances, while on the more public Instagram users have their friends in addition to a whole host of celebrities, brands, artists and other public figures. Given that the average Instagram user has more followers than the average Snapchat user, the user content is distributed to more people and and the same content generates more attention. Beyond this, Instagram generates more value with the same feature by leveraging the Facebook data of its users, allowing advertisers to specifically target their ad campaigns, while with Snapchat they’re forced to choose “millennials” as their only target.
In conclusion, Snap’s main revenue and value driver has been successfully replicated by a vengeful competitor. In any case, Snapchat will still exist with friends sending each other rich content directly, however the stories feature where content can be monetized has been compromised.
This deal-breaker combined with many other risk factors makes the IPO prospects at the current price very bleak. Among these risks I count the founding duo’s egos, which lead them to retain ALL control but inhibits them from retaining talent due to their autocratic management style and “bro” company culture.
The overvaluation is obvious
Retail investors are well aware of Snap’s business reality. The mismatch between Snap’s alleged price and business reality is far from secret.
Snap’s initial roadshow meeting in New York was met with skepticism. The FT quotes Lawrence Haverty of famed Gabelli funds as having issues with the price of the offering. Snap has been forced to revise its visions of grandeur and has revised twice its expected price range from the initial $20 to 25 billion to $19.5 to 22.2b, and finally $16.2 to 18.5b at the latest New York investor meeting.
In terms of numbers, in a recent post on Musings on Markets, Damodaran values the company at a mean estimate of $14 billion. The valuation depends on assumptions that Snap will keep getting a slice in mobile advertising against Facebook and Google which dominate the market. My assumptions are less optimistic, and in the scenario that Damodaran titles “Twitter Redux, […] user growth slows, user intensity comes under stress and advertising lags expectations” results in a market value of $4 billion.
To conclude, the retail investor that carry the bulk of every IPO, while far from perfect, are not stupid. They will not allow investing heroes to sell high and buy low on their backs. There seems to be 1) a wide range of expected outcomes, and 2) it is uncertain what the (right) contrarian thing to do is. As such on March 1 and soon thereafter, I recommend microwaving some popcorn, tuning in to Bloomberg TV and enjoying the show.
