Inside Snap’s IPO

On February 2nd, Snap Inc. filed their Form S-1 with the intent to go public. In their public offering, Snap expects to raise $3 billion at an expected valuation of $20 to $25 billion. For comparison,

Snap’s S-1 extends to over 221 pages. What you probably did not know about S-1 filings is the initial form is 8 pages despite an OMB estimate that they require 972.32 hours to complete. Under the December 2015 revised JOBS act, Snap qualifies as an “emerging growth company” because its annual revenues are below $1 billion. (At least as of 2016. Snap is reported to be aiming for revenues above $1 billion in 2017.) Snap’s status as an “emerging growth company” allowed it to confidentially file for an IPO in November 2016, released to the public only 15 days before its road show.

“History doesn’t repeat itself but it often rhymes” — Mark Twain

Snap calls itself “a camera company,” an interesting niche with its branding. There is no other mobile application calling itself a camera company. I may be the first to publicly ask, is Snap like yesterday’s behemoth camera companies? Think Eastman Kodak, Canon, Nikon, and even GoPro. If the answer is yes, their capital intensity (the amount of fixed assets used in production) is different. Whereas these other businesses historically relied on factory workers and machines, Snap relies on software engineers and sales personnel. As Jeff Sommer wrote in the New York Times last year, “These days every company is a tech company, but some have better niches, faster growth, more attractive offerings or more favorable share prices than others.”

I am not Snap’s fate will be like that of Eastman Kodak. However, we would only be smarter for the consideration. At its peak in 1997, Eastman Kodak was worth $30 billion. I imagine CEO Evan Spiegel and his management team study Kodak’s successes and failures diligently. Snap does great work, employing over 1,800 people. That materially impacts the local economy and those families. On a larger level, it contributes to the connectivity of people across the globe. I hope their success continues.

It’s my thought that seeing Snap as a camera company is a differentiated way of framing the business. The product line could be: Snapchat today, Spectacles tomorrow, and augmented reality (AR) or other unique software in the next few years. As long as it draws eyeballs, advertisers will pay it dollars.

Wait ’til I get my money right
Then you can’t tell me nothing, right?
–Kanye West, “Can’t Tell Me Nothing”— Ben Horowitz

After the IPO, others will gaze in awe at Snap’s abundant balance sheet. Oh what one can do with $4 billion of cash, no debt, and complete control over all voting stock.

Be forewarned though. As legendary value investor Peter Cundill warned, The problem with cash is it is prone to theft and stupidity.

Is Snap’s cash chest an advantage? Perhaps. It definitely beats the alternative. What Ben Horowitz wrote about the Twitter IPO applies perfectly here,

When you generate cash, you can respond to silly requests from the capital markets the way Kanye would: “Excuse me, is you saying something? Uh uh, you can’t tell me nothing”

Comparing Apples to Apples or DAUs to DAUs

In his paper “Reflections of the Ten Attributes of of Great Investors,” Michael Mauboussin highlights great investors are “numerate (understand accounting),” “understand value (the present value of free cash flow),” and “properly assess strategy (or how a business makes money).”

(Fun fact: Mauboussin teaches Ben Graham’s Security Analysis class at Columbia. He is also a hero of Bill Gurley who said, “I would not be where I am today probably if I hadn’t met Michael back then. He was the food analyst and I was the PC (personal computer) analyst, and somehow he found a way to shape everything I did and have a huge impact on my career.”)

In this section, I compare Snap’s economics with competitors I’ve identified: Twitter, LinkedIn, Yelp, Zynga, and Facebook. Snap points to Apple, Facebook, Google, and Twitter as businesses that focus on mobile engagement and advertising. Instead, my choices are based on companies with a major mobile or social presence. The hardware component of Apple and the search component of Google prove these businesses to be poor comparable companies when comparing financials.

Business at IPO

How does Snap compare to its peers when they went public? Here are some positives in Snap’s favor:

  • Their cash balance is over a billion dollars. Only Facebook had more cash and priced its IPO at $104 billion. Snap lost more money in 2016 than it earned in revenue. Their cash balance acts as a cushion in the short-term.
  • Their average revenue per user (ARPU) is low despite having 158 million daily active users (DAUs). Many investors cushion their downside with investments in businesses with below average margins. An optimist would argue Snap’s ARPU is poised to double or triple over the next year or so. (The critical assumption being continued daily usage)

Curious about the negatives?

  • Stock-based compensation is higher than any other business on a gross and per employee basis. Despite it being an annual expense, it distorts their cash burn. On a per employee basis, their SBC is quadruple the average. If employees sell their options at the $25 billion expected market cap, could their productivity decline? There are sure to be a few millionaires minted with this IPO.
  • The $515 million net loss is beyond anything institutional investors have ever seen. Then it is followed up with this risk, “We have incurred operating losses in the past, expect to incur operating losses in the future, and may never achieve or maintain profitability.” From a business perspective, losses of $500 million on $400 million of revenue are unsustainable. From a valuation perspective, growth expectations are set extremely high. Miss a quarterly growth rate, and investors will jump ship.

Trailing Twelve Months (TTM)

Industry standards have certainly changed since LinkedIn and Zynga went public in 2011. Compensation, mobile adoption, and advertising opportunities are higher and more abundant than ever before. Consider Snap versus its peers now. Its TTM revenue, ARPU, revenue per employee, net loss, and loss per share fall below each its peers except for having higher revenue per employee than Yelp. As the chart above indicates, Snap’s cash trove offers plenty of upside optionality for years to come. At a $25 billion valuation, several billion dollars of cash is not impressive. Growth is.

Unit Economics

A discussion of venture-funded business is not complete without discussing unit economics. At its current level, Tim Connors of PivotNorth Capital presents a rough sketch of the unit economics,

  • “Roughly $2.50 to acquire and monetize a new user (and getting more expensive fast with v low and slowing growth)
  • Each user generates $3 in ad revenue per year
  • Each user costs them $3.25 in Google data center costs per year to store their pictures (so negative gross margin still at 150M users)
  • Plus another $1+ per user a year in R&D costs
  • Plus another $1+ per user a year in G&A costs”

Snapchat’s global ARPU is $1.05. Its North America ARPU is $2.15. Management and investors expect ARPU to continue to grow. Indeed, eyeballs are clearly on mobile platforms. What we don’t know is how much they are worth. Ultimately, Snap’s revenue and user growth is uncertain.

Competition among mobile platforms are fierce. It is the same dynamic which occurred in broadcast TV among companies like CBS, ABC, and NBC. You can only watch one TV channel at once, and you can only interact with one mobile app at a time. We have a few forces at play in Snap’s future growth. First mobile phone adoption rates favor a growth in user base. As they say, a rising tide lifts all boats. Second the law of large numbers argues meteoric growth rates cannot last forever. There are only so many humans on earth. For example, Sanpchat’s 2016 Q4 growth rate fell to its lowest ever at 3.2%. Third, competitor product launches raise expectations about what a product must have. Finally, ARPU depends on businesses willing to pay dollars to advertise on a platform with hard to quantify returns on investment. Sure, I think advertising on Snapchat is effective. How do I justify that to my boss?

Advertising on photo-sharing platforms is exciting yet daunting. Exciting because of opportunities for well-designed and targeted advertisements. Daunting because photo storage has higher cloud costs than text. It makes the unit economics all the more different.

However, not all ARPU is created equally because not all engagement is equal. Engaging on Facebook, Instagram, or Twitter with an ARPU above $7.00 is different than engaging on Snapchat. The main Snapchat feed is currently populated more with one’s friends while other social media services have a main feed friendlier to engaging with advertisers. Similarly, many use Twitter, Instagram, LinkedIn and Facebook to engage with businesses and news sources. Snapchat’s engagement is unique from any other mobile application. Understanding that suggests advertisers use the platform in a different way.

Who owns Snap Inc?

Many news sources have reported on the Snap voting structure in more detail than I can. Here’s my summary: there are three classes of stock. Class A is non-voting. Each share of Class B stock is entitled to one vote. Each Class C share is entitled to 10 votes.

Co-founders Evan Spiegel and Robert Murphy have control. If done well, this structure can promote a long-term perspective where the focus is on improving the business over the next several years and not for the next quarter.

I am not wet behind the ears. We knew most individuals are criticizing this structure for its concentration of control. Indeed, it presents key man risk. If something happens to Spiegel or Murphy, who votes in their absence? Do we have another Sumner and Shari Redstone situation? On the other hand, Berkshire Hathaway has prospered with key man risk for decades. Only time will tell.

In the venture capital ecosystem, Benchmark and Lightspeed Venture Partners each own over 5% of Snap. Digging a bit deeper, the Benchmark Capital Partners VII fund is a $510 million fund. The Lightspeed Venture Partner IX fund is a $675 million fund. A back of the envelope calculation reveals these home run investments returned each fund several times over. Congrats to these fine investors. Lesson here: vintage matters.

CEO pay?

There are odd parts of the S-1 others have written about, including Snap’s relationship with the law firm of the CEO’s father, Munger, Tolles, and Olson LLP (Yes that Munger) and its multi-million dollar loans given out to executives. The quirk I wanted to discuss that seems material to the business is CEO compensation. The question I want to answer is it in line with comparable companies?

In the discussion on voting shares, we learned “on the closing of this offering, Mr. Spiegel will be granted the CEO award for shares of Series FP preferred stock representing 3.0% of all outstanding shares on the closing of this offering, which will become an RSU covering an equivalent number of shares of Class C common stock on the closing of this offering.” In English, Spiegel’s reward for taking the company public is a bonus of 3% of shares outstanding. He will own 25.4% of shares outstanding following the IPO. At its expected $20 billion to $25 billion valuation, this bonus is worth around $725 million. In total, Spiegel could be valued at $6.35 billion after the upcoming IPO.

It is paramount to remember these figures depend on Snap’s valuation. Can Spiegel sell these shares? Not exactly. Management sales of stock are typically a negative signal for investors. Investors understand the need for liquidity. Individuals have obligations, such as college tuition, bills, and the occasional vacation. However, in a classic example of game theory, a CEO who sells millions of dollars worth of stock can be indicating one of several things:

  • Are there signs of distress on the horizon? They know more about the business than the investing public.
  • Are they getting red Ferrari syndrome? After the grueling years of founding a company, the CEO may want to focus more on toys such as cars, homes, and vacations, instead of their business.
  • Are they donating it to charity?

Given the range of possibilities, investors will typically err on the side of selling when insider sells spike. There is research backing this up as well. With the multitude of public companies, why stay invested in a company with a management team who may not believe in the future of their employer? Evan Spiegel does not have $6.35 billion.

Second, I want to compare management pay. Starting with salary, the management team at Snap currently earns on average about $380,000 a year. Conversely, Twitter, Facebook, Zynga, LinkedIn, and Yelp averaged between $200,000-$300,000 in management salary at IPO. Management salary at Snap seems to be in line with the times at companies like theirs. Each company referenced previously had generous stock options, Snap included.

Compensation is much more an art than a science. After its IPO, Mark Zuckerberg joined Steve Jobs, Sergey Brin, Larry Page, and many others in the one-dollar salary club. Will Evan Spiegel do the same?

Feedback? Questions? Comment below.