Should you invest in Snap’s IPO?

Snapchat’s parent company Snap filed publicly for its IPO on Thursday and will soon list on the NYSE under the ticker symbol ‘SNAP’. This is the most anticipated tech IPO in years and will cement CEO Evan Spiegel as one of the richest and most influential figures in tech. Now the question for many becomes whether or not to invest. While the company will not release valuation metrics until it completes its roadshow, below are some considerations based on information in the filing. I have broken down my thoughts into key highlights (what really excites me about the opportunity?) and key risks (what concerns do I have?).

Key Highlights: What excites me about the opportunity?

  • Significant scale: As of December 31, 2016, Snapchat reported 158 million Daily Active Users. While not publicly reported, Snapchat likely has a high DAU / MAU ratio, upwards of 60% (in-line with comps such as Facebook). Given this, Snapchat has over 250 million MAU. For comparison purposes, Twitter reported 317 million MAU last quarter, and Instagram recently announced that it has crossed 600 million MAU. While smaller than these competitors, Snapchat’s scale is still incredible, especially in North America where it has more daily actives than Twitter has monthly actives. Most importantly, these users are concentrated among the hard-to-reach teen demographic that is so desired by advertisers.
  • Strong engagement: A majority of the company’s users are between the age of 18 and 34 years old. Users 25 and older visit Snapchat, on average, 12 times per day and spend approximately 20 minutes in the app. Users younger than 25 visit Snapchat, on average, 20 times per day and spend 30 minutes in the app. For comparison, Facebook users spend 50 minutes per day on its different apps and services including Instagram and Messenger. Across the entire Snap userbase, 2.5 billion snaps are created and over 10 billion snaps are viewed daily. More than 60% of DAU create snaps daily, more than 60% engage in chat daily, and over 25% post to their Story each day. It is rare to see such strong engagement.
  • Major monetization upside: In North America, Snap’s ARPU (defined as revenue divided by daily active users) in Q4 2016 was $2.15, up from $0.65 for the same period the prior year. For comparison, Facebook generated over 10x the revenue per user during the same quarter.* When Facebook went public in 2012, North American ARPU hovered around the $3–4 range. Snap only recently started monetizing its userbase and has several ad products, ranging from sponsored creative tools to Snap Ads with attachments. The company is opening up its ad platform, which gives advertisers a self-serve option, and has built better measurement and delivery capabilities over the last year. Snap’s advertising business is still young, but has tremendous upside potential.
  • Investment in product innovation: From the S-1: “The best way to compete is to make great products that people will want to use.” Snapchat has a strong history of product innovation, driven by heavy investment and a willingness to take risks. However, as companies go public, there is a slow, but steady death of innovation. Companies start managing to quarterly earnings and focusing on the short-term as opposed to the long-term. Missing forecasted earnings by even the slightest margin will send a stock price tumbling. By controlling voting, Snap can make “long-term strategic investment decisions and take risks that may not be successful and may seriously harm [its] business.” The voting rights, while infuriating to investors, sound like they might be in place to protect innovation.
  • Twitter’s fall creates major opportunity: The last thing advertisers want is a platform duopoly between Google and Facebook. The consequences of two companies becoming the gatekeepers for advertising are significant. Paul Frampton, CEO of Havas Media Group claims that “freedom of choice to work with multiple partners leads to smarter thinking and better ideas…[Snapchat] is beginning to challenge Facebook and Google, particularly in the US.” For several years, Twitter was in pole position to break up the duopoly, but the company’s failures have created an opening for Snapchat.
  • Evan Spiegel: Much of Snap’s success is due to Evan Spiegel and his vision and leadership. Evan has a different way of seeing the world and is not afraid to challenge industry norms. He has often been compared to Microsoft’s Co-Founder, Bill Gates, and Facebook’s Chief, Mark Zuckerberg.

Key Risks: What concerns me about the opportunity?

  • No voting rights?!: In the IPO, Snap is offering investors non-voting shares, which is unprecedented. As a result, CEO Evan Spiegel and CTO Bobby Murphy will have the ability to control the outcome of all matters submitted to stockholders for approval, even if one or both of them are fired by the board. This control includes election or removal of directors, and any decisions regarding a merger or sale. While Facebook and other companies have issued special shares to founders, Snap will be the first US IPO to issue shares without voting rights to new investors. This could create an antagonistic relationship between the company and future shareholders. As of Friday, several investors signed a letter urging Snap to adopt a single-class structure.
  • Slowing growth: While it is natural to expect deceleration of user growth as a company scales, the slowdown in Snapchat’s active users is alarming. After averaging an increase of 15 million users per quarter for the first three quarters of 2016, the company only added 5 million daily active users in Q4. In the S-1, the company noted that growth was relatively flat in the early part of the quarter with increased competition being one of the key reasons. As we’ve seen with Twitter, slow user growth can be deadly for a public company, especially when it is considered a “growth” stock.
  • Competition: It is no surprise that Snapchat plays in a competitive space. The company faces direct competition from Facebook, Instagram, Google, Apple, and Twitter domestically as well as from Kakao, LINE, Naver (Snow), and Tencent internationally. Facebook (including Instagram) has blatantly copied Snapchat, and it was recently reported that Instagram Stories recently crossed 150 million DAUs, making it just as large as Snapchat. Most of these companies have greater resources and have the ability to draw users away from Snap. The $3B raised in the IPO will be helpful cash reserves for the Snap to try to fend off larger competitors. In addition to competition on the user front, Snapchat competes with many of these platforms for advertising budgets.
  • What about international?: Facebook has always seen the international market as a growth opportunity. Of Facebook’s 1.2 billion DAUs, more than 85% are based internationally. Comparatively, of Snap’s 158 million DAUs, only 58% are based outside the US, generating less than 10% of revenue. Snap sees far more engagement on iOS than Android and has prioritized iOS development. It is well known that Android has a large lead over iOS in terms of worldwide smartphone market share. In order for Snap to scale to Facebook’s levels, it must diversify into other markets successfully, which might require more of a focus on Android. Competition from lookalikes such as Snow (~50 million MAUs) have made it difficult for Snap to penetrate key international markets. Perhaps the focus on specific markets is strategic. In the S-1, Snap states that its growth focus has been on the top 10 advertising markets, with 60% of DAU coming from these markets.
  • Fickle Teens: Snapchat’s young target demographic is one of the company’s biggest assets, but also its biggest risk. This group is “less brand loyal and more likely to follow trends than other demographics.” The barriers to entry and switching costs are low, making it possible for other products (e.g. Instagram Stories) to easily take users away if they can provide a strong value proposition. Further, Snapchat has yet to diversity its user base beyond its young demographic. Few companies from the US have been able to scale beyond 300 million MAUs successfully. In order to break this threshold, Snap will have to figure out how to acquire new users while retaining current ones. As users age, will they lose interest in Snapchat (“the age effect”), or will they stick with the product because it becomes habit (“the cohort effect”)?
  • Profitability: In 2016, while Snapchat grew revenue 7x year-over-year, generating $404 million in revenue, it did so with negative gross margins and a $514 million net loss. Snap mentions in the risk factors that it may “never achieve or maintain profitability”. In addition, Snapchat is heavily reliant on Google Cloud for computing, storage, and bandwidth, committing to spend $2 billion over the next five years. If the relationship is disrupted, this could be seriously harmful to Snap.

It is difficult to make a recommendation without valuation guidance. Current estimates peg Snap’s valuation at ~$25B, which would equate to 62x 2016 revenue, and 25x 2017 revenue, assuming Snap generates $1B in sales this year. There are several major concerns around slowing growth, profitability, voting rights, competition, and (likely) valuation. Given this, Snap is impressive in several regards: 1) the company has a strong commitment to innovation, which is unlike many tech companies I’ve seen in the last 10 years, 2) it has encapsulated how teens and young adults communicate with one another, and 3) it is led by a visionary CEO, Evan Spiegel who drives the company and has proven doubters wrong time and again. When Eric Schmidt calls you “the next Gates or Zuckerberg”, that means something.

I believe in the long-term value of the company. What do you think about Snap’s IPO? Would you invest?

Disclaimer: Between 2012 and 2015 I worked at Institutional Venture Partners (IVP) where we led Snapchat’s Series B investment. During the summer of 2016, I worked at Snapchat as an MBA intern on the growth team. Everything mentioned in this article is based on publicly reported information.