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SNAP – Party like it’s 1999!

Theo Maas – Portfolio Manager Arnhem Global SMA’s

SNAP Inc (SNAP), the makers of Snapchat, took their first official step to an IPO by filing their S-1 form in the US. Going through that document brought back a lot of bad memories from the late nineties when I was running a Global Technology fund for ABN AMRO. It starts on page 3 where SNAP describes themselves as a camera company. Not an internet, software or app company, but a camera company; how very ‘je ne sais quoi’. I hope it doesn’t turn out to be the next Kodak. Even the concept behind the company’s self-destructing messages is very nineties. I’m not sure if it was Inspector Gadget or Tom Cruise in Mission Impossible who first came up with the idea…”this message will self-destruct after 10 seconds..”. Then there is the total lack of regard for shareholder rights. Not even Google (or Alphabet these days) dared to strip all voting rights for new shareholders, but as a new shareholder in SNAP this is exactly the voting right you get: zilch, zero, nada. And then finally there is the very, very optimistic revenue-based valuation multiple. The company’s net loss is bigger than its revenue base (read that again if you have to). The only thing that is different to the bad old days, is that the company will list on the NYSE instead of NASDAQ.

Don’t get me wrong, I admire the amazing success that the company has enjoyed in its short life. The company started out as a picture messaging app called Picaboo in 2011, but quickly changed the name of the app to Snapchat. The primary differentiating feature of the app was that the pictures that were sent were self-deleting and hence users did not run the risk of having their pictures living on the internet forever. For some reason that became a popular feature with the adolescent user base. Adding more functionality, like filters and chatting, saw the user base grow rapidly in recent years.

Snapchat millions of average active daily average users (source: S-1 form)

The question potential investors should always ask of any social media company is: how do you monetise the users? There are two ways of doing that: a subscription model where users pay a monthly fee for service or running advertisements on the app. Given that SNAP’s user base is young (predominantly in the 18-34 age group), it is hard to charge them a fee. Millennials are not used to paying for social media use, as Facebook (which includes Whatsapp and Instagram) and Twitter have found out the hard way. Therefore it is not a surprise that SNAP’s revenues are exclusively derived from advertising. Revenues for SNAP have grown substantially and are now a little over US$400m. Based on the last quarter (Q416) this works out to just over US$1 per annum per user. This number varies wildly by geography with the US user base at US$2.15, Europe at US$0.28 and the Rest of World at US$0.15. The trick of course is to get this number up without upsetting your users and see them move to the next hot app. Keep in mind that we have very little history to go on (about 5 years of reliable history of Facebook, LinkedIn and Twitter numbers), but we do know that social media users can be a fickle bunch (Myspace anyone?).

Revenues are one thing, but these businesses also incur costs in order to derive those revenues. What is most alarming with SNAP is that this cost base is very high, almost twice as high as revenues. What is really surprising is that the gross profit (revenue minus cost of revenues) is negative as well. A business like SNAP will incur costs that are directly related to an existing user (or acquiring a new user) paying Apple and Google for access to their app stores, data centre space, cloud computing space etc.
In addition to Cost of Revenues, there are indirect costs like R&D, marketing and head office overhead. Normally, making a positive gross profit means that economies of scale will kick in and make sure that each new user will be more profitable than the previous one (as the indirect costs are allocated over a larger revenue base and hence the cost per user will come down). With a negative gross profit for SNAP, this remains to be seen.

SNAP P&L (Source: S-1 form)

We have often said and observed that a good company is not necessarily a good stock. Will this be the case for SNAP as well? To answer that we will have to make an assumption on how the market will value a stock like SNAP. Given its lack of profitability and its significant growth in revenues, the markets’ favourite valuation metric is a Price/Revenue multiple (similar to a P/E multiple, but instead of non-existing earnings per share you look at revenue per share). The biggest challenge we have is that the S-1 form for SNAP does not give a price range for its shares yet, but based on its last financing round in May 2016, we know that it is likely going to be between US$20bn and US$25bn. I think it is safe to assume the upper end of the range, given the ‘hotness’ of the IPO, so we are looking at a 2016 Price/Revenue multiple of 62 times. WOW! To contrast, I have included the much lower Price/Revenue multiples of Facebook, Twitter and LinkedIn (acquired by Microsoft in June 2016) in the graph below.

Price/Revenue multiples of Facebook, Twitter and LinkedIn (Source: CapitalIQ)

We know that SNAP in all likelihood will grow its revenues a lot faster than its three peers, but still that is a significant gap in valuation. Combine this with the inevitably long, hard road to profitability for SNAP (which its peers have successfully managed) and we have a potential investment problem, To add insult to injury, as noted above, the SNAP management team in its wisdom has decided to issue only non-voting shares. In other words, the new shareholders will have no vote in the strategy of the company.

This brings us to a simple conclusion with regards to the SNAP IPO: no thanks, not for us.

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© Arnhem Investment Management, 2017