With the Snap Inc. IPO just a day away, the big question is, "Should you buy into the Snapchat IPO?" We think the risks clearly outweigh the potential reward.
One of the biggest technology IPOs in a long long time is coming our way. Yes, we are talking about the much-talked about IPO of Snap Inc (NYSE:SNAP) the parent of Snapchat, the Venice, California-based photo sharing platform. The news mill has been buzzing as more and more details emerge as we near the IPO date. With the IPO just a day away, the big question to ask is whether or not Snapchat IPO is worth buying into. Can the company justify the huge valuations it is seeking?
Snapchat's User growth is stalling?
Growth has been one of the metrics where Snap, Inc. seems to be rolling; be it in users, revenues or losses. Yes, while the topline growth has been exceptionally good, the swell in its growing losses is equally worrisome. Snapchat's company has seen its losses swell at an even steeper rate. While the steep rise in its losses is obvious, what's not very obvious is that Snapchat's user growth is beginning to stall. A lot has been said about the rapidly growing user base of Snapchat. But, a deeper look reveals troubling facts. Not everything is as rosy, on this front, as many SNAP bulls would have you believe.
Well, Facebook just outgrew Snapchat in the last quarter of 2016. Before you conclude that's a joke, consider this. As quoted in an earlier post on Snapchat IPO, while referring to DAU (Daily Active User) growth, we wrote "Snapchat's user growth is showing a clear sign of plateauing, so early in its life cycle. The company printed QoQ growth rates of 14%, 17.2%, 7%, and 3.3%, respectively, for the 4 quarters of 2016. The comparable numbers for Facebook were 5%, 3.5%, 4.5%, and 4.1% for the 4 quarters of 2016." More disturbingly, the slowdown in Snapchat's user growth coincides with the 'stories' launch by Instagram, the Facebook (NASDAQ:FB) owned competitor to Snapchat. Any talk of a sustainable moat should end right here.
Snapchat's Unique Business Model
Snapchat has evolved into a business model which requires a tremendous scale to become profitable. Why? Well, the company has to pay huge costs to infrastructure service providers. Add in the fact that its video/photo heavy content only increases the infrastructure needs and you have an extremely low margin business. And, well, low margin business at just the gross level. In fact, as reported by Bloomberg Gadfly's Shira Ovide, Snapchat has only recently turned profitable on the gross level with a 7 cent gross profit for every dollar of revenue in Q4. Over the longer term, the picture is scary, at best. The cost of revenue came in at 311% and 112% of the revenue for 2015 and 2016, respectively. And what could be the implications?
Snapchat's Model makes user expansion a costly strategy. Why? Every additional user means a greater amount of content shared. By the same measure, a highly engaged userbase also leads to more content shared on the platform. Operating expenses, excluding the cost of revenues, came in at 117% of revenue in FY 2016, which adds to the company's gross margin worries. So what could the long term margins look like? James Cordwell from Atlantic Securities thinks Snapchat's long-term GAAP operating margin is "unlikely to be higher than 15%." In comparison, Facebook has an operating margin of around 45%. This business model makes Snapchat a low margin business, which also means that the company will need to scale, and do that quickly, if it wants its bottom line out of the red.
A raw deal At Lofty Valuation?
Well, the lofty valuations which Snapchat seeks is something which most investors/readers will be aware of now. As reported in our earlier coverage of the Snap Inc. IPO, Snapchat was gunning for a $19B - $22B valuation seeking to value the company at a price-to-sales multiple in the range of 47-55 times the trailing twelve-month (TTM) sales. Well, if that wasn't expensive enough, Snapchat might, in fact, go public at a price of $17-$18 per share against the earlier anticipated $14-$16 per share. That would push the sales multiple to a range of 57-62. If Snap Inc. does price its IPO at the rumored range, the company would have outdone any of its peers, including Twitter, in terms of valuation at IPO. The micro-blogging network was valued at 45 times its TTM sales at the time of its IPO in 2013.
Lastly, before running to grab a piece of the so-called 'camera-company' investors should understand what they get. Snapchat's business model isn't the only unique bit about the company. The company has also adopted a first of its kind share structure. So what's unique about it? IPO investors get zero voting rights. While that's not a first, the co-founders get 10 votes on each of their shares while other pre-IPO investors get one vote per share. In short, post-IPO investors get the steep valuations, a uniquely low margin business and lots and lots of "hope" that the company will outgrow these lofty valuations. All without the basic rights (to vote) of a shareholder.
Based on the latest news, Snap, Inc. the parent of Snapchat, is reportedly seeking a valuation in the range of $23B-24.75B, which values the company at 57x TTM sales, at the lower end. The negatives of steep valuations, a low margin business, possibility of stalling user growth and a three-tier share structure far outweigh the positive of stellar revenue growth. We think investors should let the Snapchat IPO pass and seek better risk-reward play to invest their hard money. The Snapchat IPO comes across as an unfavorable risk-reward play.