Yesterday, Snap popped. Are investors cracked?

Snap’s an odd company which divides opinion

Yesterday Snap (NYSE: SNAP) floated on the New York Stock Exchange and promptly popped from $17 to $24 a share.

I wrote about it yesterday. Snap’s an odd company which divides opinion, so I decided to write about it on an odd schizophrenic way. Yesterday I wrote the optimistic equity investor case. Today I’ll play the curmudgeonly debt investor and do my best pick the company apart.

First thing to say is, I’m surprised the market has taken to Snap so enthusiastically. All the talk I was seeing in the last few weeks was pretty skeptical of Snap and its strange business model. Pre IPO, surveys of investors put the consensus price significantly below the $17/share launch price.

But the people love it! Maybe they were reading Risk and Reward yesterday, who knows.

What Snap does

A quick summary of Snap, from yesterday:

Snap is the company behind Snapchat, a messaging app for phones. It was started by Evan Spiegel as a project for his Stanford University product design class in 2011.

The genius of Snapchat is that the messages disappear once they’ve been viewed once. This doesn’t sound like a big deal, but it’s important. It’s basically the reason why Snap is valued at $22.5bn today.

When messages disappear after they’ve been read, the whole vibe around communication changes. It gets less serious. There becomes less need to respond to the message, or engage with what you’ve been sent. It makes the conversations more spontaneous, more emotional, more silly. It makes Snapchat stand out from a busy field of messaging apps.

That’s probably why Snapchat is a hit with teens and young people. It’s the kind of app you first hear about from your 13 year old cousin. Teens were the first to take to it, and they’re its most devoted users today. But now it’s popular with people of all ages.

The bull case for Snap goes something like this:

  1. Brand advertising is a huge pool of money. It’s around ten times bigger than direct marketing, which is Facebook and Google’s business.
  2. Brand advertising lives mostly on TV, because those type of ads work best in that format.
  3. Snapchat has become something like TV for young people. It’s fun, engaging, and full of video.
  4. Brand advertising will migrate to Snapchat.

So what’s wrong about that story?

The devil is in the detail

Snapchat has two problems.

The first is the number of users. Snapchat exploded in popularity around the start of 2016. In less than a year it went from 180m to 300m monthly users. And that was great – like the level of growth we saw in successful social networks like Facebook, Whatsapp and Instagram.

The problem is that at the end of 2016, the growth in users came to a sudden stop. It’s hard to know why. But you could speculate that Snapchat has saturated the millennial market, and that older demographics have less use for it than, say, Facebook.

The same thing happened to Twitter at roughly the same number of users. Twitter has turned into a useful social network for a particular type of person – not a universal social network with something for everyone. Lots of people have tried Twitter and decided it isn’t for them. Snapchat is silly and hard to use – the worry is that it’s not for everyone, either.

The second problem is related to the first problem. As the excellent Ben Thompson points out, it’s related to Snapchat’s marginal costs – the extra costs Snapchat has to pay to serve an extra user. In the ideal scenario – lets call it the Facebook scenario – marginal costs per user go up at first, then hit a peak, and then start to fall. And in Facebook’s case, marginal revenue was higher than marginal costs. This meant that as long as Facebook was adding extra users, it was making more money, and the amount of money it was making per user was going up.

Snapchat’s numbers don’t look so good. The first problem is that marginal costs per user keep on going up. This means a) Snapchat is losing money on each extra user, and b) Snapchat is losing an increasing amount of money on each extra user. This might not be a big deal if Snapchat were still adding hundreds of millions of new users, because economies of scale could get marginal costs “over the hump”. But if the total number of users is stalling it’ll be much harder to lower marginal costs (and to grow marginal revenue too).

The talk from Snapchat isn’t too encouraging. It doesn’t directly address the problem I’ve described here, instead promising to invest more and more in better and better products. It seems to want to innovate its way to more users and lower marginal cost per user.

I’d like to see progress on marginal costs per user and total user growth before I’d invest in Snapchat. But who knows, maybe they do solve that problem. And maybe in five years Ford and Unilever are beating a path to their door, and Snapchat is pumping out 30 second ads for cars and toothpaste, and Evan Spiegel is the richest man on the planet.

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