Tuesday, May 22, 2018
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Snap Your Fingers For A Sinking Ship

  • Snap has had an interesting month, and with shares in the company trading at levels not seen since June 2017.
  • Breaking even, much less profitability, is a hugely ambitious target for Spiegel to have set, especially since the firm lost $720 million in 2017.
  • Short-term successes, a market buoyed by the optimism generated by Twitter finally generating a profit and hungry to see its rival Snap do just the same.

Snap (NYSE:SNAP) has had an interesting month, and with shares in the company trading at levels not seen since June 2017, when its stock was very much on the way down, and 35% off its post-IPO peak, cautious optimism seems to be slowly creeping its way onto the market, however the firm’s deep momentum, and its changeable reputation, may yet again prove the old adage what goes up, must come down.

Recently, a company-wide note sent by Snap CEO Evan Spiegel has put the firm back in the news. Spiegel told staff that breaking even is this year’s goal. Yet whether Spiegel can address the significant challenges his firm faces over the long term, investors willing to expose themselves to risk might find opportunity in the Venice, California-based company’s stock.

Does the one year share price for Snap indicate a potential longer-term rally or is it just a phantom?

SNAP CHART

The Short-Term Thesis

An investor considering increasing their exposure to the social media market might think they could do worse than an investment in Snap, after all the firm’s share price is rising, its financials are improving, and its CEO is bullish, however the firm’s history and three negative indicators suggest that the long-term outlook for Snap is very likely gloomy.

That said, as the sentiment behind Snap continues to climb, the opportunity may exist to make a speculative profit from Snap as it tries to regain mid-February levels in the low $20 range, from its current level close to $18. In the longer term, however, it would seem prudent to either hold-fire on Snap, or to consider shorting the stock if it comes close to testing the $17 and $18 marks, the most recent points of resistance.

Profitability?

Breaking even, much less profitability, is a hugely ambitious target for Spiegel to have set, especially since the firm lost $720 million in 2017, and analysts have forecast losses of up to $912 million this year.

Snap’s losses have climbed steadily. In 2016 the firm lost $293 million, and in 2017 this figure rose to $459 million. In percentage terms this means that in each of the past two years Snap’s losses have increased by 57%. Should analysts’ 2018 expectations hold, the rate of increase will fall to 27%.

Perhaps Spiegel wants to take a page out of Twitter’s (NYSE:TWTR) play-book, and cut costs in the pursuit of profitability – Snap recently dismissed over twenty HR staff and 120 engineers, indicating the firm’s current headcount of around to 3,000 is to be a near-term peak.

Yet, regardless of whether savings can be made on the staffing-side, Snap has increased its spend per user, raised R&D expenditure, and appears to believe that “expanding into new markets” is an achievable goal, as against a marketing statement for a firm that many believe has already reached its zenith.

Momentum Risks

A proverb more often associated with gravity than the stock market might seem a strange fit with a social media firm, and some stocks in the sector have defied it seemingly indefinitely — take a bow Facebook (NASDAQ:FB) — but despite Snap’s upbeat February earnings call that has buoyed the market for SNAP shares, it’s hard to see the kind of real lift behind Snap that could take it into Orbit. Don’t forget this is a company whose reputation relies so much on the celebrity “influencers” that back it that a tweet critical of the platform’s redesign from reality TV-star Kylie Jenner was able to send Snap’s share price tumbling 8%.

In the firm’s favor are the following facts: Q4 revenues grew 72% year-over-year, a figure which was 19% higher than the Reuters consensus, daily active users (DAU) grew by 18% in the last quarter to 187 million, and average revenue per user rose to $1.53 in Q4, up 46%. Even the firm’s earnings impressed, with EPS coming in at -$0.13, three cents above expectations, while top-line sales of $286 million beat expectations by 13%. Snap is growing, maximizing its income streams, and outperforming forecasts.

Unfortunately for Snap, its present growth tells only one part of the story. In 2017 the firm recorded a net loss of $3.4 billion, including stock-based compensation expenses. Filter these expenses out and losses still stand at a hefty $845 million. Revenue costs climbed 5%, and costs overall equaled 200% of revenue for the year 2017. Snap’s user growth is also slowing down, which is something often overlooked considering DAU climbs of 5% quarter over quarter and 18% year over year. In fact, a quarter by quarter analysis of Snap’s growth reveals that DAU growth is well on the way to plateauing and that the 100% DAU growth of 2014, or even the 50% growth of 2015, are best consigned to history.

Longer-Term Momentum Looks Down

The longer-term momentum for SNAP might be toward greater cost-efficiency as the firm cuts costs and improves its capacity to sweat its only real asset, its users, but there are limits to how much you can squeeze a group as fickle and variable as Snap’s key 18-24-year-old user-base. Vulnerable to debt and financial pressures, this market is also far less likely to develop a sticky relationship with what still amounts to a souped-up messaging platform.

Short-term successes, a market buoyed by the optimism generated by Twitter finally generating a profit and hungry to see its rival Snap do just the same, and the kind of hope that is endemic in the latter stages of a bull market all play a part in Snap’s climb from 2018 lows of $13.56 to highs of $20.42 a share. As is often the case with Snap, however, the momentum behind it feels like a case of the emperor’s new clothes.

Strategy and an Existential Crisis

Alongside the fact that the momentum that currently drives Snap’s shares up may well run out of steam as skeptical voices grow bolder, Snap faces an existential crisis. If the firm relies solely on the youngest age groups, it has little ability to protect itself from tastes that will invariably change, yet if it pursues an older market, Snap risks losing its cachet with its key user base, and has to take on platforms that are already strongly entrenched in their respective age markets, like Facebook and Twitter.

Right now, Snap are pursuing an older user base and taking such a risk. The firm aims to make 25-34 year olds its key demographic in the next three years and anticipates its younger client base will slowly taper off, with over 55s also starting to come on-board.

In a developing market, this strategy is all well and good, but Snap’s rivals have already adopted the firm’s unique characteristics as their own — see Instagram Stories for example — and there seems little in Snapchat that would lure people from markets that already have a leader.

Given the likelihood that younger users will be unhappy sharing what has until now been their own personal stomping ground with older siblings, adults, and parents, retention among Snap’s current core demographic is likely to prove increasingly problematic the more Snap’s demographic shifts.

Low Equilibrium Could Point to Eventual Collapse

The risk here is that Snap will be unable to maintain a sufficient degree of user stability as it tries to shift its demographics away from the youth market, and two factors suggest that maintaining such an equilibrium may prove extremely difficult: critical mass, and preferential attachment.

In 2017, Facebook’s net income rocketed 56% to $15.9 billion, and the firm achieved this without the support of the youth market. It doesn’t need them, and they don’t need it until perhaps they find out when they get older that they do. Facebook has hit a critical mass in terms of its size, its profits, and its market penetration.

To take on a market-leader with the clout that the California-based company has is a tough ask, to do it when little differentiates you other than your name and your experience seems an insurmountable task, and if you don’t think Snap can take on Facebook, and you don’t think it can keep its current position in the young-adult market, then it’s worth asking what is Snap for? If you can’t answer that, then the threat the future poses to the company is crystal clear, it may lack the critical mass to survive a significant shift in its market.

One other thing stands in the way of Snap establishing itself as more than just another upstart doomed to fail, the principle of preferential attachment. The physicist Albert-László Barabási, famous for his study in the field of networks coined the term preferential attachment, and loosely put it means that the more connections a single node in a network has — think a person, a computer, or a brain cell — the more likely that more connections will be made to it.

Bluntly put, if everyone over a certain age uses one platform, and I start making connections with people outside my immediate young-adult peer network, I start to migrate, yet if I already am a user, and have the Facebook average of 338 friends, changing my social network means incurring a heavy loss to my wider social capital. Snap offers current users of Facebook no networking incentive to make the move, while Snap users have all the incentive they need to abandon what may ultimately end up a sinking ship.

Conclusion

For a firm that just can’t make it rain, and faces risks including heightened uncertainty, a competitive environment, slowing user growth, a lack of social capital, and a fickle user-base, Snap is doing well to grow at all, yet the firm’s lack of a track-record, its high costs, and the pressure it is under to ramp up the revenues each user generates, points to the possibility that Snap lacks that certain élan vital to make it a long-term rival for the leaders in the social media space, and even perhaps for it to survive as a going concern.


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