Five years ago, when my daughter asked me whether I had Snapchat installed on my phone, my response was “Snapwhat?” In the weeks following, she managed to convince the rest of us in the family to install the app on our phones, if for no other reason than to admire her photo taking skills. At the time, what made the app stand out was the impermanence of the photos that you shared with your circle, since they disappeared a few seconds after you viewed them, a big selling point for sharers lacking impulse control. In 2013, when Facebook (FB) offered $3 billion to buy Snap, it was a clear indication that the new company was making inroads in the social media market, especially with teenagers. When Evan Spiegel and Bobby Murphy, Snap’s founders, turned down the offer, I am sure that there were many who viewed them as insane, since Snap had trouble attracting advertisers to its platform and little in revenues, at the time. After all, what advertiser wants advertisements to disappear seconds after you see them? Needless to say, as the IPO nears and it looks like the company will be priced at $20 billion or more, it looks like Snap’s founders will have the last laugh!
Snap: A Camera Company?
The Snap prospectus leads off with these words: Snap Inc. is a camera company. But is it? When I think of camera companies, I think of Eastman Kodak, Polaroid and the Japanese players (Fuji, Pentax) as the old guard, under assault as they face disruption from smartphone cameras, and companies like GoPro (GPRO) as the new entrants in the space, struggling to convert sales to profits. I don’t think that this is the company that Snap aspires to keep, and since it does not sell cameras or make money on photos, it is difficult to see it fitting in. If you define business in terms of how a company plans to make money, I would argue that Snap is an advertising business, albeit one in the online or digital space. I do know that Snap has hardware that it is selling in the form of Spectacles, but at least at the moment, the glasses seem to be designed to get users to stay in the Snap ecosystem for longer and see more ads.
So, why does Snap present itself as a camera company? I think that the answer lies in the social media business as it stands today, and how entrants either carve a niche for themselves or get labeled as me-too companies. Facebook, notwithstanding the additions of Instagram and WhatsApp, is fundamentally a platform for posting to friends, LinkedIn (LNKD) is a your place for business networking, Twitter (TWTR) is where you go if you want to reach lots of people quickly with short messages or news and Snap, as I see it, is trying to position itself as the social media platform built around visual images (photos and video). The question of whether this positioning will work, especially given Facebook’s investments in Instagram and new entrants into the market, is central to what value you will attach to Snap.
The Online Advertising Business
If you classify Snap as an online advertising company, the next step in the process becomes simple: identifying the total market for online advertising, the players in that market and what place you would give Snap in this market. Let’s start with some basic data on the online advertising market.
- It Is a Big Market, Growing and Tilting to Mobile – The digital online advertising market is growing, mostly at the expense of conventional advertising (newspapers, TV, billboards) etc. You can see this in the graph below, where I plot total advertising expenditures each year and the portion that is online advertising for 2011-2016 and with forecasted values for 2017-2019. In 2016, the digital ad market generated revenues globally of close to $200 billion, up from about $100 billion in 2012, and these revenues are expected to climb to over $300 billion in 2020. As a percent of total ad spending of $660 billion in 2016, digital advertising accounted for about 30% and is expected to account for almost 40% in 2020. The mobile portion of digital advertising is also increasing, claiming from about 3.45% of digital ad spending to about half of all ad spending in 2016, with the expectation that it will account for almost two thirds of all digital advertising in 2020.
- With Two Giant Players – There are two dominant players in the market: Google (GOOG), with its search engine, and Facebook with its social media platforms. These two companies together control about 43% of the overall market, as you can see in this pie chart:
If you are a small player in the US market, the even scarier statistic is that these two giants are taking an even larger percentage of new online advertising than their historical share. In 2015 and 2016, for instance, Google and Facebook accounted for about two-thirds of the growth in the digital ad market. Put simply, these two companies are big and getting bigger and relentlessly aggressive about going after smaller competitors.
In a post in August 2015, I argued that the size of the online advertising market may be leading both entrepreneurs and investors to over estimate their chances of both growing revenues and delivering profits, leading to what I termed the big market delusion. As Snap adds its name to the mix, that concern only gets larger, since it is not clear that the market is big enough or growing fast enough to accommodate the expectations of investors in the many companies in the space.
Snap: Possible Story Lines
To value a young company, especially one like Snap, you have to have a vision for what you see as success for the company, since there is little history for you to draw on and there are so many divergent paths that the company can follow, as it ages. That might sound really subjective, but without it, you are at the mercy of historical data that is both scarce and noisy or of metrics (like users and user intensity) that can lead you to misleading valuations.
That is, of course, another shameless plug for my book on narrative and numbers, and if you have heard it before or have no interest in reading it, I apologize and let’s go on. To get perspective on Snap, let’s start by comparing it to three social media companies, Facebook, Twitter and LinkedIn and to Google, the old player in the mix, at the time of their initial public offerings. The table below summarizes key numbers at the time of their IPOs, with a comparison to Snap’s numbers:
|Number of Users||NA||80.6||845||218||161|
|User minutes per day (January 2017)||50 (Includes YouTube)||NA||50||2||25|
|Market Capitalization on offering date||$23,000||$9,000||$81,000||$18,000||?|
|Link to Prospectus (from IPO date)||Link||Link||Link||Link||Link|
At the time of its IPO, Snap has less revenues than any of its peer group, other than LinkedIn, and is losing more money than any of them. Before you view this is a death knell for Snap, one reason for Snap’s big losses is that unlike its competitors, Snap pays for server space as it acquires new users, thus pushing up its operating expenses (and pushing down capital investment in servers). There is one other dimension where Snap measures up more favorably against at least two of the other companies: its users are spending more time on its platform that they were either on Twitter and LinkedIn, and it ranks second only to Facebook on this dimension.
The more important question that you face with Snap, then, is which of these companies it will emulate in its post IPO year. The table below provides the contrast rather by looking at the years since the IPO for each company.
Google and Facebook stand out as success stories, Google because it has maintained high revenue growth for almost a decade with very good profit margins and Facebook doing even better on both dimensions (higher growth in the earlier years and even higher margins). The least successful company in this mix is Twitter, which has seen revenue growth that has trailed expectations and has been unable to unlock the secret to monetizing its user base, as it continues to post losses. LinkedIn falls in the middle, with solid revenue growth for its first four years and some profits, but its margins are not only small but showed no signs of improvement from year to year. Now that it has been acquired by Microsoft, it will be interesting to see if the combination translates into better growth and margins.
My Snap Story & Valuation
To value Snap, I built my story by looking at what its founders have said about the company, how its structured and the strengths and weaknesses of its platform, at least as I see them. As a consequence, here is what I see the company evolving.
These assumptions, in turn, drive my forecasts of revenues, margins and reinvestment. In my story, I don’t see Snap reaching revenues of the magnitude delivered by Google and Facebook, the two big market players in the game, settling instead for smaller revenues. If Snap is able to hold on to its target market (young, tech savvy and visually inclined) and keep its users engaged, I think Snap has a chance of delivering high operating profit margins, perhaps not of the magnitude of Facebook today (45% margin) but close to that of Google (25% margin). Finally, its reinvestment will take the form of acquisition of technology and server space to sustain its user base, but by not trying to be the next Facebook, it will not have to over reach. Is there substantial risk that the story may not work out the way I expect it to? Of course! While I will give Snap a cost of capital of close to 10% (and in the 85th percentile of US companies), reflective of its online advertising business, I will also assume that there remains a non-trivial chance (10%) that the company will not make it. The picture below captures my story and the valuation inputs that emerge from it:
To complete the valuation, there are two other details that relate to the IPO.
- Share Count – For an IPO, share count can be tricky, and especially so for a young tech company with multiple claims on equity in the form of options and restricted stock issues. Looking through the prospectus and adding up the shares outstanding on all three classes of shares, including shares set aside for restricted stock issues and assorted purposes, I get a total of 1,243.10 million shares outstanding in the company. In addition, I estimate that there are 44.90 million options outstanding in the company, with an average exercise price of $2.33 and an assumed maturity of 3 years.
- IPO Proceeds – This is a factor specific to IPOs and reflect the fact that cash is raised by the company on the offering date. If that cash is retained by the company, it adds to the value of the company (a version of post-money valuation). In the case of Snap, it is estimated that roughly $3 billion in cash from the offering that will be held by the company, to cover costs like the $2 billion that Snap has contracted to pay Google for cloud space for the next five years.
These valuation inputs become the basis for my valuation and yield a value of $14.4 billion for the equity (and you can download the spreadsheet at this link).
Allowing for the uncertainty inherent in my estimates, I also computed probability distribution for three key inputs, revenue growth, operating margin and cost of capital, and my value for Snap’s equity is in the distribution below:
Assuming that my share count is right, my value per share is about $11 per share. As you can see though, as is the case with almost any young company where the narrative can take you in other directions, there is a wide range around my expectations, with the lowest value being less than zero and the highest value pushing above $66 billion ($50/share). The median value is $13.3 billion and the average is $14.9 billion; one attractive feature to investors is that there is potential for breakout values (optionality) that exceed $30 billion.
- The numbers at the high end of the spectrum reflect a pathway for Snap that I call the Facebook Light story, where it emerges as a serious contender to Facebook in terms of time that users spend on its platform, but with a smaller user base. That leads to revenues of close to $25 billion by 2027, an operating margin of 40% for the company and a value for the equity of $48 billion.
- The numbers at the other end of the spectrum capture a darker version of the story, that I label Twitter Redux, where user growth slows, user intensity comes under stress and advertising lags expectations. In this variant, Snap will have trouble getting pushing revenue growth past 35%, settling for about $4 billion in revenues in 2027, is able to improve its margin to only 10% in steady state, yielding a value of equity of about $4 billion.
As I learned the painful way with my Twitter experiences, the quality of the management at a young company can play a significant role in how the story evolves. I am impressed with both the poise that Snap’s founders are showing in their public appearances and the story that they are telling about the company, though I am disappointed that they have followed the Google/Facebook path and consolidated control in the company by creating shares with different voting rights. I know that is in keeping with the tech sector’s founder worship and paranoia about “short term” investors, but my advice, unsolicited and perhaps unwelcome, is that Snap’s founders should trust markets more. After all, if you welcome me to invest me in your company and I do, you should want my input as well, right?
The Pricing Contrast
As I finish this post, I notice this news story from a few days ago that suggests that bankers have arrived at an offering price, yielding a pricing for the company of $18.5 billion to $21.5 billion for the company, about $4 billion above my estimate. So, how do I explain the difference between my valuation and this pricing? First, I have never felt the urge to explain what other people pay for a stock, since it is a free market and investors make their own judgments. Second, and this is keeping with a theme that I have promoted repeatedly in my posts, bankers don’t value companies; they price them! If you are missing the contrast between value and price, you are welcome to read this piece that I have on the topic, but simply put, your job in pricing is not to assess the fair value of a company but to decide what investors will pay for the company today. The former is determined by cash flows, growth and risk, i.e., the inputs that I have grappled with in my story and valuation, and the latter is set by what investors are paying for other companies in the space. After all, if investors are willing to attach a pricing of $12 billion to Twitter, a social media company seeming incapable of translating potential to profits, and Microsoft is paying $26 billion for LinkedIn, another social media company whose grasp exceeded its reach, why should they not pay $20 billion for Snap, a company with vastly greater user engagement than either LinkedIn or Twitter? With pricing, everything is relative and Snap may be a bargain at $20 billion to a trader.