The State of Snap
Going into 4Q'18 and FY18 earnings tomorrow, 2/5/18, Snap has given investors a lot to think about. In the years since the 2012 IPO of $FB and 2013 IPO of $TWTR, the market has seen its fair share of social media/technology stocks. Some of these stocks adapt well to the public markets as they make the jump from Silicon Valley east. Many times this may be public market investors' first look under the hood at companies they have been using for years, and in Snap's case, they didn't like everything they saw.
I want to start off with a brief mention on my background: I am a college kid and one of my "official" areas of academic studies is Computer Science. I say this only to comment on my perspective: a Snapchat user around a large part of their target audience and impressed by the technology that Snap has created. I've said this on Twitter previously, but one of Snap's major contributions to modern society is the socialization of augmented reality. Because of Snap, millions of young people have been able to interact with impressive and high quality mobile AR in a fun and social way. I do believe that Snap's AR, while maybe not totally proprietary, carries some value for them (not $9B of value, but some value). My point is that I am not some old grump that detests technology, but instead a person that appreciates a company's product while also concluding that the company's equity is overvalued.
The two main points that I have continued coming back to as I have been following Snap are:
This is not a revenue story, but a cost story
What is the value of a user?
Costs on the Run
Starting with costs, Snap has accumulated almost $1.25B in operating expenses in 3 quarters YTD (1Q'18 to 3Q'18). To put this in context, over the last 5 quarters (3Q'17 through 3Q'18) Snap has made $1.28B in revenue. Over the TTM, Snap has amassed $2.48B in COGS and OpEx.
Most quarters, R&D is the largest operating expense and it has totaled $607M YTD. Snap explains in their 3Q'18 Form 10-Q that this covers "primarily personnel-related costs … for our engineers and other employees engaged in the research and development of our products." To break this down further, Snap laid off around 100 engineers in March 2018, accounting for about 10% of their engineering team. Using this, we can estimate there to be about 900 engineers currently at Snap out of about 3,000 employees. Roughly speaking, Snap spent about $226,000 of R&D for every engineer, a run rate of $1M per engineer a year. Obviously, this is a rough heuristic calculation, but I don't think its terribly inaccurate, given how Snap defines R&D.
Twitter (TWTR), a common point of comparison for Snap, does not disclose the amount of engineers it has, but using the numbers we get from Snap we can reverse engineer and compare. Using Twitter's $150.8M of R&D in 3Q'18, Twitter would have about 667 engineers if they had the same R&D/engineer as Snap has. Almost 240 fewer engineers than Snap seems a bit low to me, considering that'd only be 19.8% of twitters 3,372 total employees at the end of 2017 compared to Snap's engineers making up 29.3% of the 3,069 total employees at the end of 2017.
When it comes to Snap's Income Statement, costs dominate the spreadsheet but the top line still has a firm grip on the narrative. Snap has never had a quarter as a public company with a GAAP operating margin greater than -100%. That is a NEGATIVE 100% for those who may have missed the small (-) sign in front. Operating margin YTD is -132%.
A (Not So) Controlled Burn
For a company with YTD net losses of over $1B, their cash flow statement may tell a different story at first glance. A noticeable blemish is their -$658M in free cash flow YTD, but even with that, they had a net cash gain of $15.6M over the same period.
Taking a closer look reveals that most of the cash and adjustments that turned the net loss actually came from just two sources: proceeds from marketable securities and stock-based compensation (SBC). The troubling part here is that these sources of creating a net gain of cash are not reliable and become less so in the future.
Starting with marketable securities, Snap netted about $632M YTD (in comparison to the $1.06B net loss YTD). Obviously, there is nothing "wrong" with this as it is a common function of a business. This issue for Snap is that this source of net cash has decreased by $645M since the start of 2018, down to about $1.06B at the end of 3Q'18. While it may look as if Snap is conserving cash in 2018, it is clear that this conservation of the nominal amount of cash by Snap in 2018 is due to the depletion of these marketable securities. Looking at cash and marketable securities together, Snap started 2018 with a balance just over $2B and ended 3Q'18 with just over $1.4B left. At their current burn rate, they have not even 2 years let of cash and marketable securities before even considering the role SBC has to play in this rate.
The more important steroid of Snap's net cash gain is their use of stock-based compensation. YTD their SBC for operating expenses account for 33.7% of all operating expense. Specifically, 44.7% of R&D is covered by SBC YTD. When looking at COGS and operating expenses together, SBC covers 27.5% of it YTD.
Objectively speaking, SBC is not necessarily a bad thing. But in the context of a stock that has decreased almost 75% off its all time high in March 2017, the reliability of SBC being considered an adequate form of compensation by employees starts to waiver. At the end of October 2018, there were reports that 40% of Snap's employees said, via an internal survey, that they planned to leave the company. The number in 1Q'18 was 11%. On top of that, Snap was plagued with a long list of executive departures in 2018, a list that was extended recently by their CFO of less than a year Tim Stone. After Snap stated that the departure was not due to disagreement with management in an 8-K, the departure reportedly was due to a disagreement with management about a raise and promotion. Stone apparently went behind Spiegel's back to ask for a raise and a promotion to a COO-type position, as the longtime COO Imran Khan announced his departure in September. Stone was being paid $500,000 a year and had about $20M in restricted stock that was to vest in a few years. His request, I assume, was an attempt to secure more compensation in the form of cash instead of restricted stock.
As I write, Snap closed today (2/4/19) at $6.93, so keep that in mind as you read the following:
At the end of 2017, 156M Class A RSUs and 7.79M Class B RSUs were unvested with a Weighted-Average Grand Date Fair Value (WAGDFV) of $15.89 (down 8% with $SNAP closing at $14.61 on 12/29/17)
Snap has granted 55M Class A RSUs YTD with a WAGDFV of $14.19 (currently down 51%)
Employees have vested 37.65M Class A RSUs and 5,218,000 Class B RSUs at various times YTD. The WAGDFV for those was $15.66
33.8M Class A RSUs and 966,000 Class B RSUs were forfeited with a WAGDFV of $16.28
At the end of 3Q'18 139.5M Class A RSUs and 1.6M Class B RSUs remain unvested at a WAGDFV of $15.20 (currently down 54%)
As for the stock options:
At the end of 2017, there were options outstanding on 20.8M Class A shares and 11.79M Class B shares with a Weighted-Average Exercise Price (WAEP) of $4.10 (246% upside with $SNAP closing at $14.61 on 12/29/17)
Snap granted options on 4.68M Class A shares YTD with a WAEP of $14.00 (currently the WAEP is OTM)
Options on 10.39M Class A shares and 8.3M Class B shares were exercised at various times YTD with a WAEP of $2.56.
Options on 1.4M Class A shares and 171,000 Class B shares were forfeited at various times YTD with a WAEP of $15.21
At the end of 3Q'18, options on 13.69M Class A shares and 3.3M Class B shares were outstanding with a WAEP of $7.73 (currently the WAEP is OTM)
Source: 3Q'18 Form 10-Q
Source: 3Q'18 Form 10-Q
I apologize for the barrage of numbers. The main point is the significant decrease in current unvested RSUs and outstanding options will severely limit Snap's use of SBC going forward as well as to attract new talent. This will speed up the net decrease in capital, increasing their burn rate (The WAGDFV of the RSU unvested by end of 3Q'18 shows a 54% loss from when they were granted. The WAEP of options outstanding at the end of 3Q'18 is currently OTM).
"Somebody may beat me, but they are going to have to bleed to do it" - Steve Prefontaine
Snap's costs are Steve Prefontaine running 10,000m up in Oregon and they have a 108 second lead on revenue. Do I think revenue may pull within 100 second in 4Q'18? I think so. But can revenue keep making up the time? I don't; there are too many things in Steve "Costs" Prefontaine's favor and the finish line is already in sight.
The Loser of Users
Briefly, I want to address Snap's past 2 quarters of declining DAUs:
What drove Snap's value at IPO? What drove Snap's value at 1Q'18? What drove Snap's value at 2Q'18 earnings? What drives Snap's value now?
When their FCF was -$934M for FY17, when their net loss was -$3.4B for FY17, when they have not yet had a quarter with operating margin above -100%, they were valued on their users and growth of the users.
When DAU growth goes negative for 2 quarters in a row and management guides for a 3rd, what is left to value Snap on? A bet that revenue catches up to costs? Or a bet that costs slow down to revenue? I don't think so. Not with this management, user base or company.
I have no real reason to not trust Snap's recent 8-K where they announced Stone's resignation while also guiding for revenue and Adjusted EBITDA to be slightly favorable to the upside (previous revenue guidance of $355M - $380M). Based on that, I'll shoot for a top side of $395M. But as I addressed above, I'm not watching closely for revenue. I'm looking at expenses and users.
Based on Snap guiding for a user decline in 4Q'18 in conjunction with data I have collected, my best guess would be a decrease of 6M DAUs. I would be surprised at any decrease of 3M and less or of 9M or more. Call me crazy.
As far as expenses go, I am expecting to see an operating profit above -100% finally. Depending on the amount of DAUs they lose, it could get up pretty high, maybe -30% or -40%? I'll pin my estimate at -50% with the expectation that it could be higher.
Currently, I do not own any puts but may plan on buying some depending on the price tomorrow. If I had to guess, I think that Snap may beat on the financials while losing about 5M DAUs and the stock will jump on is as the DAU decrease was baked in. Barring any developments that absolutely kill my thesis, I would be looking to buy puts on the jump.
The biggest threat I see currently to my long term bearish view on Snap is the market's hope for an acquisition of Snap. If I had to pick, I'd think Amazon would be the best spot for them and offer a tremendous amount of synergies. They could use Snap as Apple uses iMessage: it doesn't directly make money for them, but it increases the value of the iPhone. Amazon could use Snap to draw users to its other services, especially by leveraging Snap's AR. I would be very interested to see how Snap could work with Alexa, Zappos (virtually try on shoes), Twitch streaming and maybe even Ring (the home doorbell and security system). Personally, I don't think Spiegel is going to sell without a massive fight for many reason that can fill up another blog post.
As always, this is not investment advice and should not be interpreted as such. I would love to hear any feedback or contrary thesis. You can email me at firstname.lastname@example.org or find me on Twitter @riskandchips