Snapchat IPO : Too Big to Fail?

One of the most eagerly awaited stock market debuts is finally here. Snapchat's parent company Snap filed for an IPO last week with plans to list on NYSE sometime in March. There are reports that Snap will be valued in the US$ 20 - 25 billion range. But does the company deserve such a high valuation? Will the IPO succeed in exciting the investor community? What are the key concerns for potential investors?

But before we address these questions, let's look at some of the key takeaways from Snap's S-1 Filing :

Snap is losing a ton of money but revenue is growing very fast

Snap delivered revenue of US$ 404 million last year, significantly higher than the $58 million revenue it clocked in 2015. The company though is deeply in the red. Net loss of $372 million in 2015 jumped to $514 million in 2016.

It has a devoted user base; but growth rates have slowed down

Snap has 158 million daily active users as of the fourth quarter of last year, and they're hooked: They use the app an average of 18 times a day!! But similar to Twitter in its IPO, Snap's rate of growth is slowing. Users grew 14% and 17% for the first two quarters of 2016 but the growth rate has since slowed down to 7% and 3% for the last two quarters of 2016.

Snap will become the first company to go public on a US exchange with non-voting stock

Snap isn't giving shareholders a vote. The filing states that even if CEO Evan Spiegel or co-founder and CTO Robert Murphy get fired, they may be able to retain control of the company. They even retain control for nine months after they die!!

Benchmark Capital and the two co-founders are the largest shareholders

Benchmark Capital, which led Snapchat's Series A round back in 2013, holds 12.7% of the shares while the co-founders Evan Spiegel and Robert Murphy each own 21.8%.

CEO will be paid US$ 750 million to take the company public

CEO Evan Spiegel will get an additional 3% of the company just for taking the company public. At a valuation of US$ 25 billion, this will translate into a $750 million IPO bonus. That is more than the revenue Snap has delivered till date!! The board granted that stock to him in 2015 "to motivate him to continue growing our business and improving our financial results."

The only official Snapchat instruction manual is buried in its IPO filing

The filing includes visual descriptions of how the Snapchat app actually works. For all the flak CEO Evan Spiegel and crew have gotten over the years for “bad design” or “crappy UI,” these descriptions make clear that every part of the app has a distinct purpose and every screen a carefully constructed layout.It will surely be useful for the many Wall Street investors who have likely never used Snapchat and would be incapable of wrapping their heads around it even if they tried (you can access the illustrations starting page 92 of the filing here)

Snapchat paid its third co-founder $158 million in cash to disappear

Ousted Snapchat early employee Reggie Brown was paid $157.5 million in a settlement to close off a lawsuit alleging that he was pushed out the company without compensation. Brown’s bone of contention was that he had originally thought of the idea that became the central premise of Snapchat — the ephemeral photo. And how much will the co-founders Evan Spiegel and Bobby Murphy make post the IPO? At a valuation of US$ 25 billion, each of the co-founders will be worth a cool US$ 5.45 billion each!

What are the key concerns?

Too expensive

If Snapchat gets a US$ 25 billion valuation, investors will be paying 62x trailing sales for the company. Facebook in contrast trades for 14x sales while Twitter sells for 5x sales. Of course, Snapchat is an earlier-stage company than either Twitter or Facebook. In any case that's a massive premium to pay. Sure, Facebook is growing slower than Snapchat but it also has something very important Snap doesn't have: Profit, to the tune of more than $10 billion last year. In order to justify the valuation, Snapchat had better be growing very quickly. Which brings us to the next point.

Slowing User Growth

Snap attributes the drop-off in user growth to "performance issues" from one of its product updates to Android phones and "increased competition" from companies that "launched products with similar functionality to ours." On top of that, Snap's sales are growing fastest in other parts of the world besides the U.S. and Europe, increasing 53% in the fourth quarter year over year there, but only 39% in North America. Still, the U.S. and North America account for about 90% of Snap's overall revenue.

Monthly data missing

Although the IPO filing includes data for Daily Active Users, it stays silent on monthly active user figures. The omission raises a warning flag - it might mean Snap’s engagement figures aren't as great as they appear at first glance. By dividing the number of daily active users by monthly active users, investors can get a better sense of how closely tethered customers are to the service. The higher the number, the better because it shows that more frequent and engaged customers are making up a greater portion of a company’s user base. And over time, that ratio would give investors a sense of Snapchat’s trajectory.

Lack of Governance

Snap shareholders will receive no voting rights when they buy shares in the IPO. Snap has rigged its governance structure such that even if the board did decide to fire Spiegel or his co-founder Robert Murphy, there would be little point in it: The executives would still retain all their voting power anyway, just as they would, for another nine months, even if they died. 

Intense Competition

The competition against Facebook and Google (which owns YouTube, an online-video site, against which Snapchat will directly compete for ad dollars) is unlikely to let up. Facebook tried to buy Snapchat for US$ 3 billion in 2013, and has since copied many of its popular features. Last summer Instagram, which is owned by Facebook, launched its own “stories” feature; its parent company is now testing the idea of rolling out this feature on its own social network. Usage of Snapchat stories has declined significantly since Instagram stories began.

Management style / Lack of bench strength

Mr Spiegel will also need to prove his ability to lead. There is discomfort surrounding his style of working - he is secretive and controls information tightly. No one but Mr Spiegel—not even the board and other top executives—knows all the important details of the firm’s strategy and future plans. He is off-limits to most employees and travels between Snap’s buildings in a black Range Rover with a security detail. Also, the talent pool behind the CEO is not as experienced as one would like. Adult supervision will come from Michael Lynton, a seasoned entertainment executive, who is resigning from running the film studio of Japan’s Sony to serve as Snap’s chairman. But there are few like him at the company.

Conclusion

Snapchat's IPO is one of the most eagerly awaited IPOs for sometime especially given how barren the tech IPO landscape has been in recent years. It is not everyday that a company gets listed with a valuation of US$ 25 billion or more. But getting listed is likely to be the beginning of a tough slog. Facebook and Google are formidable competitors and they will not make life easy for Snapchat. On top of that, being listed will invite close scrutiny from investors on the path to profitability. This is what Snap says in the IPO prospectus :

"We have incurred operating losses in the past, expect to incur operating losses in the future, and may never achieve or maintain profitability."

Not exactly the kind of language you want to read as a potential investor. But investors are nevertheless likely to pile into the IPO especially large investors who suffer from Facebook FOMO (that's "fear of missing out", in case you are wondering). All concerns related to profitability, governance and slowing growth rates are likely to be consigned to the back burner....for now. Whether that is the smartest thing to do - only time will tell.

PS: Are you excited about the Snapchat IPO? How do you think it will perform as a publicly listed company? Please do share your views in the comments section. Thanks for reading!