Snap ($SNAP) is one of the companies that have a terrible performance as a public company, down 50% since its IPO back in March 2017 (first trading day closing at $27/share, today at around $13).
Most of the time as a public company, the price fluctuated between $5 and $25. Until the last quarter of 2021. The price started to increase and got to over $80/share in less than a year. Since then, the price is down over 80%.
This post has two goals:
1. Explain what is Snap, how it makes money, and what contributed to this crazy share price movement.
- Provide an analysis of the company's financials and valuation.
Let's get started!
What is Snap?
If you take a look at their annual report, the company is being described as a “camera company”. In my opinion, this is misleading as Snap is not manufacturing and selling cameras. They explicitly state that they generate substantially all of the revenue from advertising. My definition is a bit different, “Snap is a social media company that makes money selling ads“.
How does Snap make money?
There's a simple formula that can be applied to every social media company that has the advertising model as a main source of revenue.
Revenue = # of users multiplied by ARPU (Average revenue per user)
Having this in mind, Snap can grow only by increasing the # of users and/or increasing the ARPU.
The # of users
There are two events that I believe are relevant to mention when it comes to this metric:
- The IPO – If we take a look at the growth of DAU (Daily active users) on the platform, at the point of IPO, Snap had a great history and a great story. Storytelling is very important when raising funds. The # of users grew from 50m in Q1/2014 to over 150m in Q1/2017. However, after the IPO, for the next 3 years (up until the end of 2019), they added roughly 50m. Not only did they have slower growth than before, but there were quarters when the # of DAU declined.
- The pandemic – The # of DAU started growing again around this period, but the share price didn't start increasing until Q4/2020. Why? The answer is simple. Whenever there's an external event that brings new users, there's always doubt that these users will leave the platform once that event is over. However, as time went by, it was clear that the new Snap members were there to stay and this number kept increasing. So the share price went up and up and up…
However, growth has limits. There's a limit to the # of users a platform can bring, as well as, a limit on the average revenue per user.
In 5 markets (US, UK, Australia, France, Netherlands), the company has incredibly high penetration. By this, I mean 90% of the 13-24-year-olds are on the platform and 75% of the 13-34 year-olds. I find these numbers sad as I am not a big fan of social media and the impact it has on society, but I won't go there as this post is purely intended for Snap as a company.
So growing the # of users is difficult in their most valuable markets. They'll have to wait until more children become teenagers and join the platform. Therefore, a large part of the future growth lies in expansion internationally and increasing the ARPU which could be challenging in this environment.
The high growth of the last 2 years is again declining and the momentum shifted. The share price declined from $80+ to today's $13.
As one of the most famous investors, Eminem mentioned in his most popular song “Lose Yourself” – Snap back to reality, ope there goes gravity.
Snap's big bet?
One of the areas where Snap seems to be ahead is AR (Augmented reality, not accounts receivable). Over 250m of users engage with AR per day on average. This is definitely huge. If we take into account that the users play with AR lenses over 6b times per day on average, well, we can easily calculate the average per user. The engagement is quite high.
So what is this actually? One simple example is trying to see how certain shoes look on you. Instead of going to the store, Snap has the technology to convert a 2D image to 3D and allow you to see the outcome through the camera. Of course, this application is not limited to shoes or clothes, but it is a simple example to understand the technology.
However, they are not alone. Metaverse is one of Facebook's big bets, so they are facing competition in this area.
Growing through acquisitions
Snap has done numerous acquisitions over the last 7 years. Although this is always a risky strategy as there's no certainty the company will fit well in the existing environment, it is very difficult to judge whether these acquisitions are successful or not. The companies that have been acquired are in this industry and are expected to add new features or improve the user's experience, but it cannot be measured whether they are a good investment or not as they become part of the Snapchat application.
The real decision-makers
Evan Spiegel and Bobby Murphy are the two most important people in this company. Not only because they have high management positions, but because they control over 99% of the voting power in the company. No, they don't own over 99% of all the shares. Here's why. Snap has 3 types of shares:
Class A – publicly traded, these are the ones that we can all buy but have 0 voting rights.
Class B – not publicly traded, have 1 voting right per share
Class C – not publicly traded, have 10 voting rights per share.
You might be wondering, well, if I buy 1 share or 1000, even if I had voting rights, it would've made no difference. Why should I be interested in this? Lack of control is being priced at the share price. Imagine a hypothetical scenario where a large institutional investor is deciding between investing in company A and company B, both being exactly the same, except company B's shares, have no voting power. They would only invest in company B's shares over company A's shares, only if they are cheaper. The big-name investors want to have the ability to influence the direction of the company. The discount for lack of control is between 10-20%. In my valuation, I'm using DCF as if the shares have voting rights and I'm subtracting 15% of it at the end.
Historical financial performance
The company's revenue is growing significantly, from $1.2b in 2018 to $4.4b in the last twelve months (ending Q1/2022).
At the same time, gross margin improved from 32% to 60%, and all the operating expenses reduced as a % of revenue:
– R&D from 65% to 38%
– Sales & Marketing from 34% to 20%
– General & Administrative from 40% to 17%
Hence, the operating margin improved from -107% to -15%.
The balance sheet
Snap is not a capital-intensive company, the largest expenses are related to its employees and the balance sheet is fairly simple to follow.
On the asset side, out of the $9b, $5b is related to cash and short-term investment. This has increased significantly, from $1.2b at the end of 2018.
Where did this cash come from? It came mainly from debt as their long-term loans increased to almost $4b.
Having a high cash position is good to reduce the risk of bankruptcy for money-losing companies. However, Snap is not losing money (if we exclude the share-based compensation) and there will be pressure to put the $5b in use. It is likely that we see another acquisition coming soon.
The level of debt is at an acceptable level, especially if we take into account that the interest rate was very low when they increased the debt. In my opinion, this was a great decision by the management team.
The valuation
I used a DCF model to estimate the company's value. The assumptions are listed below:
Revenue growth: 15% for the next 12 months, followed by 20% in the 4 years after that and declining over time to 3.41%.
Operating margin: To improve over time, reach 9% in year 5 and 25% as of year 8.
Discount rate: Currently 8.3%, increasing to 10.3% over time (as the FED is raising the interest rate)
Discount due to lack of control/voting power: 15%
Outcome: $9.11/share
*Note: In the DCF calculation, the outstanding equity options are also taken into account.
What if my assumptions are significantly wrong?
Based on the assumptions stated above, the revenue will grow by 280% to $16.8b in the next 10 years and the target operating margin is 25%.
Let's take a look at how the valuation of the company (per share) changes based on different assumptions related to the revenue 10 years from now and the operating margin:
| Revenue / Op. margin | 20% | 25% | 30% |
|---|---|---|---|
| 200% ($13.3b) | $5.4 | $7.3 | $9.1 |
| 280% ($16.8b) | $6.8 | $9.1 | $11.4 |
| 350% ($19.8b) | $8.0 | $10.7 | $13.4 |
| 550% ($28.6b) | $11.5 | $15.3 | $19.1 |
There's a lot of uncertainty ahead of Snap and its success depends on many variables. At the current level, it can also be an interesting acquisition target by the larger companies.
I'd like to get your feedback regarding the post and feel free to share your thoughts.
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