As Snapchat (NYSE:SNAP) IPOs, it's clear the company has quite a few advantages. Specifically, it's a great product with very strong engagement and user growth. Of course, three years ago this was exactly what people said about Twitter (NYSE:TWTR). Since then, Twitter has struggled to monetize its user base and its user growth began to slow. As such, the stock is worth only 1/3 rd of what it was worth at its peak, and 1/2 the valuation of Snapchat post-IPO. While Snapchat's co-founders have wide-ranging visions for the company, when reviewing the S1 and the competitive landscape, it became clear to me that they face many of the same challenges as Twitter. Ultimately, I believe these challenges will weigh on Snapchat's premium valuation and investors will find Snapchat performing closer to Twitter than Facebook (NASDAQ:FB) over the next 2-3 years. (Author's note: unless otherwise stated, all information about SNAP is pulled from the S1).
SNAP's Product and User Growth
Snapchat's product is very strong and does give the company some advantages in its competitive market. The product is well optimized for user engagement in terms of finding that "magic moment," or that point in time where users realize the value a product can provide in their lives. Snapchat is unique in that this moment can vary by demographic. Younger users likely find this moment when playing with geofilters, while older users may have the moment when exploring Snapchat publishers and interacting with their favorite brands. Either way, Snapchat's product is optimized so all demographics can find these moments relatively quickly. This product optimization has let Snapchat build very strong user engagement.
It's interesting for investors to note that Snapchat has chosen to focus on Daily Active Users (DAUs) as its key metric for engagement. DAUs is growing strongly and I agree with management that it is the most relevant metric for the company and investors to follow as a performance indicator. Unlike a platform like Facebook, where users are likely to spend 20-30 minutes in one sitting, Snapchat is likely to be used by consumers in short frequent bursts; this makes the DAU metric more relevant than Monthly Active Users (MAUs) because it more accurately captures this style of engagement. Indeed, this is one clear differentiator between Snapchat and Twitter - despite its similarities to Snapchat, management focused more on MAUs. I believe this mistake was a huge reason why Twitter's management didn't recognize deceleration in user growth and engagement early enough to address the problem. Even today, Twitter still does not report DAU numbers, and it is hard to know just how engaged the user base is. It's also interesting to note that Twitter management may have recognized this issue, as in its last two quarterly reports Twitter has begun highlighting DAU growth, which is now back to double-digits. Like Snapchat, this should be its focus.
Despite the strengths of the product, investors should remember that many of Twitter's growth/engagement problems were not visible at this stage in its evolution. Certain areas of the user experience that bugged Twitter are also major problems for Snapchat. Difficulty in finding friends, for instance, has always frustrated me on Snapchat. This specific problem really hurt the ability for Twitter to attract marginal users and it can do the same to Snapchat. Attracting these marginal users is key to maintaining the growth numbers that Snapchat will need to justify its IPO valuation. It is possible that, as Snapchat begins to reach saturation in the developed markets with its core user base, other engagement issues will come to light that will keep marginal users away. Further, and in a strong contrast to Twitter, Snapchat is heavily reliant on smartphones and broadband networks due to its nature as a video/image sharing product that requires more bandwidth. This severely limits its exposure in emerging markets, where the broadband networks aren't as developed and could contribute to a steep drop in user growth. To conclude the discussion on products, it is also worth noting that, in recent months, we have seen huge competitive pressure from Facebook. Instagram and WhatsApp have released similar features as Snapchat and the current feedback on these features is very good, which could be bad news for Snapchat.
Monetization is the key reason why Snapchat is likely to disappoint investors at its current valuation. While digital advertising is a growing space, Google's (NASDAQ:GOOG) (NASDAQ:GOOGL) and Facebook's massive market share make it likely that this growth will mostly go to these two, while other companies fight for scraps, or even shrink. The reason that Google and Facebook have been able to build this market share is because their products are incredibly successful in gathering consumer data and using that data to maximize advertiser return on investment (ROI). This data allows advertisers to target massive groups and track conversion rates scientifically. This is revolutionary, as large-scale advertising campaigns traditionally had no way to do this. Snap can't do this either, because the platform is not well-suited for developing the type of data that Facebook and Google use to run these campaigns. The mention of "challenges in user metrics measurements" in the risk section of the S1 points to this. Here, Snapchat alludes to the fact that it hasn't been able to develop specific information about its users, such as age and gender - key demographic information that is necessary for advertisers to maximize ROI. This is intuitive when considering that most of Snapchat's data is unstructured (images/videos), which is significantly harder for computers to analyze and organize (essential if a company eventually wants to monetize the data). This "data problem" is very important for investors to keep in mind, because it means that, even if Snapchat can overcome the growth headwinds, it still likely will struggle to monetize in the ways that Facebook did. While Twitter has struggled with this, it is worth noting that the data that Twitter can collect from its users does seem as though it should be significantly more robust and useful than Snapchat's.
Whether or not Snapchat has the data to steal market share from Google and Facebook, it's worth noting that ad campaigns are much harder to deliver on Snapchat without disrupting the user experience. While investors may look at Snapchat's S1 and see positive metrics from its advertising program, they leave me skeptical. Many of the metrics it refers to force me to question data measurement practices. For example, some metrics it points to include "users who watched ads with sound on," "play time per user," and "increase in search traffic." The first two metrics are self-selecting groups, meaning they don't include users who skipped the ads (investors can't assess how effective these ad campaigns really are). The last metric doesn't tell investors anything whatsoever as far as whether Snapchat's ads contributed to the increase in search traffic. It's telling that Snapchat doesn't refer to many metrics that advertisers usually look at, such as click through rate, to measure campaign success.
To conclude the monetization analysis, investors need to remember that Snapchat is only in its first few days of monetizing through ads; while this means there is room for growth, it also means that advertisers have yet to fully assess whether or not the money spent on the platform is worthwhile. This lag in assessment of marketing campaigns has been clear in other public companies. Twitter, for example, has seen revenue lag user growth numbers by 6-12 months likely because of this. Further, there are things that Snap does very well. Snap has strong brand awareness through its publisher and geofilter programs. While these types of ad campaigns will always be utilized by marketers, they don't have nearly the same ROI as the types of targeted ad campaigns discussed above, and thus won't be able to justify SNAP's current valuation. Many of the monetization problems I've outlined above were very similar to Twitter's problems and, eventually, were the key drivers of Twitter's massive shift in strategy towards more live programming and the huge reorganization of its internal sales structure.
App or Ecosystem?
One key indicator for success for many of the largest internet companies was their ability to move from a single app to a fully integrated platform from which other apps are plugged into and engage with (an ecosystem). When a company can develop this ecosystem, it makes switching costs significantly higher, giving the company a Warren Buffett style "moat." Facebook is a great example of purely software-based ecosystems, whereas Apple (NASDAQ:AAPL) is a software-hardware mixed ecosystem. Both of these companies are great examples of how getting to "ecosystem" status increases user's switching costs. To create sustainable long-term growth (and shareholder value), it is imperative any internet company can become an ecosystem. It isn't clear to me that Snapchat is capable of making its product move from app to ecosystem. Management's current approach seems to use hardware to create an ecosystem, in the reverse of GoPro's (NASDAQ:GPRO) attempt to move from a camera company to a social media company. For GoPro, this did not work, and I don't think it will for Snapchat either. It's telling that it's targeting hardware, rather than focusing on developing a software-based ecosystem to emulate Facebook. To me, this shows the limits of Snapchat's appeal. It is very much an app-style product, which is perfectly optimized for mobile, has a few simple features that work very well and is easy to use for consumers. There isn't as much of an opportunity to integrate Snapchat into other products or develop it into a product that can work well on everything. As such, it's unlikely to ever cross from "app" to "ecosystem." Here, it does significantly worse than Twitter, which has some features of an ecosystem. Features that the shift to live should allow Twitter's management to focus on.
Valuation and Conclusions
When we look at all the headwinds facing Snapchat, it's hard to see why it deserves such a premium over Twitter. To get a better idea as to the valuation compared to Twitter, I ran a comp screen on CapIQ comparing Snapchat, Twitter and Facebook. Note that this is not meant to give a very specific valuation of SNAP, only to show that the risks I outlined above are clearly not being accounted for in the stock.
Here are some key takeaways from these numbers. First, Snapchat is already being valued as worth twice as much as Twitter, with 1/2 of forward revenue estimates. Even if Snapchat was valued around the same area as Twitter, its forward EV/Revenue would be about the same or higher than Facebook, despite the fact that Facebook and Google are capturing all the growth in the industry. These valuation metrics, and the forward projections that analysts currently have for Snapchat, tell me that the market is looking at Snapchat and seeing a company that they think can steal market share from Facebook and Google. They are not pricing in any of the risks that I analyzed above. Investors need to look at this and decide on their own whether Snapchat is really going to compete with these internet giants? Is that really realistic, given the headwinds facing the company? Given that shareholders are receiving non-voting shares and have zero say over the direction of the company?
At the very least, it is extremely likely that it will take Snapchat 2-3 years before it can do this: 2-3 years in which Snapchat will not be able to justify these valuation numbers, disappointing investors and likely doing very poorly in the market. In fact, this is exactly what we saw with Twitter. Now, with Twitter priced more realistically, the realignment of Twitter's strategy towards live programming gives investors a chance to actually profit from owning Twitter. With that in mind, I have become a shareholder in Twitter. Conversely, I wouldn't even consider purchasing Snapchat unless its valuation was halved. Investors should stay far, far away from this IPO.
Disclosure: I am/we are long TWTR, AAPL.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.