Snap Is Dead On Arrival

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About: Snap Inc. (SNAP), Includes: FB
by: Andy Wong
Summary

Investors have been comparing Snap's IPO and opportunity to that of Facebook.

This comparison is off base for multiple reasons.

Facebook's strategy is very simple: spend more money.

Facebook generates $3.8 billion in free cash flow per quarter while Snap has a total cash balance of $3.3 billion and a negative free cash flow.

Thesis
Snap (NYSE:SNAP) is perhaps the most exciting IPO of this year. It has all the classic ingredients: Tech stock, no profits, good story. "Buy SNAP now if you missed Facebook (NASDAQ:FB)" seems to be the narrative. There are many differences between Facebook and SNAP that do not justify this comparison. In the following article, I will highlight why this is the case and why SNAP will not be able to compete with Facebook on a level that justifies a $22 billion market cap.

Introduction
Relaying Snap's mission statement will illustrate what I mean by good story:
"We believe that reinventing the camera represents our greatest opportunity to improve the way that people live and communicate."

I am instantly skeptical when I hear mission statements talking about "reinventing" common goods. But, perhaps, I'm just a grumpy skeptic. To me, SNAP's mission statement should read something like this:
"Selling as many adds as possible through our camera app."

No profits, but plenty of cash

Of course, most investors don't care about "short-term" profits when it comes to promising tech stocks. I mean that in the most sincere way. Most investors will often forego short-term profits if the company is attempting to accelerate growth and dominate its market. This behavior is most common in tech stocks and we're seeing it now again with Snap.

Investors don't need to worry about the company running out of cash as a result. The company has about $3.3 billion in cash and short-term investments (bonds). The free cash flow sits at a negative $173 million as of 2Q17. So, assuming that SNAP does not accelerate its cash burn, the company has enough money for the next 18 quarters or 4.5 years or so. Although, I do expect the company to accelerate its cash burn a bit in the name of growth. How much exactly is hard to tell given that we only have two quarters of historical data plus the fact that the company does not provide any guidance:

"Mark, as it relates to your question on guidance, whether it's DAUs or peak EBITDA losses, we're going to run the Company here for the long term. We want the flexibility to make the right decision in the long term. So we're not going to be short sighted about profit decisions to make a quarter or whatever that would end up being. So at this point, there is not going to be any financial guidance coming from Snap."

Facebook

Putting SNAP's cash position differently, SNAP's total war chest is about the 6/7th of Facebook's quarterly free cash flow. This alone is already a serious competitive disadvantage. And since I believe that SNAP does not have any economic moat, Facebook should be able to outcompete SNAP by simply investing more. Let me explicitly state that I don't use economic moat and competitive advantage interchangeably. A competitive advantage is "softer" than an economic moat. I consider an economic moat to be a sustainable competitive advantage. In the case of Facebook, simply having more money is not a very strong competitive advantage. In the case of Snap, having a slightly better app is not a strong competitive advantage either. Examples of an economic moat would be customer switching costs, network economics or cost advantages. Examples of mistaken moats are things like great products and great management. Of course, having great products and management certainly brings an advantage.

Why IS SNAP's app better than Instagram?
The apps are quite different. Instagram is more of a social status app. The app has its own kind of celebrity: social influencers. Most of the content that is posted on Instagram is actually being posted by celebrities and social media influencers. While influencers also post content on Snapchat, the app is not influencer-focused.

But, even though most content doesn't come from regular users, the celebrity stories are definitely being watched. From the above-linked New York Magazine story:

"It's worth noting that while these teenagers aren't posting their own Instagram Stories, many of them will watch a story posted by an account they're following. 'Most of them are from celebrities and brands and dogs.'"

In any case, the result is that Snapchat has a higher user engagement. Snapchat users spend an average of 25 to 30 minutes on the app per day, while user activity on Instagram hovers around 15 minutes a day. Keep in mind that this does not explicitly relate to Instagram Stories. The fact that Snapchat has better engagement is a common argument used to justify an investment in Snap. I don't believe that Snap's lead in user engagement will remain. Facebook's user engagement numbers are growing as well and Facebook's Snapchat copy-cat (Instagram Stories) is a lot younger than Snapchat.

More money beats slightly better product
The proof is in the pudding. It is already widely known that Instagram has surpassed Snapchat in user size. Sure, Snap has lots of exciting AR/VR they could possibly explore. Nothing is stopping Facebook from throwing another billion dollars in the next copycat effort. It is clearly working. Facebook does not need to innovate. It has money. Snap is basically Facebook's R&D lab. This article does a good job explaining how Facebook is becoming faster and faster at cloning Snapchat features.

Another big difference between Snap's IPO and Facebook's IPO is that Facebook barely had any competition. Facebook had surpassed MySpace in terms of user base as early as 2008 and the company IPO'd in 2012. That is vastly different from competing against the most dominant player in the space that generates free cash flow the size of your war chest in a mere quarter.

Conclusion

Snap is not the same as Facebook and their IPO story was vastly different. Facebook was already the leader in its space when it IPO'd and didn't have any noticeable competition. Snap is taking on Goliath, and while it might have a superior app right now, it doesn't have anything that Facebook can't copy. Until Snap creates something that Facebook can't copy, there's no reason to put a dime in the company. Facebook knows it can copy anything Snap creates and is copying Snap's features faster and faster. The strategy might not be pretty or "cool", but is definitely effective judging by the fact that Instagram stories is already bigger than Snapchat.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.