Snap IPO: Exploring the Company's S-1

Snap (SNAP 2.89%), the social media company behind Snapchat, has expressed interest in an IPO for months, but recently took significant steps toward making that a reality.

In this episode of Industry Focus: Tech, Motley Fool tech analyst Dylan Lewis and contributor Evan Niu, CFA, wade through the company's S-1 and breakdown the business for investors. They run through some of the big risks facing Snap, how the company's valuation stacks up, and some key concerns investors should have with the voting rights for the shares they'll be able to purchase. 

Editor's note: This episode was recorded prior to firmer valuation figures becoming available, so there might be some minor differences in the numbers in our discussion.

A full transcript follows the video.

This podcast was recorded on Feb. 16, 2017.

Dylan Lewis: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It's Friday, Feb. 17, and we're talking tech and exploring Snap's IPO filing. I'm your host, Dylan Lewis, and I'm joined on Skype by fool.com senior tech specialist Evan Niu. Evan, how's it going?

Evan Niu: Pretty good, pretty good.

Lewis: Are you a Snapchat user? Do you have it on your phone?

Niu: I recently downloaded it just to play around with it. I've read plenty about it, I know how it works, I know the gist of it. But I started playing around with it, and it's really not intuitive or easy to use. [laughs] I don't have a lot of people on there that I follow, so I certainly don't have the full experience of regular users. But I don't really see the appeal to it. It seems really niche to me.

Lewis: Yeah, I'll say, I am a Snapchat user. I have a lot of friends that use it. My interest will wane depending on how often my friends are using it, and that will bring me in or out of the system. But, it seems to be super popular with millennials, and given a lot of the buzz with the company and the fact that it is a big tech company that's thinking about going public, there are a lot of investors that are interested in it.

Niu: Yeah, there's been so much hype around this thing. It doesn't seem to me like it has a mainstream appeal, which is the exact problem that Twitter (TWTR) has run into over the past few years. I see a lot more closer comparisons to Twitter than Facebook (META -10.56%), which is the exact opposite storyline that Snap is going to try to sell doing its roadshow.

Lewis: Yeah. Listeners, to give you an idea of what we're going to talk about today, give you a little overview of Snap, the Snapchat property specifically, talk a bit about their plans to go public, and what Evan and I noticed when we dug through the S-1 that recently became available. So, we talked about, they are social media company, but they call themselves a camera company, which is interesting.

Niu: I noticed this really funny coincidence -- I don't know if you would call it a coincidence -- Snapchat used to consider itself a storytelling company, and now it's calling itself a camera company. Meanwhile, GoPro used to call itself a camera company and now is trying to call itself a storytelling company. So, these two companies, they have this weird identity thing where they want to be each other, and I don't get why, because it's not like GoPro is doing very well. I think it's kind of a weird thing rebrand themselves as a camera company. I mean, they have the new Spectacle glasses with cameras, but I don't know. It's just a weird identity to me.

Lewis: Yeah. For listeners who might not be familiar with the social media platform Snapchat, basically, you can think of it as a messaging platform where you are, for the most part, shooting quick, instantly deleted pictures and videos to you and your friends. You can also post them as stories. It has gained a lot of popularity with the millennial group. User count is still kind of low, we can talk about that a little bit, but the company is planning to go public, looking to raise $3 billion via the public markets in an issuance that would value the whole company a somewhere between $20 [billion] to $25 billion. As tech IPOs go, this might be one of the biggest ones for 2017.

Niu: Yeah, definitely. It's definitely the most exciting, the most looked forward to. People have been waiting for this thing for years.

Lewis: Yeah, and anything that's consumer-facing is naturally going to have a lot more buzz to it. I think there might be some folks out there who are saying, "Wait a minute, I thought I saw an announcement that this company planned to IPO back in the fall of 2016. Why are we just getting the S-1 and all the information about the company in the past couple weeks?" That's because Snap opted to go public via the confidential IPO process. This process and this approach is a byproduct of the 2012 Jumpstart Our Businesses Act. Basically, under this updated legislation, companies with under $1 billion in annual revenue can file paperwork for an IPO confidentially with the SEC. That allows the company to go back and forth with the regulatory agency without alerting the public that they are planning on IPO-ing, although Snap chose to do so anyway. Then, once the company decides they do want to go forward with an issuance, the filing must be made public at least three weeks prior to the IPO roadshow beginning, which is when the underwriting investment banks begin talking to clients and building interest in a potential issuance. This is all to say, while the "confidential IPO" name might sound kind of shady, this is something that's totally on the up-and-up. And that is the reason why we only got a look at the company's books and the S-1 earlier this month, even though they announced intentions to IPO a ways back.

Niu: Right. I think part of the purpose is to, like you mentioned, avoid public scrutiny for the early drafts of the S-1. All companies always have to file the S-1, but this way they can refine it without all the public scrutiny, looking at it and scrutinizing it. I think the idea is to encourage more companies to explore the IPO process, and if companies do end up going public, they get more capital, and it just boosts the economy in terms of more investments happening. I think that's the goal. But, yeah, it is a little weird when you hear "confidential."

Lewis: Yeah, and I think it also gives companies the opportunity to maybe think about going public and walk back without sharing all of their business information publicly. So, you can test the waters and see if you're ready, and you might decide you're not, but you don't have to go through the question of your business practices, if you think you're going to file and you have to publicly walk back.

Niu: Right, exactly.

Lewis: So, that's part of it. There are some adjustments in the regulatory requirements for how far back a company needs to provide financial statements, as well. But really, all in all, it's a tool that allows small-growing companies to keep some of their core business info private and make the going-public process a little bit easier. And that's really all there is to the confidential IPO process. Given that the company's S-1 filing became public earlier this month, I think it's fairly safe to assume we're going to see Snap trading on the New York Stock Exchange sometime in the next couple months. Evan?

Niu: Yeah, seems like it's coming.

Lewis: Considering that they are a social media company, I think it makes the most sense to start looking at their user base and what's going on there. That's kind of the lifeblood of businesses like Facebook and Twitter, and Snap is really no different. Within their S-1, they mention, "We assess the health of our business by measuring daily active users because we believe that this metric is the most reliable way to understand engagement on our platform." So, it's clear that this is what they're honing it on as a key metric, and it's what investors are going to be watching as well.

Niu: Yeah. I did find it interesting that they don't disclose monthly active users, they only disclose daily active users, which is right around 160 million. With social media companies, I always tend to look at sequential growth as opposed to year-over-year growth, because with user base, that's the nature, there's no seasonality, it's just how much you can grow over time. So, I look at sequential. In that respect, Snap's growth is really decelerating -- it's grinding to a halt, almost. And the company tries to explain this in saying, "Oh, it's because we haven't come out with any big new product innovation." And, of course, that has an impact, but you also have to worry about competition, because Facebook has done a really good job copying a lot of Snapchat's features, especially the Story thing, which is now on Instagram. Facebook already has, I think, about 150 million daily active users using Stories now. And they launched that last year, and it's an exact replica. So, you have to wonder if that's what's taking a bite out of it. And, obviously, Facebook is much bigger, they have more resources, they can innovate and develop faster. It's really Mark Zuckerberg, and Silicon Valley's -- I mean, Snapchat isn't based in Silicon Valley, but Facebook certainly is -- and Facebook tried to buy them, and if they can't buy them, they'll copy them, and they compete, and that's exactly what they're doing. And they're doing a really good job so far. So, I think there is some concern about competition and whether or not Snap can really keep up.

Lewis: Yeah. And Facebook famously made Snapchat an offer, I believe it was somewhere around $5 billion or so, a little ways back, and CEO Evan Spiegel said, "No, we're going to see what we can do with this on our own." If they wind up going public at this gaudy valuation, it certainly works out well for him, but you wonder if that might have stoked the competitive fire in Mark Zuckerberg a little bit.

Niu: And he can also empathize, because he did the exact same thing with Google (GOOG -1.96%) (GOOGL -1.97%). [laughs] So many people tried to buy Facebook, and he said, "No, I want to do my own thing," and now Facebook is enormous and he is one of the richest men in the world. [laughs] 

Lewis: Yeah it's hard to blame him for that. To put some numbers on what's going on with their user growth, like you said, year-over-year, the numbers look really great. They're up 48%. But sequentially, Q3 to Q4 of 2016, growth was only 3%. So, if you look at the graph that they provided in their S-1, it does look like growth is flattening out a little bit. Given that so much of the expectation for these social platforms is continuing to build user base, and being able to monetize that user base really well, you have to worry about that as an ongoing risk for the business.

Niu: Yeah. If they are a niche product, which, it seems that way to me, then this could be it...and, obviously, 160 million daily users is a pretty big number. And you can build a healthy business there if you keep your expectations modest and try to build around that base. Whereas, if you're trying to grow, if you're spending a ton of money trying to grow it, and you can't, which is exactly the problem that Twitter is having, then that's when it starts to hurt financially. But if you just accept it for what it is and plan your business accordingly, you can build a pretty decent business out of it.

Lewis: Yeah. For some context, I went back and looked at Facebook's S-1 to see how they stacked up when they went public. At the time, they had 480 million daily active users, and they were posting 48% year-over-year growth and 6% sequential growth. You hear that and think, "Well, those growth rates are kind of similar, right?" The difference was scale. Even when they were doing single-digit sequential growth quarter-to-quarter, they were still adding tens of millions of users, not five million, as Snapchat did last quarter. I think that's a huge risk, especially as you see a more entrenched competitor taking what's working for you and has a lot of traction with users that you already have on your platform and just applying it to this massive user base that they have.

Niu: Right. Facebook is interesting because they started earlier, before the really big rise of mobile. So a lot of their early days were on desktop. Then, they had to navigate the transition to mobile, which they have done ridiculously well, far better than I think anyone ever imagined, whereas companies like Twitter and Snap, they came out on mobile from the beginning. Particularly Snap -- I mean, there is no desktop Snapchat. 

Lewis: Right. Beyond the user base, I think a lot of people want to know what's going on with the financials as well. In 2016, the company booked $404 million in revenue, up from $58 million in revenue in 2015. That is humongous growth, but that is on a very tiny denominator. The reality with Snapchat is that they really just kind of turned on the monetization engine there, and have only really rolled out ads for a very short period of time. Right now, even, it's still a pretty ad-light experience for users.

Niu: Yeah. They only recently released their API to automate ad sales, which is a hugely important part of scaling for advertising businesses, because it allows your advertisers to do this automatically, it's much less labor-intensive to do it. So, they literally only did this a few months ago, and it's still in beta. So, it's very early days in terms of their ad business.

Lewis: And that's really what's going to be making up most of the money for Snap overall, right? Advertising made up 96% of Snap's revenue in 2016. I don't expect that to change. We talked about how they have the Spectacles as well, and they bill themselves as a camera company. There might be some hardware applications somewhere down the road, but in terms of a scalable, high-margin business, they're going to look to monetize the Snapchat platform first, because if they can do it well, the opportunity is the biggest there.

Niu: Oh, absolutely. You can't make money on hardware. Those glasses...you might make a little bit of money, but the whole point of that is to get people to use the platform.

Lewis: Exactly, yeah. And that just feeds into the idea of people posting their stories and sending stuff to friends, and making that video and picture capture a little bit easier. Looking down at their bottom line, they ran a $500 million loss in 2016, down even more from losses of $370 million in 2015. The company is also free cash flow negative to the tune of $670 million. No surprise there. It's a high-growth tech company, very rarely are they profitable when they go public. But one thing, I don't want to nitpick too much with costs, but one line item that popped out to me was general and administrative expenses are $165 million, which is more than they spent in sales and marketing, and almost as much as the company spent in R&D. And they talk about how this is attributable to headcount increasing 200% year over year, but from a corporate strategy perspective, it seems like there's sinking a ton of money into G&A. I would think, if anything, the big money suck would be on the tech side, and gaining talent and pushing the platform in a new direction.

Niu: Particularly with them talking about how important product innovation is to driving user growth, you would think they would invest more in that. But yeah, overall, I'm not too surprised at their costs in terms of their operating expenses. I just don't know what they're going to do next to try to really grow the platform more. Why aren't they spending more money on R&D?

Lewis: Yeah. And they're going to have to. If you look at the current valuation...we talked about how they're probably going to end up IPOing somewhere in the $20 [billion] to $25 billion valuation range. That would mean that they are trading at 62X trailing sales. Not earnings, sales. That is a huge number.

Niu: Yeah, it's ridiculous. I remember when Twitter and Facebook went public a few years back. They both went probably right around 25-26X sales. And back then, I was like, "Wow, that's really expensive." [laughs] And now, 62X sales, it's unheard of. It just speaks to the hype around this company. Of course, the valuation is going to change, and we don't know what they're actually going to price the IPO at. Right now, everything is really preliminary, and they don't price the IPO until the night before it actually goes public. And, of course, that's all a function of how successful the roadshow is. If they can really drum up investor interest, or conversely, if they don't, then that's going to really drive what the IPO price is at. But there's a possibility that this goes higher if they have a really good roadshow, which is insane. Can you imagine them getting closer to 70X sales? Who knows at this point -- it's not impossible for that to happen. It's just insane that this company would be able to command such a premium.

Lewis: And I think another layer of context here: Were it to IPO and have a valuation somewhere in the mid 20s, it would basically be valued at twice Twitter's current valuation. According to analysts, Snapchat has more daily active users than Twitter, but Twitter brought in 5X as much revenue last year. So, when you think about what a really successful ad launch would look like, and building out the platform in a way that has non-invasive ads that don't really detract too much from user experience, and you start to get into that $2.5 billion annual ad revenue, and building on that. And they would be doing that at twice the valuation that Twitter is currently at. So, you just look at the numbers, and it's really tough to make it work, the way it's currently priced.

Niu: Yeah. There's no way I'm touching this thing. [laughs] 

Lewis: Beyond valuation and some of the user growth issues, I know that you particularly wanted to hone in on some of the stuff with voting rights with the shares they'll actually be issuing.

Niu: Yeah, I think it's really interesting. The shares that they're issuing to the public get zero votes. Not even one, zero. A lot of tech companies have been doing this thing for a long time where they give the public shares one vote, and the insiders get these supervoting shares with 10 votes or more. That allows the company founders and insiders to maintain control no matter what. Google is probably the biggest and earliest example of this. Even today, collectively, all the insiders, between the executives and directors of Google, they collectively control about 60% of the voting power. So, public investors really have no say. If they disagree with something, they have no recourse. Facebook is, of course, another good example, with Zuckerberg himself personally controlling about 60% of the voting power. So, he wouldn't even have to ask anyone, he just does whatever he wants. So, the question is, is it really a big deal? Investors are now used to this idea that they don't get a say and how these companies are run. The difference with Snap is that they're basically being upfront and being like, "You don't even get to pretend like you have a say." 

Certainly, it's all bad from a corporate governance perspective on principle, because obviously, it's better for shareholders to have a say. But at the same time, you can see that it's worked quite well for companies like Google and Facebook. Imagine if Google shareholders had a vote in telling Google not to do all this random side stuff that they explore, you could argue that the company wouldn't be as successful as it has. There is a case to be made that this is a good thing, in some situations. But we don't know how it's going to play out for Snap.

Lewis: Yeah. I think one of the reasons why I have a bone to pick with it is, you have the two company co-founders, Evan Spiegel, the CEO, and Robert Murphy, the CTO. They are the sole owners of the supervoting Class C shares, which get 10 votes. Any Class Bs or Cs that are sold are transferred automatically convert to the Class As, the non-voting shares. Anything that would happen with them, they have a supermajority, and anything that might happen would continue to concentrate that power. So, you look at these tech companies later on issuing non-voting shares, or with Facebook, deciding that they want to split its stock and issue C shares so that Mark Zuckerberg can retain his control of the company and be able to give away the non-voting shares through his charitable efforts. Mark Zuckerberg has demonstrated that he has the right combination of that tech-forward thinking and the business savvy in order to run one of the world's biggest companies and do it incredibly successfully. Spiegel and Murphy don't have that track record. 

Niu: Right. Zuckerberg has definitely earned some respect. He's really demonstrated that he can execute on these bigger-picture strategies and growing Facebook in the way that he has. The stock split thing is funny because, like you were saying, he voted it in personally, single-handedly. It doesn't matter if you didn't like the stock split, which hasn't actually occurred yet even though it's been approved, because he said it would happen. But, yeah, you really need to trust these founders. And Spiegel is 26 or 27. Of course, Zuckerberg was too, a few years back. But, to your point, he just doesn't have a track record. And it's like, what has he done beyond creating Snapchat? You can't really point to any single great business move and be like, "That was a really smart strategy, that was a really good move." You know? You have to have a lot of faith.

Lewis: One of the other things I'm seeing a lot of people talk about, digging through the S-1 and doing their homework on the company, is the company's cloud strategy.

Niu: Yeah, this is really an interesting topic for me because Snapchat is doing something that's really unprecedented in terms of how they're approaching their cloud infrastructure. Most of the time, when companies are launching these apps and online services and consumer-based products, eventually, when they get to a certain point, they start investing in their own infrastructure, either by building their own data centers and servers in co-located facilities that they share with other companies, or building their own. Facebook is building its seventh data center, and it's fully owned. Twitter co-locates its data centers. Snap is not doing any of that. Snap is relying 100% on third-party cloud infrastructure providers, Google Cloud and Amazon AWS. It's just crazy because the scale at which they're operating, it would normally make sense to start investing in it yourself, but Snap is content to basically continue to do this through third parties. It's not clear if this is going to work, because no one has ever tried this before, so it's this huge experiment, and there are a lot of risks because you don't get to control your infrastructure in your back end, which is incredibly important to your business, and you're also spending a ton of money. Obviously, building the infrastructure yourself costs a ridiculous amount of money. But over time, it will eventually pay for itself. 

So, what Snap is doing is that they committed to spending $3 billion total over the next five years between Google and Amazon combined. Google is the primary provider, and Amazon is basically a backup. They're spending $400 million a year on Google. The spending commitment with Amazon ramps up, it starts at like $50 million and then it's $350 million by the end. But that's a huge spending commitment. This is, very specifically, their largest cost. If you look at their financials, the cost revenue is predominantly composed of these infrastructure costs, and cost revenue is greater than revenue. So, they have a negative gross margin right now because of this strategy very specifically. At the same time, because of these long-term commitments, the pressure is now on for the ad business. You have to grow ad sales to these levels just to keep up with it, just to break even on gross profit, before you even start talking about operating expenses. 

The pressure to grow the ad business is incredibly high, and they have almost no experience doing that. So, it's a huge risk not only operationally, but it's also a huge risk financially. If you are unable to grow your ad business enough to cover these costs, you're just going to be hemorrhaging cash. And it doesn't matter how popular the service is, if you're just blowing through money and you can't bring in enough to cover these costs, it's not sustainable. We don't know if they'll be able to do it or not, but the point is, the risk that's there is insane. They have to really turn up these ad sales just to cover their spending commitments.

Lewis: Yeah, beyond all of the general investor interest in Snap that will undoubtedly be there for the next couple years and beyond, I think there will be a lot of tech insiders watching this decision. If it works, maybe they'll use it as a blueprint, and decide that it allows the company to be more nimble. But, you have to wonder about the company's ability to control costs, and have total control over what's going on with the IT infrastructure, because that's how everyone is interacting with their product.

Niu: Yeah. Everyone in the cloud infrastructure market is watching very closely, because they're like, "This is crazy, how much this company is spending." It's great news for the cloud infrastructure market, of course, because it's one of the biggest customers out there. They're bringing in a lot of money, and everyone is going to see if this can really work. I mean, it's worth noting that Snap is hedging itself saying it might eventually -- in the S-1, it says they may choose to invest in its infrastructure at some point. A few months ago, they actually poached Amazon's head of data centers for AWS. So, it's like, there are some hints that they're exploring the idea of doing their own infrastructure. But, at the same time, it probably wouldn't be for the next five years because of these commitments. So, yeah, they're still leaving themselves an out. But it seems really risky. It might work out great. In the event that things go down -- let's say the service just crashes -- that does let them ramp down variable costs with more flexibility, as opposed to, if you spend all this money to build all this infrastructure and the service dies for whatever reason, theoretically, then you would be stuck with all this infrastructure you paid all this money for. Versus, just paying it as a variable expense based on usage. So, it's going to be something that's going to be very interesting to see play out, not just because of Snap, but also because of the implications for the bigger companies that are providing these services like Amazon and Google, also Microsoft. Microsoft would certainly like to get a piece of that spending. But yeah, I think that has a lot of implications for the broader infrastructure market.

Lewis: To bring it back around to the stock itself and how we're looking at it, it seems like you and I are in the same camp here -- we have some concerns over user growth, the valuation as it's currently being reported, we'll see what happens after they run through the roadshow, but the valuation is a little too rich for us to really even look at too much, also we have a lot of questions about the competitive risks with some Facebook and Instagram looming out there, and possibly being able to just grab features and drop it on their installed base. Does that wrap how we feel about Snap? Anything else you want to add in there, Evan?

Niu: I don't think Snap's investable, honestly. There are so many risks, the financials don't make sense, the valuation doesn't make sense, you get no voting. [laughs] I don't doubt that shares will pop from the offering just because of the hype, but as we've seen with many overhyped IPOs in recent years, it only takes a few months for the market to sober up. Plus, Snap's also doing a different thing with the lock-up period. Employees will be able to sell sooner -- the lock-up expires for employees sooner than is typical. Normally, it's about 180 days. They're going to allow their employees to sell at 150 days, along with all the co-founders. So, there could be some selling pressure as all these investors and employees cash out. The employees and all the insiders are going to make a ton of money, but as far as public investors go, I don't know. It's also worth mentioning that their stock-based compensation expenses so far are quite small because they're still private. I think last year it was something like $30-some million, which is a tiny proportion of their expenses. But when companies go public, the liquidity event triggers a ridiculous increase in stock-based compensation cost because now that stock is worth so much more. And that's typical for all companies that go public -- right after they go public, they have a huge increase in stock-based comp. That's something to be aware that is coming. Plus, they're probably going to start unloading pretty quickly. I don't know, I just don't see, after the initial honeymoon, how this thing can really go even further, after it's already at such a ridiculous level. You know what I mean?

Lewis: I am absolutely with you. Listeners, you can be sure that as details start to crystallize and we get a better sense of what's happening with the Snap IPO, we'll be sure to do an update on this episode as market conditions clear up a little bit. But, for now, I think that does it. Evan?

Niu: Yeah, I think we hit it.

Lewis: Listeners, that does it for this episode of Industry Focus. If you have any questions, or if just want to reach out and say, "Hey," you can shoot us an email at [email protected], or you can tweet us @MFIndustryFocus. We love getting listener questions, so please shoot them to us. If you're looking for more of our stuff, you can subscribe on iTunes, or check out The Fool's family of shows at fool.com/podcasts. As always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against stocks mentioned, so don't buy or sell anything based solely on what you hear. For Evan Niu, I'm Dylan Lewis, thanks for listening and Fool on!