Snap (NYSE:SNAP) went public in early March and it's already been a roller coaster ride for investors.
On this episode of Industry Focus: Tech, Motley Fool analyst Dylan Lewis is joined by contributor Evan Niu to explain why long-term investors interested in the business should probably hold off on buying shares of the company.
Also, they examine a few significant issues with Snap's business strategy as it stands right now, how Snap's initial public offering (IPO) measures up to last year's tech IPOs, and why they're skeptical of the company's hardware ambitions.
A full transcript follows the video.
This podcast was recorded on March 3, 2017.
Dylan Lewis: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It's Friday, March 3, and we're following up on our discussion of Snap. I'm your host, Dylan Lewis, and I'm joined on Skype by Fool.com's senior tech specialist Evan Niu. Evan, how's it going?
Evan Niu: I'm OK. I'm a little jealous that I didn't get to sell $300 million worth of stock this week, but there's always next week.
Lewis: Yeah, it seems like some of those early Snap insiders did pretty well. The market has been pretty kind to the ephemeral messaging app in its first day and hour of trading on the market. What is it up, 20% today?
Niu: Yeah, it's up another 20% today, it jumped 44% yesterday, so right now it's about a $34 billion company already. [laughs]
Lewis: Which is nuts. That is multiples of Twitter's (NYSE:TWTR) market cap.
Niu: Yeah, it's two to three times at least. At yesterday's close, it was 2.5X the market cap of Twitter, so today is probably pushing three.
Lewis: That is insane. There are some crazy valuation metrics that we might briefly touch on with that. But when you look at this market reaction, there was a lot of demand for this issuance. I read on CNBC that the issuance, the IPO, was 12 times oversubscribed, which basically means the overall demand for the shares at issuance price, when the banks were underwriting that IPO and they were talking to clients, was 12X what was being made available by the company. So, you see what's going on in day one and day two of it hitting the market, and you have people that probably didn't get quite the allocations they were looking for in the underwriting process and are now trying to get more. You also have people who are just generally scooping up demand on hype. There's a lot going on there with Snap.
Niu: Yeah, I definitely agree. A lot of people are probably interested in this deal, and the underwriters only have so much that can go around, so the allocations probably weren't as much as people were hoping for. But that's kind of what happens when you have a deal that has as much excitement as this one. To circle back on some of the valuation metrics you mentioned earlier, as of last night, Snap closed at $24.50, which put them at a $28 billion company, trading at a price-to-sales [ratio] of like 71. Today, with this jump right now, that's getting closer to 85. They made about $400 million in revenue last year. If they're at $34 billion, that's 85X sales. It's just insane. [laughs]
Lewis: That is crazy. And we had talked about, in the episode we did two weeks ago looking at Snap's S-1, what a rich valuation it was going to be coming in at. And that was when they were speculatively somewhere between $20-24 billion on this issuance. To see it go up even more continues to raise those red flags that we were talking about. Listeners, this episode is going to be more of a follow on the IPO and some news we've seen recently about the company. The deep dive that was very core business-metrics-oriented we did two weeks ago. You can always go back and check that one out for a discussion of user base and monetization and the approach there. But, just a heads-up. One of the news items that I wanted to touch on was a look at lockup period with the IPO. This is something kind of a folklore, we don't know 100% what is going on here. But, a couple days before the IPO, Snap had mentioned that they were expecting investors buying up to a quarter of the shares in the IPO to agree to not sell them for a year. Which seems crazy to me, that large institutions would agree to that.
Niu: Yeah, it's a pretty unusual requirement, as if this offering wasn't unusual enough with some of the other things they've been doing, like the voting stuff we talked about before. This is a really weird ask of institutional investors. And it's a direct contrast to the lock-up they're doing. They reduced the lock-up period for some of their own employees. At the same time, they're asking these new investors to come in and hold on for a year. Of course, the goal is to mitigate volatility, because IPOs tend to be really volatile. So, they want some commitment from these investors, say, "Hey, don't sell," to try to manage that. In their prospectus, they didn't really change their language. They said they expected to have 50 million shares worth of these agreements, but they pointed out they do not have any firm agreements or commitments yet. I'm curious if they actually got any.
Lewis: Yeah, it's hard to know if anyone took the bait on that. The benefit for Snap here is pretty clear. The lock-up period, like you said, helps reduce volatility, moderates the stock price, prevents people from getting in and out. It incentivizes people to buy and hold. But if they did wind up getting some people to go into these binding commitments, that might be another reason why the stock is moving so wildly in the first couple days. We talked about how only about 200 million shares being issued, and if 50 million or any fraction of them are also not a part of that, because they can't be sold once they've been issued, then that's obviously going to restrict the supply that's out there for people who are looking to scoop up shares.
Lewis: You touched on what was going on with the employees, and I do think this is kind of interesting. Snap announced that they were making some changes to their lock-up expiration. They're basically going to be reducing the amount of time employees need to hold on to shares down from 180 days to 150 days. This is similar to what they were asking of the institutions, and this is a standard thing for insiders at any IPO. But what you'll wind up seeing because of this, I'm guessing, is a decent number of shares becoming available in late July.
Niu: Right. That's always something that anyone looking at trading an IPO should always be aware of, these lock-ups, which tend to put a lot of selling pressure on the stock. I wonder if Snap will do a secondary offering in a few months, just for employees and selling shares, where they're not actually raising money. That's not uncommon these days, for companies to do these follow-on secondaries shortly after the IPO, purely as a way to manage volatility associated with lock-up expiration, because that way they can just kind of, if you know you have a bunch of employees and investors from before that want to sell, you can set up a secondary offering and do it in a more structured and orderly way without flooding the open market with all these sell orders that push the price down. Instead, it's more orderly. And usually, obviously, the company just raised a bunch of money from issuing the shares. Usually, if they do it, they just have it just for the employees to sell shares. The company itself is not actually issuing more shares. So, I wonder if they'll do that. It does seem like they're concerned about volatility, and that's something that companies do these days.
Lewis: Yeah. I also do think it's a little interesting that the commitment they were looking for from some of these large institutions was beyond the period that they were asking employees and co-founders and early investors to hold onto shares of the stock.
Niu: It kind of sense of mixed message. [laughs]
Lewis: [laughs] A little bit. They're clearly looking for long-term buy-and-hold folks there. One of the other news items I saw --
Niu: Really quick, I think it's even more ridiculous that whole one-year period, because during their road show, some investors were asking, "Where do you see yourselves in five years?" Which is a standard interview question. That's a question you should be able to answer.
Lewis: I think I had to answer that when I was coming to the Fool, yeah.
Niu: Yeah, it's a very common question in general. And it's not an unreasonable question to ask, particularly for an investment, and if they're asking you to hold on for a year. And I was reading some reports about the road shows, and they couldn't even answer that question. So, a lot of investors were like, "Where are you going to be in five years?" And they were like, "I don't know." Really? You don't have a long-term vision, or any answer at all? They just dodged the question. I thought that was really suspicious.
Lewis: You know, that might be the perfect transition into the next section that we're going to be talking about. There had been some news coming out about their hardware business. In the last episode, we talked about how Snap is saying, "We are a camera company," yet they currently make a very tiny amount of money from their Spectacle camera glasses. I think around 96-98% of Snap's revenue currently comes in through ads. We have two pieces of news when it comes to hardware. Originally, they only sold these Spectacles at specific locations via vending machines. So, there were these tech insider moments where they would find out there was a vending machine somewhere in San Francisco, and it would be flooded with people in line down the block forever. It was very novelty, it was very buzz-oriented. They've announced that you can now buy the Spectacles online at spectacles.com for just $130, which seems pretty expensive for, basically, glasses that capture what your smartphone does.
Niu: And probably not as well, either. I know that the Spectacles use an Ambarella image processor. I'm not sure who actually produces the actual image sensor or the tech specs. I don't think Snap has released the tech specs very broadly. I think they've been playing close to the chest. But, it's weird because you have company that's trying to brand itself as a camera company and they've only been making a camera for a couple months, whereas through the vast majority of their history they have relied on the smartphone camera that's already in your phone, which, in a way, is easier, because the entire smartphone industry has placed a lot of value on really innovating and developing the camera systems because it's such an important thing to consumers. So, you have this intact industry that's pouring money into building the best possible cameras, and then you have Snap come along saying, "Oh, we're going to be a camera company." It's almost committing them to trying to out-innovate the smartphone industry, which, of course, includes Apple, which is the richest company on Earth. We were talking about this earlier. Apple's camera department alone has somewhere between 800 and 1,000 engineers working just on cameras, which is why the cameras are so good. Snapchat now has a total of 1,800-1,900 employees. Apple's camera department alone is half the size of Snapchat's entire company. So, who do you think is going to win? [laughs]
Lewis: Yeah, where is the innovation going to come from.
Niu: Yeah. And sure, Snap has this little form factor thing you put in the glasses, but I just think there was certainly a lot of buzz around it, but whether or not that's going to be a long-term deal...it's just really hard to make the pitch. I also don't understand because, in terms of investor perception specifically, I think most people consider Snap a software-as-a-service company. Software-as-a-service companies get much richer valuations in terms of all of the valuation metrics because they're more profitable, they can scale better, etc., whereas consumer hardware businesses get very low valuations because everything gets commoditized, you have really thin margins, consumer preferences change a lot so you're always at the mercy of these products cycles, and, not many companies can navigate that well, so investors don't give them very good valuations. So, you have Snap, that historically is a software-as-a-service company trading at ridiculous valuations now trying to say they're a hardware company, but it's like, why would you want that association if, by proxy, you might be asking for a lower valuation? [laughs] It's weird, I don't understand it at all.
Lewis: Yeah, if you want to look at the market's opinion of consumer device companies, check out GoPro and Fitbit. These are two companies that sell what I would consider to be very successful mainstream consumer device products, but they've hit saturation points with how much they can penetrate a market, and have struggled to get outside of those markets, and that's one of the problems that a lot of consumer hardware companies run into.
Niu: Even if you look at all these old, mature Asian companies, like Sony -- Sony trades at less than one times sales. Toshiba, all of these household names in consumer electronics, they trade really cheap.
Lewis: Yeah. It's bizarre to me. The next piece of news we're going to talk about is even more bizarre. According to reports from The New York Times, the company had other hardware ambitions, namely drones. At the moment, details are scarce, but several anonymous sources at the company confirmed Snap has been pursuing a drone camera project. I guess the thought here is, drones would allow aerial Snaps, it would allow people to capture video and images in a more novel way and a cool landscape way. Again, this seems kind of crazy to me, for this to be the focus.
Niu: [laughs] Yeah. It makes no sense to me. As ridiculous as the Spectacle thing is, trying to brand a company around those, the drone thing also makes no sense to me. It's hard to imagine someone buying a drone. First of all, it's hard to imagine Snap coming out with a drone that is competitive with what's already out there from DJI and even GoPro. Look at even GoPro trying to get into drones -- they've had a lot of trouble. A company like GoPro that had experience making cameras still has trouble making a really compelling drone that has all the full features that people expect nowadays.
Lewis: They famously had to recall one of their products, because they were having trouble with it.
Niu: Yeah, because the battery was loose. If you shook it, the battery would move by a millimeter and the contacts would lose power, which is a really simple and kind of embarrassing problem. It was such a silly little mistake, and it probably had something to do with their manufacturing or something, I don't know. But yeah, the point being, GoPro hasn't really pulled off the drone thing very well either. And they were probably much better-positioned to make that kind of jump in the first place. And, of course, this is just a report that they're working on. Who knows if they actually do it. I hope they realize that it's a bad idea, and probably save everyone a bunch of headaches if they just don't do it at all. I mean, I guess it's not surprising that they have looked into it, since they want to become a camera company. But whether or not they actually do it, I think the chances are probably against it. I would hope so.
Lewis: Yeah. I get that, it's tempting to be a tech company and have these really sexy side project. You see the stuff that Alphabet has done with Google's self-driving cars. That is so far afield from their core search property. Even Facebook (NASDAQ:FB) getting into virtual reality on the hardware side with Oculus. But, you look at those two companies, those are businesses that have a cash cow underlying all of these futuristic R&D projects. Their core platforms, their ad-selling platforms are doing wonders for them, and are allowing them to throw money off on the side, and see what happens with these more futuristic, hard-to-pin-down-what-the-impact-might-be type projects. I think with Snap right now, there's a little bit of a focus concern on my end, because you haven't really figured out your core platform yet, you haven't monetized it really well. You're still rolling ads into it and building it into the user experience. And, you have like 3% quarter-to-quarter user growth. You have so many issues with what should be your core focus, I'm not really sure why they're doubling down on their hardware initiatives, if this is something they're really spending a lot of time on.
Niu: That's a good point, I agree completely. Why aren't they focusing on getting the core business up and running in a good way? They're just now really rolling out these ads. Of course, in advertising, your ability to target ads is really critical in delivering value to your advertisers, who are the actual customers. That's who pays you. Facebook does a really good job with ad targeting because they have so much of your data. Twitter, I think, has had some troubles, which is partially why they're not monetizing as well as they should be. So, I guess the question is, how much user data can Snap really get, and how valuable will that be? Most of the stuff you're putting on Snapchat disappears immediately. What kind of data can they gather that's going to be really useful to turn around and use for targeting? It's kind of the same thing with Twitter. A lot of times, people can view tweets publicly without having to sign in, which limits Twitter's ability to gather data on them, which is also why it's harder for them to monetize their users. It's a big question on execution going forward, how they can really grow this ad business. If they can, this will do well. They are very new to this.
Lewis: Yeah, it's something that I think they really have to figure out still. You look at the data points that Facebook and Google have on their users, and you're right, it's totally different, the profile is so robust for what people have on their Facebook. They know all my interests, they know everything I like, and they're able to incorporate that into the algorithms they're using to feed stuff up to me. Google knows exactly what you're searching for, and can serve up hyper-relevant stuff. With Snap, they know your friends, they know your demographic, and maybe they know some of the outlets that you're typically interested in on the story side. But I think they still need to do a ton to figure that out, and I'd rather see them doubling down there than going further afield with some of these hardware projects.
Niu: Yeah. The big emphasis on hardware in general is confounding to me. I don't understand why they're doing it, or why they're trying to make this pivot -- if you want to call it a pivot. They should just get down to working on their actual ad platform, focus on the software-as-a-service stuff, before they really start dabbling in this hardware stuff. Hardware is hard.
Lewis: And the way that their hardware is set up, too, their Spectacles are built-in to integrate with Snapchat. They're not really a device that you can use across platforms.
Niu: Well, you can export, and it exports in a circular format as opposed to the square format that most people see. So, there is a way that you can export content that you take on Spectacles. But, yeah, the point is, you would think they would want to tie exclusively to the platform. But then, it's like, why would you buy some product that's only available for this platform? Conversely, if it's not a good product, if it works on all platforms, why would you buy it unless it's the best product out there? It's this really weird Catch 22. Imagine, would you buy a product that could only submit stuff to Facebook? It doesn't make any sense. But that would be the differentiating factor. But yeah, their whole strategy makes no sense to me.
Lewis: Yeah, it seems a little backwards. The point that I was going to make is just, the biggest salesman for the hardware stuff is going to be people being on the platform in general. The addressable market for those products is going to be whatever the user base that they have is. Right now, it's around 160 million daily active users. The most compelling way to make that hardware business look appetizing is to continue to grow that user base, then maybe you have people that want something that's a little bit more dedicated. I'm still skeptical of that. But ultimately, that logic ties back to, build the platform out and grow the user base, and worry about hardware second, right?
Niu: Yeah, I agree.
Lewis: So, Evan, I maintain my "I'm not touching this stock" position at this point, given the company's strategy that we just talked about and the valuation. Those are two things that are big red flags for me. But I'll also say I'm very generally against buying a super high-growth company in its first few quarters after going public, simply because there is so much volatility in the share price. If you look back at the big tech IPOs from 2016, I think there were three of note: Twilio (NYSE:TWLO), Nutanix, and LINE Corp. Twilio IPO-ed at $15, shares popped 90% on the first day, ran up to over $60 a share in September, and has fallen back down to the high $20s since. Nutanix, priced at $16, shares popped 145% on the first day. They currently trade somewhere in the mid-20s. Lastly, LINE Corp priced at $32, shares popped 27% on the first day, currently trade in the mid-30s. What you will see with all of those is huge first-day trading spikes, a lot of enthusiasm, and then a fall back down to a much more moderate valuation. Of those three, only Twilio is above where shares ended on day one, and they're up about 10%. I run through that list just to highlight there's a ton of volatility and a ton of hype that comes into these early tech companies. It's OK to sit on the sidelines. Even if you're a Snapchat bull, it might make sense to hang back a little bit and let the market settle on a little bit more on an agreed-upon price. Let some of those early employees actually sell their shares when the lock-ups expire and have a little bit more supply out there on the market, and you might wind up getting a better price for what you're buying.
Niu: Yeah. Even if you like the company, it doesn't mean you have to like the stock. Right? At these current levels, for sure.
Lewis: Absolutely. And I'll say, I like the platform. I use Snapchat. I have used it for several years. It's a cool way to mess around with my friends. I'm not sold on the business case yet, and I'm certainly not sold on the stock. But, you can like one without liking the other, or liking all three, for that matter.
Niu: Right. It's just a valuation.
Lewis: And when we talk about the valuation struggles, some of the business struggles that we see for the company, we're not the only ones out there. I think there are a lot of people out there who are bearish on Snap. I think the average investor out there sees all that bear sentiment and says, "OK, well, I'm hearing that it's overvalued. To me, that triggers the idea that maybe I should short it, or use some options to make a bearish bet against the company." And I've actually seen some murmurs about this on Twitter, and I think someone might have written in on The Motley Fool podcast group about this. I'm generally against advising anyone to short anything, because the downside can be pretty catastrophic. But I think it's a question we'll see a decent amount around these types of times. Evan, do you want to explain a little bit why investors can't do any shorting right now, and there really isn't much they can do in the ways of options at the moment?
Niu: Technically, you can short a stock early on, shortly after going public. But it's really hard. If you think about who actually got shares -- you have underwriters and investors, institutional and retail. Of course, when you short a stock, you're borrowing the shares to go sell, and then you need to buy them back at a later time, ideally at a lower price to return them. But there's not a lot of people in the early days, in general, of IPOs that are A, willing to lend their shares -- there's just not a lot of supply on the lending side, in terms of securities lending. There's really just not a lot to go around. And, to add on to that, a lot of brokers can set their own internal requirements to mitigate their own risk exposure. For example, I used to work at Charles Schwab. Schwab is very conservative. They really don't like taking a lot of risk. Most IPOs aren't even marginable for around the first 30 days. You really just can't short them if Schwab doesn't let you have them in the margin account. But that's just Schwab, every broker will have their own requirements. So, it's really hard to short shares directly. And even if you could, like you mentioned before, it's so volatile, so it's just kind of a crapshoot either way. So, it's probably not a really great idea to go short a stock that just went public as soon as you can, just because it's a tricky proposition to begin with. In terms of options, options get issued every so often. The first time that a stock can technically be eligible to have options created for it is about five days after the IPO. It's up to the options exchanges to decide if they want to create these contracts, and the Options Clearing Corporation, if they want to create these contracts based on investor demand.
There's a handful of requirements for a stock to even have options on it. The most important one is the five-day thing. They'll meet all the other requirements pretty easily. I would expect that options on Snap would show up, probably, next week or the week after that. Obviously, there's a lot of interest and demand around this offering, so I imagine that the options Clearing Corporation will probably issue these things out pretty soon. If you want to bet against it -- which, to be totally honest, I'm thinking about doing -- shorting is certainly very risky, and so is options. So, these are both very risky in general. But I think, with options, there are a million strategies you can put together. But I think you could put together a bearish strategy with options in a way that also controls your risk better, versus if you short it straight out, theoretically, you have unlimited downside if the stock keeps running like it does. With options, depending on what strategy you pick, you can pick some that are actually a little bit more conservative in terms of your risk exposure. But yeah, I'll be keeping an eye out for this. I think it will come down pretty soon.
Lewis: Yeah, I think that options discussion might make for a great Industry Focus episode in the future. I think for Fools out there who are seeing what's going on with Snap, you always have to kind of remind yourself that nothing about the core business has changed from the day before it went public to today. All of the key quarterly financials and business metrics that we like to look at are exactly the same as they were before. It's just that market sentiment and hype has pushed the stock up. If you continue to like it at that valuation, then it doesn't really matter, for people that are a little bit more sensitive to high-valuation stocks that might keep you out of it.
Niu: Yeah. I think the market will sober up pretty quickly.
Lewis: We'll see. This will be one of the companies that I think we'll talk about a ton in 2017. A lot of people know it, it's consumer-facing, and clearly there's a ton of interest, just based on the way that market has been treating it so far in its first day and a half or so of trading. More to come. Anything else before I let you go, Evan?
Niu: No, I think we covered it.
Lewis: Well, 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 firstname.lastname@example.org, or you can tweet us @MFIndustryFocus as well. If you're looking for more of our stuff, subscribe on iTunes, or check out the Fool's family of shows at fool.com/podcasts. Also, we're having a happy hour/meetup if you're going to be in the Austin area for South By Southwest, I just wanted to give you guys a heads up. If you want to drop us an email at email@example.com, we'll get you all the details. It'll be a decent crew of Fools out there, and we'd love to meet up with some members and people that follow the shows.
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!
Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool's board of directors. Dylan Lewis owns shares of Alphabet (A shares), Ambarella, Apple, and Facebook. Evan Niu, CFA owns shares of Apple and Facebook. Evan Niu, CFA has the following options: long January 2018 $120 calls on Facebook. The Motley Fool owns shares of and recommends Alphabet (A shares), Alphabet (C shares), Ambarella, Apple, Facebook, Fitbit, GoPro, and Twitter. The Motley Fool has the following options: long January 2018 $90 calls on Apple, short January 2018 $95 calls on Apple, short January 2019 $12 calls on GoPro, and long January 2019 $12 puts on GoPro. The Motley Fool recommends Twilio. The Motley Fool has a disclosure policy.