The recently public Snap (NYSE:SNAP) saw a little bump in its share price in late March after sell-side analysts gave the company mostly positive coverage.
In this episode of Industry Focus: Tech, Motley Fool analyst Dylan Lewis and contributor Evan Niu explain what the buy-side sell-side divide means, and then dive into the coverage from these analysts and what they are saying about Snap.
A full transcript follows the video.
This video was recorded on March 31, 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 31, and we're talking analyst coverage and Snap. I'm your host, Dylan Lewis, and I'm joined on Skype by fool.com senior tech specialist, Evan Niu. Evan, what's up!
Evan Niu: Going well, just drinking my coffee.
Lewis: Yeah, I'm happy to get you before you have the big outing with the kids to the aquarium, right?
Niu: That's right, going later today, having a family day.
Lewis: That's the life of a contractor, right there. [laughs] So, Evan, shares of Snap enjoyed a nice little bump earlier this week thanks to some analyst coverage which seemed to give the stock a pretty rosy outlook. For today's show, I figure we'll talk a little bit about the sell-side analysts, and the life of the sell-side analysts, the people that are putting out these research notes, and run through the recent research we've seen and how we feel about it and how it jives with some of the stuff we've read and our own opinions. Before we get too far into the discussion, I think there are probably some listeners out there that aren't super familiar with the buy-side sell-side dynamics of the investment industry. Do you want to run through that first?
Niu: Sure. Basically, the buy-side are analysts that are working for funds that are actually buying the stocks. They're the ones that actively have money in whatever they're picking. The sell-side analysts are the guys you see on TV, the research notes you hear put out. Those analysts work at banks or investment firms and all they do is do the research and try to sell that research to the buy-side. The sell-side usually cannot own any of the stocks that they research for objectivity purposes. A lot of the times, what they try to do is try to get the buy-side to come trade at their brokerage, and then the sell-side analysts get a small percentage of the commissions that those clients pay. And often, they will pay inflated commissions on purpose through an arrangement called soft dollars, which, from the fund's perspective, shifts costs from the management side to the investors. It's kind of a shady thing that's always been there, but that's just the way it works. [laughs]
Lewis: So, when we see these notes coming out, or, when we see new price targets, these are all coming from the sell-side analysts, and this is them publishing research. Really, it's a client book-building method for them, and it's a way to build buzz about companies that they're following, and put out their thoughts on them.
Niu: Exactly. It's more or less just trying to get exposure, marketing pitch, to say, "We have this really good research," and try to attract more clients to buy that research, whereas a buy-side analyst, if a buy-side analyst does their own research, let's say they do a super deep dive and they have some information they think is super valuable, obviously, they're not just going to advertise it, they're going to go act on it and try to make money on it, if they have better information than the rest of the market. That's the goal. But, yeah, so, they're not going to be the ones that are out there talking up too much. Of course, sometimes you see people on TV that are like, so-and-so capital management. They do like to go out there and be seen in the media. But most of the time when you hear about price targets, readings, underweight, overweight, buy, hold, whatever, that stuff is all sell side.
Lewis: By my count, looking at Snap, we have six buy ratings, two hold ratings, and one sell rating from analysts so far. A lot of price targets seem to be in the high $20s and low $30s from some of the underwriting banks from the IPO. It's kind of funny how that works out, huh?
Niu: Yeah. The underwriters have a longer quiet period. The quiet period just went up, so now all the underwriters can start putting out their own ratings. Some of the other ratings we've seen before were from other firms. If you look at the IPO, there were seven underwriters. One is boutique and really doesn't issue ratings, Allen & Company. One hasn't issued a rating yet, as of right now, they haven't issued one, that's Barclays. So, out of the five remaining underwriters, there are four buys and one hold. So, of course, it looks a little like they're biased, because they underwrote this giant deal. But, to be fair, there are some other more objective ratings that have come out in the past few days also that are buy ratings, like Cowen, Citi, Jefferies, RBC, and a couple or some others last week or so. So, it's not like you have to be an underwriter to like the stock, there are certainly other people who had nothing to do with the deal that are out there being bullish. But, as far as investors are concerned, it looks a little biased, but there is supposed to be this Chinese wall between investment banking and research, but I'm sure the analysts are very well aware that if the other side of the business has this huge deal, it doesn't really look good if you go out and start bashing it, because they're probably not going to win those deals in the future.
Lewis: Yeah. I think before we get too far into this conversation, it's good to be clear, there are regulations in place to prevent the investment banking arm of a firm from reaching into research analyst coverage. Like you said, there's the wall between the business. Usually, folks can't even be in the same room with each other without a chaperone or something like that. But, there are some incentives at play. Really, you can't be surprised by this, because at the end of the day, the underwriting banks just spent months talking about how great Snap is to all of their clients, all of these institutional investors, all these high-net-worth individuals. So, it's really not all that surprising for an analyst from that firm to feel the same way about it, right?
Niu: Yeah. They should be able to, objectively, if they really felt that way. But the optics would be really hard to justify. Like you mentioned, they've been talking this thing up. The underwriters make all sorts of money on these deals, not only in terms of the fees that they collect, but in terms of, once the trading starts and they have their big clients. The whole goal of these IPOs is to put together, engineer a nice pop on the first day. Most people say the IPO went great if you get a big jump. Snap did on the first day, and went up about 40% on the first day of trading relative to the offering price. They have a lot of incentives to make the deal look good. And then, of course, once the quiet period is over, if the analysts come out and start bashing the company, it doesn't really make a lot of sense. That's not to say that it's impossible, I'm sure there are cases that it's happened. I don't have any off the top of my head. But, I think you'd have to be really naive to think that these Chinese walls work exactly as they're intended to all the time.
Lewis: Yeah. And while it is tempting to drop conspiracy theories with this type of stuff, I do think it's worth remembering that, like I said, these banks spent a ton of time telling institutions and high-net-worth individuals what a good company Snap is, and really selling Snap. So, losing that business and tarnishing the relationship with those institutions or those high-net-worth individuals that they spent so much time bringing in with these research notes would be almost a bigger loss for an investment bank or a research firm or an investment management company. So, that's something that plays into this. As an aside, I think the quiet period and the regulations are set up in a way that reinforces all of this. We talked about how they can't put out any notes on this. That's only for 25 days after the issuance. To go back to this, they just talked about how excited they are about the company on their roadshow. Nothing is going to change, there aren't any new financials out. So, I think one way they could improve these regulations is maybe by forcing analysts to wait until the company has reported a quarter of financials first, because that would actually give them the chance to say something new. And then, if they wanted to put out bearish coverage, they would always have the ability to hide behind the fact that, in the most recent quarter, they saw something they didn't like. It gives them an out.
Niu: Right, it could give them a little bit more justification. But I think the challenge there is, earnings schedules are so tricky, and they can be so specific to each company. So, I think the regulations are meant to -- I guess they felt 25 days is a good enough period of time.
Lewis: Yeah. The takeaway here is, you should never expect to see a research analyst come out and bash a company that his or her firm had underwritten the IPO for, it's just probably not going to happen all that often.
Evan, we've both been bearish on Snap. I thought, since there was a lot of optimistic notes coming out about the company, it might be good for us to look at it and see what the other side of the coin is, and whether we agree or disagree with any of the points that they're making. One of the first things that I clued in on here was a quote in the research note from Heath Terry of Goldman Sachs. He says, "Snap is a venture-stage investment in the public markets, something unseen in recent years where nearly all internet companies waited until later stages of growth and profitability to go public. While this clearly carries a higher risk profile, we believe it also comes with higher reward potential." This is something I agree with. I don't know about you.
Niu: Yeah, I think it's kind of an apt description. I agree that I don't necessarily think it's a good thing. I mean, there's also a reason why most companies go public later in the stage. Trying to assess a venture-stage investment is extremely complicated and hard, and it's crazy risky. I don't think it's necessarily a good thing for public investors who don't have that kind of experience to analyze companies from at that stage. It's just a lot trickier to value and invest in, which is why that stage is usually done in the private markets. To open it up to public investors and say, you have a chance to invest in an earlier stage than most companies would do this, yeah, I agree there's probably a higher risk that translates to higher reward, but I think investors have this natural tendency, whenever they hear that phrase, "high risk, high reward," they don't focus on the high-risk part. They focus on the high-reward part.
Lewis: They just see the dollar signs, right?
Niu: Right. But you have to put equal weight into both sides of that equation. I think the risks here are extremely high. And it's true that they might turn into high reward. But I don't think public investors are as good at that, at weighing out all the risks for a company at this stage as an experienced venture capitalist is.
Lewis: Yeah, Snap is still so early in the monetization strategy, and what they will look like as a money-making business, if they ever become one, is still really hard to make out. I chatted with the founder of Indiegogo, Slava Rubin, and Bill Clark from MicroVentures, a venture capitalist, while I was at South by Southwest, and he said, venture-stage businesses, 7 out of 10 of them go belly up. I don't expect Snap to go bankrupt by any means. But that gives you a sense of the profile for the type of business that Snap is being equated to, and the idea that, it's really hard to picture what it'll look like in its full form. Because of that, you have the higher risk and potential for large gains down the road, but the downside is certainly there.
Niu: Yeah, I think that part of my skepticism also is, maybe there's a sense that they want to take the company public earlier than most other companies might do it because they want to cash out and take advantage of the environment and the hype. And also -- again, I'm being super skeptical here -- maybe they internally think unit growth is hitting a peak, so they're like, "Let's go ahead and cash out now. There's tons of hype, people want to buy in, and we're hitting this wall. And the hype might fade away if we don't do this." I just think that maybe part of it is that they wanted to cash out. If you look at how they structured the deal, it's not very investor-friendly, it's not very shareholder-friendly, from a governance perspective. Maybe that's a small part of it.
Lewis: And companies control when they go public, for the most part. So, if you're looking at your financials and the core business metrics, and you are seeing that sequentially user growth is 3% in the most recent quarter, you might decide it's starting to look like a good time to go public because your books are about as good as they're going to look before you really start rolling out the core monetization strategy.
Niu: It's all hype right now.
Lewis: Yeah, exactly. I know, to go back to that, one of the things that both of us were a little worried about when we were looking at the IPO was user growth. They're at about 160 million daily active users now, like I said, up just 3% sequentially from the previous quarter. That was 48% year-over-year growth, though. One of the things I saw in some of these research notes was some user growth estimates. I thought it would be interesting to run through these and see what you think. Cowen estimated that Snap would have roughly 195 million daily actives at the end of 2017, which would be good for 24% year-over-year growth, and would basically be a 5% sequential growth rate for the rest of the year. I actually think that's fairly reasonable.
Niu: All these analysts, all these estimates are just numbers in the spreadsheet. They just plug in these growth estimates. I think the more important question is, how do they actually get there, as opposed to just assuming these numbers on some spreadsheet are all fine and dandy. And that's how all models work, of course, that's what they are. But at the Fool, we tend to think about it more in terms of business on the ground. How are they going to do this? How are they going to grow users, how are they going to grow their ad sales? Because all these models will say, "We expect this number of revenue by 2019 or whenever." But I think there's a lot of uncertainty with Snap's execution going forward, in terms of both ad revenue, trying to grow that, as well as trying to get more users on the platform. I don't know, I think it's a more complicated answer than a lot of these analysts make it seem to be. Does that make sense?!
Lewis: Yeah, I wanted to bring it up to show, this is what a rosy outlook looks like. For growth of the platform, that doesn't seem crazy to me. But, one of the things I am a little bit worried about, we haven't talked about this a ton in our past coverage of the company, I think international growth, particularly in developing markets, is going to be a lot harder for Snap than it has been for some of the other social media companies, because it's such a video-intensive platform.
Niu: Right, that's a good point. Video requires a lot more bandwidth, and a lot of emerging markets don't have a lot of good LTE network bandwidth on the infrastructure side. LTE penetration is quite low in some markets. Which is a challenge for the broader smartphone market to grow in those areas, too. But for Snap specifically, because they rely on higher-speed connections, because the app is so video and photo intensive, yeah, that's another thing that's going to hold them back.
Lewis: One thing that I didn't really see a ton of discussion about in the notes was Snap's status as a camera company. Frankly, that was one of the things that I was most worried about in looking at the prospectus and the general vision for the company. Most of these analysts are looking at Snap as if it's a social media platform and a traditional online business, and so much of the messaging from Evan Spiegel and management has been, "We're a camera company, we're going to be playing in hardware." Clearly, there's some sort of integration they see there as being super valuable. To me, that's always been a vision and strategy question mark, and I was a little surprised that people didn't touch on that more.
Niu: I'm kind of glad they didn't. Like we've talked about before, we think it's a weird way to brand themselves and identify themselves. It doesn't really make a lot of sense. So, I'm glad that the analysts aren't really putting too much emphasis on that, because as of right now, that's a tiny portion of the business. To focus there like management says to focus there would probably be misplaced. So, I think it's encouraging that they are focusing more on the ad side of the business. To speak more on the ad side, from the Morgan Stanley note, they were talking about how a lot of the upside they see is from ad load. Right now, they estimate that they're at something like 0.6 ads per daily active user per hour. They expect that to rise to eight. That's about a 13 times increase over the next year or two. But this is kind of a catch-22, because Snap is huge among millennials, but millennials hate ads. So, while, of course, in any context, if you increase your ad load, you risk hurting your user experience, you risk your users not liking it. But I think that concern is particularly important for millennials, who might be even more sensitive to an increased ad load that would start hurting the experience more than other demographics. Again, this goes down to this whole idea of execution on the ad business. There's another note, the Credit Suisse one said this is a "margin expansion story," because they're expecting sales to grow faster than cost of goods sold. But I don't really think that says a whole lot, since Snap has a negative gross margin right now. Getting that to positive territory should just be table stakes, you should just expect them to do that. The uncertainty there is whether or not they can actually execute to grow ad sales. There is quite a bit of visibility into what their costs are going to require, because they have these cloud infrastructure spending commitments. So, can they grow ad sales faster than that? That's a huge question, and that's going to really determine, in terms of this whole margin expansion idea, if they can actually do that. So, yeah, there's just so much uncertainty here. I don't know how they're going to actually execute on all of these fronts and live up to these buy ratings.
Lewis: Reading through the buy ratings, I will say, even as someone who has been a bear for quite some time, I can see it. There are certain elements of Snap that are very interesting. You talk about increasing the ad load. The user growth stuff still terrifies me. But you see the success that Facebook has had as an online business, and it starts to creep into your head, "Maybe I've been a little too pessimistic on this." Then I come back to valuation, and I'm like, "Nope, I'm staying away from this for now." But I am forcing myself to be a little bit more open-minded with this company and say, if the valuation drops to something a little bit more reasonable, I might give it a look. But for me, it's always good to read what people who take the other side of a stock feel, because it forces you to balance out your opinion. It hasn't dramatically changed anything for me. I don't know about you, but it doesn't sound like it.
Niu: No, I'm still pretty skeptical. Another thing to think about is, a lot of the spending that's going on on Snapchat, from my understanding, it's a lot of experimental budgets from advertisers, because they're trying to test the waters, because they know Snapchat has this huge base among millennials, which are hard to reach. So, they're trying to see if they can get return on their advertising dollars there. But now, the onus is on Snap to actually deliver results on those ads. Millennials have this practiced apathy toward ads in general, which is why it's so hard to reach them. If Snap is unable to actually deliver results, that ad spending is going to dry up pretty quick. That being said, it's important that Snap is such a young platform. So, it's hard to know. They could kill it, but they can also totally screw it up, and you just don't know yet at this point. I do think it's a little disconcerting that Evan Spiegel is reportedly really adverse to data-driven decision making. He relies more on experience. If you want to pitch him something, you tell him how the users will feel, what they're going to experience. You don't give him numbers. Which is weird, because advertising businesses are fundamentally all built on data, they're all numbers games. So, it's this weird thing like, why aren't you taking the data more seriously? Facebook itself has had some missteps over the past six months or so regarding their ad metrics, and they're getting a bunch of crap about, their metrics aren't good, their data is not good, which is extremely important to advertisers. So, again, it calls into question the risk, and how well they can actually develop this completely new ad business that they've never really done before. So, yeah, I'm still pretty skeptical overall, I would say, despite these buy ratings.
Lewis: Yeah. On that note with advertising and execution, I think if you're looking for signals and you use Snap and their products, one thing to watch for is whether the ads you see on there drive you to something, and whether it's a transaction or to consume content or something like that, or if it's brand presence stuff, because the ad placements that will drive you to some sort of call to action that gets you to sign up for something or puts you in a situation where you can buy something, those will always command a premium. There's always going to be room in advertising budgets for brand presence and just being in front of consumers. But anything that can actually drive you to a consumer decision is going to command a much higher value in ad budgets. That's really where I think a lot of spend is going to go. That's something that Facebook has done incredibly well, in showing the ROI to advertisers, and showing, "We're not just going to have your products up there and people can like them, we're going to be able to get you into a position where people are going to be buying things." So, as a consumer, that's a way to have the finger on the pulse of success of Snap and their advertising business as they roll it out. Evan, anything else you saw in the notes? Anything else going on before I let you go?
Niu: No, I think that'll do it.
Lewis: Listeners, that does it for this episode of Industry Focus. If you have any questions, or just want to reach out and say, "Hey," you can shoot us an email at firstname.lastname@example.org. You can always tweet us @MFIndustryFocus. 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!
Dylan Lewis owns shares of Facebook. Evan Niu, CFA owns shares of Facebook. Evan Niu, CFA has the following options: long January 2018 $120 calls on Facebook. The Motley Fool owns shares of and recommends Facebook. The Motley Fool has a disclosure policy.