Snap (SNAP 1.75%) relies on its ability to innovate in order to attract new users and advertisers to its app. In fact, it says it has no other competitive advantage beyond its ability to create more interesting and better products than other companies. That point has been highlighted by Facebook's (FB 3.91%) unabashed efforts to copy the best features of Snapchat in its various apps.
But Snap won't be deterred, and it's investing heavily to come out with the next great feature for users and new advertising products for its customers. But that innovation doesn't come cheap; Snap's research and development expense increased 3.5 times in the first quarter compared to last year. In its 10-Q, management notes the increase was "driven by an increase in research and development headcount of approximately 260%." That's a lot of engineers!
Image source: Snap.
Expanding the ad product is key to revenue growth and operating leverage
Snap's ad product is still very young, but it's growing extremely quickly. That's in part due to the novelty of the platform, the size of its audience, and the appealing demographics to advertisers. Indeed, Snap invested a lot in its sales and marketing team to help sell ad units, and its expense grew 330% year over year in the first quarter.
But the sequential growth of Snap's sales and marketing expense slowed meaningfully in the first quarter compared to last year. Meanwhile, R&D expense growth accelerated in the last two quarters.
The shift corresponds with Snap's move to open its ads API to enable programmatic purchasing of its ad inventory. Instead of a sales team selling brands directly on a specific ad unit, brands can let computers buy ads through the API, giving it access to more targeted ad units. That benefits advertisers, as they're able to generate higher returns on investment, and it benefits Snap, as it's able to generate higher average ad prices and reduce the need for sales and marketing.
Most recently, Snap launched a self-service platform akin to Facebook's Power Editor and other ad-buying tools. The goal is to attract smaller advertisers to Snap's video ads product, which would greatly expand its advertiser base and support ad revenue growth.
Improving the product for users
Just last week Snapchat rolled out a major product update that includes new features such as limitless playback (instead of previous requirement for a limit of up to 10 seconds per Snap), video looping, and a Photoshop-esque magic eraser tool that lets users remove objects from images. Other major recent updates include public stories centered around a topic (like a basketball game or puppies) and the ability to search for them.
Snapchat's new features appear to be gaining traction with users. Snap says the average user spent more than 30 minutes in the app per day in the first quarter, compared to the 25 minutes to 30 minutes the company reported in its S-1 filing.
Can Snap stay ahead of Facebook?
Even with all of its spending on R&D, it will be hard for Snapchat to produce a product that Facebook can't copy. In fact, Facebook appears to be copying Snapchat features at an even faster pace, and CEO Mark Zuckerberg thinks the social media titan has already out-innovated Snap. Instagram's latest update added face filters and public Stories through geolocation and hashtags.
While Snap's R&D budget is exploding, the $72 million it spent last quarter is a drop in the bucket of Facebook's R&D budget of $1.2 billion (excluding share-based compensation). Considering the features Facebook is stealing from Snapchat are a big engagement driver for Facebook's apps and present a lot of monetization potential, investors should expect Facebook to put a good portion of its budget toward competing directly with Snapchat.
Snapchat has to hire lots of new engineers to stay ahead of Facebook; Facebook just needs to reassign teams to new projects to copy whatever it does. That allows Facebook to move more quickly in response to Snapchat, which means any major innovations from Snapchat won't last long enough to attract a lot of new users.
With sluggish user growth, that's one fewer driver of Snap's revenue growth. The company will lean heavily on increasing average revenue per user going forward to drive overall sales growth. That means focusing on more backend improvements like its ads API. Still, that will only take Snap so far, putting a ceiling on revenue growth.
