Snap's (NYSE:SNAP) initial public offering earlier this year was met with huge excitement from investors, launching the company to a lofty valuation. Last week, the Snapchat operator reported its first-ever quarterly earnings -- and the stock plummeted over 20% as a result.

On this episode of Industry Focus: Tech, Motley Fool analyst Dylan Lewis and senior tech specialist Evan Niu dive into the earnings report, and explain what major red flags had so many investors exiting their positions. Listen in to find out the most important numbers in terms of growth rates, revenue, and monthly active users, and what they mean for the company; a few critical issues that Snap isn't addressing; how the Spectacles are performing and where they fit into the company's strategy; the less-than-inspiring way that CEO Evan Spiegel is responding to competitive threats from Facebook (NASDAQ:FB); and more.

A full transcript follows the video.

This video was recorded on May 12, 2017.

Dylan Lewis: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It's Friday, May 12, and we finally got our hands on Snap's first earnings release. I'm your host, Dylan Lewis, and I'm joined on Skype by Evan Niu. Evan, how's it going?

Evan Niu: Pretty good, I'm having way too much fun watching Snap tank today, I have to admit.

Lewis: You do have a little bit of options action with Snap, right?

Niu: Right, I am short, small a short position with some puts. So, I'm enjoying the action today.

Lewis: Even without having any skin in the game, so to speak, I will say this was the earnings report I was most looking forward to this quarter. We got a look at Snap's prospectus a couple months back, but you talked about, when a company goes public, the idea that very often, it's when it's in the company's best interest, or current management's best interest to go public. The numbers look maybe as good as they're going to for a while until they figure out monetization. I certainly thought that was the case with Snap. It seems like you probably did, too.

Niu: Yeah. Generally speaking, I consider IPOs a marketing event because you go on this road show, you're drumming up interest. And you have to have some numbers, of course, to back it up, but it's really about how you spin numbers and how you tell your story. And if you have a good road show, you have a good IPO, you raise a bunch of money. But now, we're at the first public earnings release, and I think that's really the wake-up call for any company that goes public recently, and it's the first big test. Now that we're public, because, obviously, earnings releases are a regular quarterly thing, and now you get to follow the company on an ongoing basis, it's not just this big marketing event like the IPO was.

Lewis: Yeah, the honeymoon period is certainly over for Snap. Following the release, shares were down 20%. And that's really because the numbers didn't look all that great. Revenue came in at just under $150 million, which was up from $39 million a year ago previous quarter, and the Street was looking for somewhere in the neighborhood of the high $150 [million]-$160 million range. Net loss came in at $2.2 billion, which was up from $100 million a year ago, a large chunk of that was from stock-based compensation. We're going to touch on that later. Shares fell 20%. I think one of the big scary things, also, looking at the report, was what was going on with user numbers.

Niu: Right. Of course, with any social media company, user metrics are extremely important. Everyone is all too familiar with how Twitter did not do well with putting up user numbers, and that's really why Twitter as a stock has lagged. They also haven't really been putting up strong ad revenue numbers, either. So, that's kind of where Snap now finds itself. We'd already seen in the prospectus that daily active user growth was decelerating, especially if you look at it on a sequential basis, which is what I like to do with social media companies. Yeah, they're up to 166 million. It's better this quarter than, probably, the past couple of quarters. But it was also shy of what people expected.

Lewis: Yeah, you can break out what's going on with users a couple different ways. You said sequentially or year over year. Quarter to quarter, the company did add more daily actives this quarter than they did the previous quarter, so, some cheers there. But if you look on the year-over-year growth rates, they're decelerating. You go back a couple quarters, and the company was posting growth rates of 65%, 62%, 48%, and now they're at 36% year over year. It seems like they're getting a little bit closer, a little bit closer, a little bit closer to the ceiling in terms of user growth, and what that overall audience might look like, and that's naturally what's going to scare investors quite a bit. They've talked a little bit in the past about how they're not huge on overall user numbers, they're really big on engagement, they like to highlight what was going on in terms of user spend with time on the platform. And they highlighted that people are spending 30 minutes per day on average on the platform last quarter. And they said the metric was up. I don't really remember them giving a firm number in the past when we were looking at the prospectus, Evan, do you?

Niu: I don't remember. They might have, but I can't recall off the top of my head.

Lewis: Yeah, I was looking back and I saw a range of 25-30 minutes when they released all their information for the IPO. So, it's hard to know exactly how high that's up. If management is saying that it's trending up, that's nice. But it's not like it was a massive improvement, based on, at least, what we know going back to the prospectus.

Niu: Speaking on user numbers, Evan Spiegel had this really weird comment on the call about how, "Our rivals are doing what we call growth hacking," which is when you send people notifications, and prod people into using the app and getting their friends to use the app. He was kind of saying this in a bad way, like, "We're not going to resort to those types of methods to try and grow user numbers." But, it's like, why is that a bad thing? Everything these companies do, all of them, is meant to increase engagement on the platform. Why is it a bad thing when a company is experimenting in different ways to try to get their users engaged, get their users to grow their own network of friends on the platform? Those, to me, are just regular things that a company should be doing to increase engagement. Yet, Evan Spiegel is trying to downplay, and say, "We're not going to do that." It was a really bizarre way to frame that, when you would think that a company like Snap that's trying very hard to grow users would consider experimenting with some of those types of things. It was just a weird comment to make.

Lewis: And, also, to put the platform under a microscope for a minute, I don't know if you use the messaging side of Snapchat at all, or if you're more on the story side with your posts, but if you wind up actually sending each other messages to friends back and forth on the platform, you get a notification that your friend is typing a message. Are there any other platforms where you get that notification? That is absolutely a push to get people playing on the platform or, and to give people a heads up.

Niu: Yeah, exactly. I wasn't aware of that because I don't really use the platform. That's kind of crazy, because that sounds exactly like what he's talking about, which is sending you little notifications and prodding you to stay in the app, stay engaged.

Lewis: And I see that and I don't need that. Just tell me when I actually have the message.

Niu: [laughs] Yeah, that's a weird notification, that someone is typing. Of course, a lot of time on messaging platforms, you see when people are typing. But a notification that someone is typing does seem kind of annoying.

Lewis: Yeah. Something else to keep an eye on with what's going on with user growth is, all of it's coming from North America and Europe. You look at the company's rest of world segment -- those are the three ways they break it out right now -- and that's been relatively flat over the last three quarters. It's like 39 million, 39 million, 40 million. I think some of that is connectivity. Obviously, developing parts of the world don't necessarily have access to the same broadband cell service. And, obviously, Snap is a very visual and data-heavy app. But, I think that's problematic long-term for the company. 

Niu: Yeah. I think that's a conscious decision on their part, because they're only focused on the U.S. and Europe. There's been all of these headlines you've probably seen about, Evan Spiegel called India as being a poor country, and doesn't want to expand into it. Of course, that didn't go over very well with users in those countries. But, the underlying business rationale for why you might not want to expand in those countries is, ad monetization in those countries is very low. It is, financially, very hard to make money there. But, of course, saying the country is poor is a horrible way to go about it. But, if you look at their business, they don't really scale well to emerging markets because of their use of third-party cloud infrastructure, which we'll touch on in a minute. Their costs are very high, and the monetization is very low. So, if they were to expand into emerging markets, it accelerates their losses, because they get pinched by really poor ad rates and really high costs. So, financially, they don't really have that much of a choice, because they would bleed out a ton of money if they tried.

Lewis: Yeah. I guess I would argue that they're still in the phase of business where it's OK to be creating losses, because if you're building the daily active user base, people are going to ignore that for a long time. If you can get into some of these emerging markets and really be rooted there, you're putting yourself in a better long-term position. Whereas, right now, Facebook is eating their lunch in a lot of these developing markets, and they're just dropping a lot of features that Snap has in its app that they really developed and popularized. I think by the time Snap gets to some of those markets, people are going to be like, "I can already do this on Messenger or Instagram."

Niu: Yeah, I definitely think it's a short-sighted thing, to ignore these emerging markets.

Lewis: But you also think the company's hosting strategy as well is short-sighted, as well. This is something that a lot of companies haven't done. Rather than investing in their own infrastructure, whether it's building out their own data centers, or doing co-located facilities for their servers, Snap is relying entirely on third-party cloud infrastructure providers. That's kind of new. I know you've been a skeptic of that in the past.

Niu: Yeah, it's a very unique strategy. If you look at it from Snap's perspective, the benefits they're saying of why they do it this way is, I think one is reliability and resilience, because AWS and Google Ad are extremely powerful. That way, they can ensure the services are up-and-running. If you remember Twitter in the early days, it had outages all the time because they had so much trouble scaling because people were coming to the service so quickly, it was overwhelming Twitter's own servers, and their in-house infrastructure that caused constant outages. So, by relying on AWS and Google Cloud, Snap can avoid that, because those clouds are so strong that it's really unlikely they're going to be hit with an outage. Of course, it could happen. But there's much less risk of that happening. The other piece of it is, they're trying to save all this money on capital expenditures. Capital expenditures last quarter were very low. They're always low for Snap, because that's just how they approach their cloud stuff. It was $18 million or something. 

On the call, they mentioned, "We estimate that using a capital-light approach has saved us billions of dollars in capital expenditures," which is true, but if you turn around, they've also committed to spending $3 billion at AWS and Google Cloud over the next five years, combined. You're not really saving that money, you're still spending it, you're just, instead of spending money on capital expenditures and having that asset on your balance sheet where you depreciate over time and it's your infrastructure, now you're relying completely on these third parties. Those are variable costs. That's going to be a really big challenge for scaling, because those costs are going to scale, too. They did renegotiate their contract pricing during the quarter with both AWS and Google Cloud. They did say that lower contract pricing did help their cost structure a little bit. And if you're looking at it from Amazon or Google's perspective, Snap is a huge customer in the space. They're probably one of the biggest customers out there with these types of spending commitments. These are the two biggest cloud providers, so of course they're going to be bidding pretty aggressively and competing for this contract, and I'm sure Snap is pitting them against each other and really leveraging that in negotiating. So, yeah, they are getting some better pricing now. But, it just doesn't seem like a good long-term strategy. If you really want to have good long-term growth, you just build infrastructure yourself, eat the costs up front, but then you can scale so much better.

Lewis: Yeah. You talked about it being variable and somewhat subjective to pricing negotiations. This most recent quarter, hosting costs ate up 70% of revenue, and that's actually down from the last couple quarters where it was up near 80% a few quarters ago. 

Niu: A year ago, it was like 160% -- hosting costs exceeded revenue a year ago.

Lewis: Yeah, I'm not sure how much further that's going to fall. We might continue to see it move down into the high 60s, or something like that. But, I don't know how much lower that floor is going to be. But, it really speaks to how their cost structure is very different than a Facebook, a company that has decided to build out, what, seven data centers at this point?

Niu: Nine.

Lewis: Nine? Wow. So, rather than have that fixed cost, like you said, as they have more people using the platform, and more people using the platform longer, the cost for them doing that is going to continue to go up, which is something that could be good or bad, it depends on your outlook and what you value for the business.

Niu: It gives them more flexibility if things start heading down, if people stop using the platform and users start abandoning Snapchat. Then it's better, in that situation, because you're not stuck with all this infrastructure you have built, and your costs will scale down. But, obviously, Snap is hoping things go up, in which case, it's really hard. They're getting squeezed by these costs, and I think it's really short-sighted. But to be fair, they have hinted that they might pursue their own infrastructure at some point in the future. But, they were very vague about it in the prospectus. They didn't specify timing, and, of course, they do have spending commitments for five-plus years. So it doesn't seem like if they do it on their own, it would be within the next five years, at least.

Lewis: Yeah. And vague has been a consistent theme in a lot of the communication we've gotten from Snap's management.

Evan, I know that we had a couple little other interesting tidbits we wanted to touch on. Why don't we start with Spectacles? I know leading up to their IPO, one of the biggest things I was wondering was, what is this doing for their business? This is hardware, we think of them as a software and platform play. Are they getting anything meaningful there? What your take on what's going on?

Niu: It's weird because Spectacles seems to be the basis for why they rebranded themselves a camera company, because now they make a camera product. But, we've talked about this before, it's a strange identity to try to carve out for yourself. But, they have started disclosing a little bit more detail about Spectacles. They said last quarter, Spectacles revenue was about $8 million. At the same time, they've also broken down their costs in more detail, which is very useful for investors. We talked about the hosting costs, which they broke out. But, if you look at this other category, other cost to revenue was about $20 million, and I'm pretty sure that is predominantly related to Spectacles, if you look at the language in their filing. If you think about it, that's operational, the only other real part it could be. The revenue, $8 million, and the cost was $20 million, so obviously they're losing about $12 million in the quarter on Spectacles on the hardware side. And that includes building these machines and having inventory costs, and all the physical logistics associated with physically selling a product, which, this is the first time they've ever done that. So, they're probably losing a bunch of money upfront. Hardware is, of course, naturally very hard to do as a sustainable business in long term, where you can have product cycles and get people to constantly buy your product. But, in terms of engagement, I think it's very interesting because it doesn't seem like Spectacles do a whole lot in terms of engagement, either. On the call, Spiegel said there have been 5 million Snaps created via Spectacles to date. Spectacles launched in November. At the same time, they said in the first quarter there were three billion Snaps per day created. So, throughout the whole quarter, we're talking about 270 billion Snaps that are created on the platform. Less than 5 million of that comes from Spectacles. If you do the math, that's 0.002% of Snaps created -- less than that because that's just in the quarter. So, it just begs the question, why are you doing this? No one is using these things in a meaningful way. It's literally a rounding error at this point, 0.002%. Who cares about that?

Lewis: Yeah, that's basically a footnote, right?

Niu: Yeah. You're losing money, you're putting all this effort into it, you're probably hiring a bunch of people to work on these things and whatever comes next in the product pipeline on hardware. And they're not doing anything in terms of engagement, users aren't really using them, and now you're jumping into this space of trying to develop camera hardware, which, the other 99.998% of usage is coming from smartphone cameras. Smartphone cameras are amazing these days. There's no way that Snap is going to come out with a better camera than Apple or Samsung. So, why? It makes no sense to me. They're losing money, they're not helping engagement, and there's no way they can actually compete.

Lewis: Yeah, when I first saw them doing this, I thought they were really smart in creating a lot of buzz every time that they launched a new location, they would drop these vending machines that had a limited number of Spectacles in the middle of these remote spots, or in city areas. They wound up getting a ton of press for it. I thought it was a really brilliant marketing play, and it built a lot of awareness for the company. But there's a big difference between building buzz and being a viable product segment. I don't think that investors should expect a whole lot to be coming from the Spectacles or the hardware segment any time soon, if ever, just because, like you ran through the economics right there, and they're really not that great for the business.

Niu: Yeah. I definitely agree that the launch was a very successful marketing campaign, because everyone was buzzing about it. There was a lot of hype around these things. So, I definitely agree that the event was successful as a marketing event. But, now that we're starting to get some numbers out of the company, in terms of usage and financials, it just doesn't seem worth it to me.

Lewis: One of the other things that popped out to me looking at the report was, I mentioned earlier, net loss came in at $2.2 billion. Non-GAAP EBITDA (earnings before interest before taxes, depreciation, and amortization), which backs out stock-based compensation, came in at just under $200 million loss. I think it's worth emphasizing that EBITDA backs out stock-based compensation, because stock-based compensation was huge for Snap in this most recent quarter.

Niu: Yeah. Out of the total net loss of $2.2 billion, $2 billion of that was stock-based compensation. It's not uncommon for companies that go public, because what usually happens is, a lot of the private stock that's been given out when the company is private, there's these performance conditions that can only get met when the company goes public. So, what that does is triggers a ton of vesting and huge expenses are now recognized. So, that's what happened here. But, I think in this case, it's a huge number. For context, when Facebook went public, their first public earnings release, they reported $1.3 billion in stock-based compensation. That's less than what Snap just reported. And when Facebook went public, it was a massive company already, and they IPO-ed at over a $100 billion market cap, and they had 700 [million]-800 million monthly active users -- they were much bigger at that time, and their stock-based comp was less than what Snap just put up.

Lewis: I think one thing that's worth emphasizing with this argument, though, is one grant in particular ate up one-third of that total $2 billion.

Niu: Yeah. That's another red flag to me. As soon as Snap went public, Evan Spiegel got a giant bonus for taking the company public. Those bonuses aren't unheard of in themselves. But what's alarming is the magnitude of it. The CEO grant says he gets an extra 3% of shares outstanding once they go public. So, it turned out to be about $625 [million]-$640 million, that Snap recognized all upfront, immediately after the IPO. And that's just for him, which, as you mentioned, is about a third of the $2 billion total for the quarter. But, what is so weird about it is this award vested immediately, but they pay it out to him in quarterly installments over three years. It's considered an unsecured liability, like, you are an unsecured creditor with this. But then, why did it vest? Because it vested all up front, they ate this giant cost up front. And because it vested up front, there's no service requirements. Obviously, the point of having vesting time frames is to retain employees and make sure they stick around. But they just gave him all this up front, and he could leave the company right now if he wanted to.

Lewis: And he would retain all those shares.

Niu: Yeah, he still gets to keep them, and they just pay them out over three years. But they're vested, they're his.

Lewis: Yeah. Evan, I know you wrote a whole fool.com piece about this. Listeners, if you want to see the numbers broken down on paper rather than having them told to you, email into the show, industryfocus@fool.com. I'm happy to send it along. I think the thing that you need to remember with this is, the type of grant that we see here, one, it's not particularly great for the business, because you're recognizing a ton of stock-based compensation at once. And it's also not particularly great if you're a long-term investor who wants the CEO to stick around and have skin in the game and a vested interest in the long-term outcome of the business. Like you said, he can walk whenever now.

Niu: Yeah. I don't understand why they wouldn't have it vest over time. Not only would that spread out the cost of the grant, but it also has retention effects. Not that I'm a huge fan of Evan Spiegel as a product visionary, per se, to begin with. But, on principle from a governance perspective, it just doesn't seem right. Combined with all the other governance red flags we've seen with this company, like no voting and things like that, it just doesn't seem like Snap cares about its investors. It seems like they just want to enrich themselves, particularly Evan Spiegel.

Lewis: Yeah. And frankly, a lot of the comments from management seem to strike that tone with me, too. A couple in particular that really stood out -- one from Spiegel, "We're kind of famous for not giving guidance on product pipeline." We talk about transparency and having shareholders' best interest in mind, there wasn't any guidance anywhere. We didn't really get much in terms of product, we didn't get much in terms of financial guidance. I understand that it's a high-growth business, and it's obviously going to take some time to settle out. I think we were bound to have a big reaction either way to the results, because no one knew what to expect, really. But, it feels a lot like this is a company being run by Spiegel and Murphy that have all the controls and don't have to answer to anybody, and that's because they don't. That's exactly what this is. The way it's all set up, they can do whatever they want.

Niu: Yeah. The whole voting structure, it's very literally saying, "We want your money but not your opinion." [laughs] And that's never good, in any context. Just to touch on what you're saying, his comments on the call had this air of arrogance, like, "Oh, we don't care." Of course, they don't want to give any hints about what they have in the product, because they don't want Facebook to copy them, [laughs] of course, until they release it, and then Facebook will just copy them later. But, yeah, they came off as very smug and arrogant, despite the fact that investors are clearly not impressed. I think heading into the results, the chances of the stock jumping were very remote, because of the valuation. There's so much priced into the valuation at the IPO, which we've talked about on previous shows. The bar is very high already. Any small miss, you're going to get punished for. They missed quite a bit on several fronts. So, it's not really surprising to me that the stock dropped as much as it did, because there's no way it could have lived up to the valuation.

Lewis: In fairness, this is something we've seen time and time again. This happened with Twitter, this happened with Facebook. A lot of expectations coming out of the IPO, and then the next morning wake-up where you're like, "Oh, we need to run a real business here that's making money and put up solid numbers quarter to quarter." I think this is part of the reason why, even if you do think Snap is a long-term stock that you want to own, you want to buy -- or really, for that matter, any recently public stock -- it might make sense to wait a few quarters and see how the numbers shake out first. Because management knows a lot more than you do when it's time to go public, in terms of the trajectory of the business. And also, when you're pre-monetization the way that Snap was, you're not exactly sure what those revenue streams are going to look like, or what the final business is really going to become.

Niu: Exactly. That supports my theory that they're just trying to cash out. Some people argue that they went public prematurely relative to -- usually, you want to have some more solid financial numbers before you go public. They were just now starting to grow the ad business, which is why the growth rate in the first quarter was so huge, because they're coming off such a tiny base. So, there was some concern, like, why are they going public now, versus waiting until they have some better results in their track record? Which, of course, makes it better to justify to investors. But, I think the whole thing is, they just want to cash out as soon as they can, and get rich.

Lewis: Yeah. In some ways, I can't blame them, right? [laughs] Evan, anything else you want to hit?

Niu: No. I hope they keep trending lower.

Lewis: [laughs] Listeners, if you want to check out any more of our coverage, Evan's done an awesome job looking at some of the stuff from earnings for Snap. Head over to fool.com. Like I said, if you want any stuff sent over to you, just write into the show at industryfocus@fool.com. You can always tweet us at @MFIndustryFocus as well. 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. Shout out to Austin Morgan for mixing the show. 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), Apple, and Facebook. Evan Niu, CFA owns shares of Apple and Facebook. Evan Niu, CFA has the following options: long January 2019 $20 puts on Snap Inc. and long January 2018 $120 calls on Facebook. The Motley Fool owns shares of and recommends Alphabet (A shares), Alphabet (C shares), Amazon, Apple, Facebook, and Twitter. The Motley Fool has a disclosure policy.