1 Big Hurdle for Snap to Overcome

Snap needs to teach advertisers about its product before they'll adopt it.

Adam Levy
Adam Levy
Jun 5, 2017 at 12:06PM
Technology and Telecom

Snap's (NYSE:SNAP) advertising business is only in its third full year of operation, and it's already expected to bring in nearly $1 billion. Still, Snap has its sights set much higher, and its investors do, too, as they're paying a significant premium on shares compared with competing social networks such as Facebook (NASDAQ:FB) and Twitter (NYSE:TWTR).

But there's one big obstacle Snap needs to overcome to grow well past $1 billion in ad revenue.

"In terms of growing the advertising business, I think the big thing is education," said Imran Kahn, Snap's chief strategy officer. Snap has spent the past year or so beefing up its advertising capabilities with new targeting, measurement, and ad-buying options. Now, it's hiring more people to its sales team to educate the market and grow its ad revenue. "Other companies have done that," Kahn said, "and it's an execution story."

"Snap Inc." in black on a yellow background

Image source: Snap.

A familiar problem

Educating the advertiser base may sound familiar to anyone who follows Twitter. After Twitter posted its first-ever year-over-year decline in advertising revenue in the fourth quarter last year, COO Anthony Noto told analysts that the company is sitting down with advertisers to tell them about the improved engagement it's seeing. "We're taking them through the increased inventory, the higher scale, the greater growth, all of which we think can lead to better ROI [return on investment] and helping them run through their models, so that we can get better allocations," he said on the fourth-quarter earnings call.

Kahn proposes that Snap just needs to do the same thing, educating the market about its measurement capabilities and ability to reach the right market at the right time. As the market learns more about its product, more and more advertisers will come on board, he suggests.

Twitter says it saw a stabilization in its downward ad revenue trend in the latter half of the first quarter. Noto attributes that to the work its sales team is doing to go out and educate the market. Twitter's success suggests that if Snap can educate the market earlier and more often than Twitter, it may be able to keep riding this huge wave of ad revenue growth.

But that costs a lot

Over the past year, Snap's sales and marketing expense exploded from $13 million to $56 million. The headcount in the department increased 230%. Snap is rapidly hiring new people to educate the market and sell more ads.

The year-over-year growth in sales and marketing expense is more than any other operating expense line item, including research and development. Nonetheless, Snap experienced a sequential revenue decline during the first quarter despite the relatively early days of its ad business. Kahn blamed this on more pronounced seasonality among brand advertisers compared with small businesses. As it adds small businesses, he says the trend will smooth out.

Snap will have to battle Facebook to win over small advertisers. The mammoth social network has over 5 million active advertisers on its flagship platform and 1 million on Instagram. With Facebook introducing similar ad units to Snapchat, Snap will have to prove it can produce a better ROI than Facebook.

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That'll be a tough sell, considering Facebook's ad targeting capabilities, and it may limit the upside of Snap's ad prices. On the other hand, the proliferation of Snap's ad format (full-screen vertical videos) means it's more economical for small businesses to make those types of ads, making it easier for Snap to sell them.

For now and the foreseeable future, most of Snap's revenue will come from big brand advertisers. If it successfully educates the market and convinces them it can produce good returns on investment, it could have several years of very strong revenue growth. Of course, it has to continue to deliver strong ROIs and make it worth every penny. Ultimately, however, Snap's growth will be limited unless it can attract significant interest from small businesses.