Snap (SNAP -0.74%) is one of the biggest IPOs of 2017, but the market is backing away from the company with every new quarterly report the Snapchat operator puts out.

In this episode of Industry Focus: Tech, analyst Dylan Lewis and senior tech specialist Evan Niu dive into Snap's second earnings report, which the company released last week, and explain why it sent shares down over 10%. Find out the biggest red flags in the report in terms of revenue, user growth, and other key metrics; what management had to say about the dismal trends and what they mean for the company; why they're still not sold on Snap's Spectacles concept; and more.

A full transcript follows the video.

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This video was recorded on Aug. 11, 2017.

Dylan Lewis: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It's Friday, Aug. 11. We're running through Snap's second quarterly report as a public company. I'm your host, Dylan Lewis, and I'm joined on Skype by senior tech specialist Evan Niu. Evan, what's going on?

Evan Niu: Well, you know how much I love bashing Snap, so this should be a fun show.

Lewis: Yeah, I will say, I love earnings season, but this is the show that I've been looking forward to most this quarter. Snap is a company that a lot of people have been watching for a long time, it's probably the biggest IPO of the year, and it's always great to get some fresh numbers and get an update on what's going on with the business, particularly when it moves quite as much as it does when it's Snap. So, looking at the results, really all you need to do is take a glimpse at the stock chart, and that says everything about the market's opinion of what Snap dropped this quarter, huh?

Niu: Yeah. People were not very pleased. User growth for any social media company is a big headline number, and they fell short.

Lewis: Yeah. Revenue for Q2 was $182 million, which is up 153% year over year. Given how early Snap is in its monetization process, the lumpiness there and the massive growth figures are hard to take seriously. But, the user numbers, like you said, struggled. The company now has 173 million daily actives, which is an increase of 21% year over year, just a 4% sequential boost. I know the market was looking for more. With what happened with the top line and what happened on the user side, both being disappointing, the stock traded down, I think it's down about 10% or so since reporting. Looking at what's going on on the top line, we see these gaudy growth rates, but something that I was reminded of in doing research for the show is, to date, in 2017, the company has brought in just over $330 million in revenue. Before the IPO, there was discussion that the platform would bring in just under $1 billion in revenue in 2017. You look at those numbers and that run rate, and usually the digital ad market is heavily weighted toward Q4, but they're setting themselves up to have to have a really great Q4 to hit that 2017 figure that they were touting when they were doing the road show.

Niu: Yeah. I think that's going to be pretty tough, because they're so new at this ad business. They don't really give quarterly guidance, either, which I think a lot of investors are disappointed by. With the company like this that's so young, some visibility goes a long way. And certainly the company has a forecast internally, so it's like, why don't you share that? Or at least, beyond investors, give Street analysts some idea of how to calibrate their models. If you don't give them anything, and the analysts have to come up with their own numbers with no input from the company, no guidance, then what you end up having is really wide fluctuation in estimates. And those estimates set investors' expectations, subsequently. So it's kind of disconcerting that they don't provide any type of guidance whatsoever.

Lewis: Yeah, they're kind of creating the situation for the wild price swings that happen after the quarterly reports, just because they're not giving the market whole lot to work with.

Niu: Exactly.

Lewis: Looking at their financials, we would be remiss if we did not talk about their bottom line, as well. The company is still not profitable, and I'm guessing that won't change anytime soon.

Niu: They lost about $443 million in the quarter. One thing I did think was kind of funny was in the press release, when they did the year-over-year comparison, they said that was not meaningful, whereas typically, when a company says not meaningful, it's usually because they're coming off a really small base, so a super large percentage change is misleading; or, if you're swinging from a negative to a positive and then you have a negative growth rate, which doesn't make sense, either. But in this case, they went from a $116 million loss a year ago, which is not an insignificant amount of money to lose. That's a pretty decent number. Then, that basically triples to $443 million. So, it's kind of silly that they're like, "Oh, that's not meaningful."

Lewis: Yeah. I would love to be able to treat $440 million as a drop in the bucket. It must be nice over at Snap HQ. [laughs] We talked a little bit about user stuff before. Coming back to that, like I said, the overall user number was disappointing. I think the Street was looking for something in the mid-170 million range.

Niu: I think 175 million is what people were expecting.

Lewis: Yeah, and it wound up coming in at 173 million. The North American market grew 4 million to hit 75 million daily actives. So, disappointment there. But the narrative that we've been getting from Snap's management for a long time has been, "Don't look so much at DAUs, we're an engagement-driven platform, we have a lot of really dedicated users that love using our product." And I think one of my frustrations in trying to break down this company is that we get some color on engagement with those users, but it isn't terribly consistent, and we have to do a lot of work on our end, some back-of-the-envelope numbers here, to get a sense of what's going on with some of the engagement metrics. 

In Q2, management said that they saw 40 minutes spent per day for users under 25, and over 20 minutes per day for users over 25. So, that gives you a sense of what people are doing on the platform. The previous quarter, they had said that users spent over 30 minutes per day on Snapchat. So, it's like, I think those numbers are generally trending together, and I would hope that means that 30 minutes per day is either holding or slightly increasing, because the platform does slant young and predominantly under 25. But that's an apples-to-oranges comparison, and it's really hard to know for sure that engagement is trending the right way.

Niu: Right. I will give them a little bit of credit in the sense that they are improving monetization, which you can see in their average revenue per user, or ARPU. It improved sequentially from $0.90 globally to $1.05, which is the same as they did in Q4 of last year. So, it's not like some huge, crazy record increase. But they are making some progress, and certainly that's related to engagement. But I agree that the inconsistency in the metrics is a little weird. But, to give them a little bit of credit, they are improving on the monetization, particularly in these low-monetization geographies like Europe and the rest of the world. Those actually did put up pretty meaningful increases sequentially to hit new levels of monetization, $0.39 in Europe in $0.29 in the rest of the world. Still a fraction of North America's monetization, which is at $1.97. But they are making some progress. I don't want to be totally mean on them. [laughs] 

Lewis: And that's really how Snap's management and CEO Evan Spiegel are looking at the business. He's repeatedly said that the focus shouldn't be on DAUs, and he really touts the ARPU number as the thing that analysts should be focusing on. I think, to explain his logic a little bit, here's a quote from the most recent conference call. He said, "We would have to add more than 10 million daily active users in the rest of the world for every 1 million daily active users in the U.S. and Canada in order to make the same amount of money. So, obviously, with 10X the number of users, we also incur 10X the hosting costs to make the same amount of money, so that would impact our cash flow profile for our business." 

So, with that focus on ARPU, what he's also really saying is, the focus should be on the North American market, because that's where ARPU is the strongest. For the most recent quarter, Snap's North American ARPU was $1.97. It was $0.39 in Europe and $0.29 in the rest of the world. So, that gap helps explain why he feels that way. I'm not sold on the idea of only focusing on the valuable markets, and I'm also not really sold on that being a meaningful indication of how the business is doing, because there are a lot of opportunities for growth in North America, and yet we're only seeing single-digit sequential growth rates. 

Niu: Right. I honestly think it's kind of a cop-out. They're both very important. They're arguably the two most important metrics, he's basically saying that only one of them is important. That doesn't make any sense. Obviously daily active users are hugely important to a social media company, and him trying to distract away from it, I think it's a conscious attempt -- they've seen what happened at Twitter, and Twitter gets a lot of criticism about slow user growth, disclosures, and all this other stuff. And I think what they're trying to do is trying to avoid that narrative. But ultimately, you're not tricking anyone. If you don't put up the good user numbers and you're a social media company that's driven by ads, investors are not going to be happy.

Lewis: And again, to give them some credit here, Snap's platform had some limitations that make it tougher for them to grow in developing parts of the world. It's a very data-heavy app, and it requires a lot of time with photos and video, which is not as conducive to low-connected areas. But if the focus is North America, we talked about how they have 75 million daily actives in North America, and a single-digit sequential growth rate in that market. There are over 250 million smartphone users in North America. There's a massive runway for Snap to continue to add those super valuable users that Evan Spiegel is focusing on. So, I'm not sold that that's the only thing we should be looking at. When you see that they could go basically 3X and not even totally fill the North American market and be totally saturated, I can't help but focus on what's going on with DAUs.

Niu: No, exactly. I think the big problem there is, their user growth in North America -- which, as you mentioned, is by far the most important market, and even they're trying to focus everyone on this North American market -- their user growth on a sequential basis is not really doing much. It's just flat-ish. They're adding about 3 [million] to 4 million users per quarter, and that rate of adds is not really accelerating or decelerating. But the point that I'd like to make is that, I think one of Snapchat's biggest problems has always been the fact that it's just not really an intuitive platform, and it's very limited to this niche, younger audience. To get to those really meaningful penetration numbers of the U.S. market, like you mentioned, out of 250 or 260 million smartphones, you have to appeal to the mainstream. And Snap does not do that, and I don't see them ever doing that. I think their ceiling is going to be much lower until they can come out with some breakthrough feature or revamp the interface, or something to make the platform appeal to a wider audience, which I don't think they've done yet.

Lewis: I think two other reasons that people have to fixate on what's going on with DAUs is, when you have Facebook launching Snap-like features on its platform, on Instagram and Facebook in particular, platforms that have massive installed bases, there's a chance that people will use them on those platforms, and they might be in markets that Snap doesn't really operate in, or doesn't really focus on now. And by the time Snap does decide to really prioritize them, the users there are going to be like, "Yeah, so what? I can already do this on Instagram. I don't need this." So, that might hinder long-term growth for them. I think looking at things from the Street, and from our side as analysts, too, we have to obsess over what's going on on the user numbers, because they're so early in monetization that revenue is going to be all over the place. It's great that average revenue per user was up 100% year over year, but they were barely rolling out ads at this time last year. It's a great growth number, but it's off of such a tiny base that it's really devoid of any long-term business impact.

Niu: It's not meaningful, right? [laughs] 

Lewis: [laughs] Exactly. This is truly not meaningful.

Niu: That's also because Snap went public so early. Most companies in the space wait until they're a little bit more established, have firmer footing in their core business before they go public, whereas Snap basically had no clue, and arguably they still barely know what they're doing in terms of the ad business. And the fact that they went public so early in their life, you're kind of asking for this.

Lewis: Evan, I know two things that really surprised you this quarter were increases in headcount and the big commitment the company is making to R&D spend. Why don't we spend a little bit of time talking about that?

Niu: Looking at the income statement, the line item that jumped out to me the most was R&D expense, which jumped from a year ago, it was $36 million. Now we jumped to $255 million. That's a quarter of $1 billion that they're spending on R&D. Now, the majority of that is stock-based compensation, about $160 million of it, but that's a massive increase. All of these operating expenses jumped by a lot, I think for several factors, one being that the stock is now public. So, whatever RSUs are vesting during the quarter are now vesting at much higher prices, so the stock-based compensation just kind of naturally jumps up based on what the market is doing compared to what they were at when they were private, a year ago. So, that partially explains it. 

Then, you also have the headcount increases that you mentioned. R&D headcount increased by 190%. Sales increased by 160%. G&A, general and administrative, increased by 110%. So, they're hiring at a crazy rate, which is obviously going to drive up costs, too. But then, you have to say, what are they actually getting out of these expenditures? They made a couple acquisitions during the quarter, but those were mostly paid for in cash, so stock-based comp doesn't play into there. But I don't think they have a lot to show for it. Your R&D headcount is tripling, and what features have you unveiled other than a dancing hot dog?

Lewis: The dancing hot dog! [laughs] I can't believe I listened to a conference call where the dancing hot dog came up multiple times. I never expected that to happen in my time covering tech stocks.

Niu: That's a $250 million hot dog.

Lewis: I will put it to our man behind the glass, Austin Morgan, who occasionally uses Snapchat, like myself. Austin, have you done anything with the dancing hot dog? Is the dancing hot dog enough for you to interact with Snap?

Austin Morgan: I have not done anything with the dancing hot dog. But, as someone who does video, for them to so easily put it in a place and track the hot dog to stay in the place with the video moving, it's pretty impressive.

Niu: But would you pay $250 million for it?

Morgan: No I would not. But, with drone footage, I can use the high-end programs like the Adobe Suite, and motion-track text into my footage. But that takes a long time, and it's really hard to do.

Lewis: So, what you're saying is, on the technical side, what Snap is doing what the dancing hot dog is very impressive.

Morgan: It is, I think. 

Lewis: I think that's the lost on a lot of Snap's users.

Morgan: Absolutely. Most people are like, "Oh, look, this hot dog, you can put it on this table." But when I turn around, it stays on the table. That's pretty hard to do. I wouldn't pay $250 million for it, but.

Niu: I think, in the bigger scheme of augmented reality, which is ultimately what that hot dog is all about, Snap has made their name for these live video filters that are basically augmented reality. All the sudden in the past year, you have Facebook and Apple jumping in and being like, "We're going to really take over this space." So, as impressive from a technical perspective what Snap is doing for a small company, I think they're going to get overwhelmed and crushed by much larger companies. Facebook and Apple jumping in directly into augmented reality in a big way, how do you compete with that when you're Snap?

Lewis: It's tough, because it seems like in a lot of spaces that they're going to be trying to make money in, mainly AR and digital ad spend, they're going to be going up against titans. You have Facebook and Google on the digital ad side, you have Apple and everybody else in AR. One place that they have seemed to be able to carve out their own niche is with their Spectacles business. The camera sunglasses? Camera glasses -- I guess, is the best way to describe them -- help capture Snaps for their platform. We got a little update on what's going on with them.

Niu: Yeah. They said they had about $5.4 million in Spectacles revenue, which was about 3% of total revenue, and if you divide it out by the retail price, it implies roughly 42,000 units. Which, again, that's like a rounding error when you're talking on the scale of these DAUs that we've been talking about. Forty-two thousand units, and you have 170 million people using your platform? Who cares? And they're putting all this effort into becoming a "camera company," and their only camera hardware product is a rounding error on their financials. [laughs] So, it's just more evidence in my mind that Spectacles is kind of a waste of time and energy. As we've talked about on previous shows, they don't actually make money on these things.

Lewis: Yeah. It seems to me like it's largely been a marketing and branding tool, something that has built awareness about Snap. It was very artfully done, the launches, I will say, dropping those vending machines in these remote locations and on city blocks and just having people line up and creating a ton of buzz. The problem is, you can't sustain that forever. You have to start selling them as a real product. 

Niu: And no one wants them. [laughs] 

Lewis: Yeah, it's a niche product that not a lot of people use. So, it's kind of tough to know what the staying power of that is. There are rumors that they're doing other things on the camera side, possibly with some drones or things like that. Maybe that's where some of that R&D spend is going. Like we mentioned before, the company really doesn't offer up much in the way of guidance. They have outlined some of their main priorities, though. These are some things that investors can watch in the coming quarters to see how the business is tracking. The big three for them, driving both revenue and ARPU growth while expanding gross margins; No. 2, moderating capital intensity of its business to ensure strong EBITDA to free cash flow conversion; and then No. 3, investing in front-of-house resources and M&A to build up RapidScale in innovation and monetization. Anything really jump out at you from this report with respect to any of those, Evan?

Niu: This is a topic they brought up last time, the last call, as well. With their capital intensity bit, I think it's really misleading the way that they frame their capital intensity strategy. They basically constantly brag about how low their capital expenditures are. Last quarter was, like, $20 million or something. And that's primarily just expanding facilities and stuff like that, it's not actually building infrastructure, because they completely outsource all of their cloud infrastructure. So, on one hand, they're bragging about low capital expenditures. The flip side is, their hosting costs are enormous, and consume the vast majority of the cost of revenue, to the point where, we've talked about this many times before, they have a really hard time scaling. They're making progress because they're getting better pricing on some of the hosting fees. But hosting fees are consistently in the 70%-80% of total cost of revenue, and that just doesn't seem scalable to me. Those are all variable costs, because the more people use the platform, the more that Snap has to pay for the usage fees while they're simultaneously trying to sell enough ads to cover those costs, and try to come up with a positive gross margin, which they are very inconsistent on. They've done it occasionally, had a positive gross margin. They did it this quarter. But a lot of the times, these hosting costs are more than their revenue. I just think it makes no sense for them to be like, "Hey, our capex is really low," but then they just ignore the fact that the other side to that is, their hosting costs are completely out of control. 

Lewis: The way that they've set up that business doesn't really allow them to enjoy the leverage of adding users that a lot of businesses at their scale do, right?

Niu: Yeah. In general, one of the reasons why investors love tech, in a lot of ways, is because online services are supposed to be able to scale incredibly well, to the point that when you really start to get that operating leverage, your profitability just explodes. But Snap will never do that, because they have no operating leverage.

Lewis: Yeah, that's true. One thing that I am curious to see, I don't think we're going to see it any time in the next couple quarters, but it might be something that in a year or two from now, we start to get some color on, is ad rates, particularly as they move more and more to a marketplace-driven ad fulfillment solution. That's something that we get from most of the major digital media players, and certainly Twitter and Facebook. So, it'll be interesting to see what's going on there. They've talked about how the market dynamics have driven down ad prices and made them more affordable for folks. One of the problems that we've seen with Twitter is that the ad prices have continued to fall precipitously over time, and it's been tough for them to make up revenue on volume. Down the road, it would be great to get some color on that from Snap.

Niu: Right. I also want to mention one other point, separately, unrelated to the ad rates. I think they're also trying to get in front of these fears about the lock-up expirations that are coming. We just had a lock-up expiration last month, and there's two more in this month. And Spiegel's like, him and Bobby Murphy will not be selling any shares this year, to try to reassure investors. But, collectively combined, they own about 20% of shares outstanding. They have the supervoting shares, so that voting power is closer to 90%. But pretty soon, all of these shares are going to be free to sell, and they can't speak for all the early investors, venture capitalists, employees who might want to sell. Plus, he's saying the rest of the year, that's like four months. So, he's basically committing to not sell for four months, when both of them cashed out hundreds of millions of dollars, so certainly they don't need more money.

Lewis: Yeah, I'd hope at this point that they wouldn't want to sell.

Niu: [laughs] I mean, we know he went on that road trip to take a little yacht in Italy, while investors are upset about the stock price cratering. But, yeah, I think these lock-ups are still going to be meaningful events for investors, because I think they will add a lot of selling pressure, despite his effort to downplay those fears.

Lewis: Yeah, I think you're right. If people are looking for more stuff in general with what's going on with Snap, certainly follow Evan. I know you've already written a couple pieces about what's going on with earnings. I'm guessing you'll have a couple more coming out this weekend and the next week or so. You're one of's best when it comes to Snap earnings and Snap coverage.

Niu: With a negative bias. [laughs] 

Lewis: With a negative bias, that's fair.

Niu: Admittedly. Because, I am short. I am short, let's be clear.

Lewis: It's always good to get it out there. Anything else before I let you go today, Evan?

Niu: No, I think we covered it pretty well.

Lewis: All right. Listeners, that does it for this episode of Industry Focus. If you have any questions or you just want to reach out and say, "Hey," shoot us an email at [email protected], or you can tweet us @MFIndustryFocus. If you're looking for more of our stuff, subscribe on iTunes or check out the Fool's family of shows at

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 -- and Austin Morgan, he's on the show, too -- thanks for listening and Fool on!