Snap's (NYSE:SNAP) troubles growing its daily active user count have been a big focus for investors ever since the company made its initial filing to go public. The biggest reason for the slowdown seems to be the launch of Instagram Stories, a feature the Facebook (NASDAQ:FB) subsidiary blatantly copied from Snapchat. But most investors understand that storyline well, and Wall Street analysts have had months to bake the user trends into their forward-looking estimates.
Analysts bullish on Snap have a positive outlook because they believe the company will be able to rapidly increase the average revenue per user, or ARPU, on the platform. There are a couple of major factors that contribute to that -- ad impressions per user, and average price per ad. The former is largely dictated by Snap, which manages ad supply to maintain a good user experience in the app. It's also affected by user engagement -- the longer people spend in the app, the more opportunities they have to see ads.
Average ad price is now largely dictated by the market's demand for Snap Ads. And, unfortunately for Snap investors, the market hasn't been too kind so far.
Self-serve advertisements are risky
Last quarter, there was a huge shift in the way Snap sold ads on Snapchat. The company sold over 60% of its ads through its self-serve and API partners, which use an auction system instead of a fixed-price model. That's more than double the previous quarter.
The result was a decline in average price per Snap Ad. While many businesses were willing to spend more for ads in Snapchat, the auction allowed them to pay less. Limited demand for the ad units will make it tough for Snap to increase ad inventory without destroying value. That will put a damper on ARPU growth.
For its part, Snap is spinning the lower ad prices as a positive. "I think lower pricing is an important driver of growth at this stage, especially in the short term because it provides incentives for advertisers to get over the hurdle of having to learn how to use Snap," CEO Evan Spiegel told analysts on the company's second-quarter earnings call. He also noted that the slower inventory growth at Facebook may force advertisers to seek out alternatives in the second half of the year. Snap's ad pricing and engagement, he posits, will make it one of the more attractive options.
A long-term bet
To be sure, shifting to a self-serve auction format for the vast majority of advertisements is essential for Snap to become a profitable company long term. Twitter tried to make the shift to self-serve ads years ago, but it still sells the majority of its ads directly to large brands. As a result, its profit margins are relatively slim. Facebook, by comparison, sells most of its ads through automated systems, and it generates loads of cash every quarter.
Self-serve platforms allow Snap to reach smaller advertisers, which can collectively produce a lot of ad revenue. Since Snap doesn't have to invest in sales reps, ad buyers can bid on as much or as little advertising as they need with very low minimum purchases. The presence of smaller bidders can also help drive up ad prices for the big ad buyers, which have already shown a willingness to pay more if they're asked.
Still, it will take time for Snap to draw in small businesses. It's already spending heavily to introduce the new ad-buying tools to businesses, increasing its marketing spend as a percentage of revenue last quarter. As Snap continues to invest in drawing in new customers to its self-serve platform, it will also put a damper on its profit margin in the near term until it has the appropriate scale to show some operating leverage.
As a result of the negative impact on average ad prices and the negative impact on profit margin, Snap may continue to underperform expectations. The shift to auction bidding is a risky endeavor, but a necessity if Snap wants to become a profitable business at some point in the future. That point may be a bit farther away than most expect, though.