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Snap's Third Quarter Was a Train Wreck

By Evan Niu, CFA - Updated Nov 8, 2017 at 9:01AM

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And not just because of cash burn.

Snapchat operator Snap (SNAP 4.78%) reported third-quarter results last night, and investors were not happy about it; shares fell 10% in after-hours trading. Revenue jumped 62% to $207.9 million as the company aggressively transitions to its new self-serve ad platform, which both reduces the entry-level cost for advertisers while automating ad sales. The Street was expecting $236.9 million in sales. Daily active users (DAUs) rose sequentially to 178 million, also shy of the consensus estimate of 181.8 million DAUs.

The company's net loss more than tripled to $443.2 million, but Snap considers this exploding bottom line to be "Not Meaningful," listing "NM" under the percent change just like last quarter. (It's not just because Snap is comparing two negative numbers, either, as it lists a percent change for adjusted EBITDA losses widening.)

Snapchat logo

Image source: Snap.

Beyond the headline figures, here's everything else investors need to know about Snap's quarter.

About that hard-to-use app

Snapchat is notoriously difficult to use, and has an unintuitive interface. On Snap's first public earnings call, CEO Evan Spiegel defended the interface by making a comparison to teaching his grandmother how to use email, essentially saying that Snapchat focuses on younger demographics that are more interested in technology. Spiegel basically dismissed usability concerns, adding, "And so I think, over time that strategy has worked for us." Snap's first venture capitalist investor, Jeremy Liew, even once argued that the confusing interface was key to its success among younger users.

Well, Snap is reversing course. Spiegel announced that the company is now redesigning its app "to make it easier to use." This is good news, but it also entails huge risks. Spiegel predicts a "strong likelihood" that the redesign "will be disruptive to our business in the short term," and it's too early to say how the change will affect user behavior. Other than saying the redesign would focus more on content discovery, Spiegel declined to elaborate on what it would look like.

Snap blamed its DAU shortfall on how it chooses to measure DAUs

Snap also conceded that DAU user growth fell short of its internal expectations, adding just 4.5 million new DAUs during the quarter. Spiegel partially blamed the shortfall on how Snap reports DAUs: Snap uses an average for the entire quarter, and said strong DAU growth in September was "offset by the more modest months of July and August."

But this is a self-inflicted situation, as Snap is the one that defines how it reports user metrics. In contrast, larger rival Facebook reports DAUs as the average for the last month of the quarter. Snap does not disclose monthly average users (MAUs).

The expected Spectacles writedown

Reports surfaced last month that Snap manufactured way too many pairs of Spectacles, and was sitting on "hundreds of thousands" of units in inventory. On top of that, it had an additional $29 million in additional purchase commitments related to hardware products. It was pretty clear that a writedown was coming; the only question was how much it would be. Spectacles inventory must be included in "Other assets" on Snap's balance sheet, which was $61.7 million at the end of the second quarter, so at least investors knew the upper limit.

Person wearing Spectacles with a yellow background

Image source: Snap.

Snap ended up eating a $39.9 million charge, which included writing down inventory as well as charges associated with canceling purchase commitments. Unlike in prior earnings calls, Snap did not disclose Spectacles revenue for the third quarter, but it's safe to say sales were negligible.

Feel the cash burn

Snap's IPO earlier this year was a major cash infusion, which allowed Snap to finish the first quarter with $3.2 billion in total cash. Fast-forward to the end of the third quarter, and Snap now has $2.3 billion in total cash on the books. The company has blown through nearly 30% of its cash in six months.

We know that about $400 million of that went to acquisitions over the summer, but operating cash flow last quarter was negative $194 million. Capital expenditures are extremely small due to Snap's capital-light strategy (more on this later), coming in at $25.9 million. Snap calls its capital expenditures per user an "industry leading $0.15," except this is misleading. No other company uses this metric, and Snap is merely shifting costs to operating expenses instead of investing in its own infrastructure, which is more sustainable at the scale that Snap is operating.

The net result is that free cash flow was negative $219.9 million.

Hosting costs are steady

Speaking of the capital-light model, in which Snap relies on third-party cloud infrastructure providers instead of building its own servers and data centers, hosting costs were $121 million, or about $0.68 per user. That represents about 58% of the $1.17 in average revenue per user (ARPU) during Q3. That proportion of hosting costs to ARPU was identical to the second quarter, and did contribute to margin expansion.

Management also said the company is "benefiting from the dual cloud hosting environment," likely referring to pitting its two infrastructure providers against each other to score pricing concessions, which Snap successfully did in the second quarter.

Investor takeaway

Overall, it was a pretty terrible quarter. Snap fell short of expectations on all pertinent operating metrics and results, and it's embarking upon an incredibly risky strategy of redesigning its core app, all while its primary ad business is still barely getting off the ground and management deals with hardware missteps.

Snap also lacks cost discipline, and that's taking a big bite out of its cash position just months after its IPO. It's a good time to be short (like I am).

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