Snap (NYSE:SNAP) reported earnings last week, and shares fell yet again. In this episode of Industry Focus: Tech, analyst Dylan Lewis and senior tech specialist Evan Niu, CFA, dive into the report to explain what went wrong, why the market is backing away from the company, and a few potential bright spots in an otherwise uncertain-looking long-term future for the Snapchat operator.

Find out what it means for the company that their head engineer has decided to leave, how Snap's Spectacles business is doing and what that says about CEO Evan Spiegel's management, why market estimates for Snap vary so widely every quarter, and more.

A full transcript follows the video.

This video was recorded on Nov. 10, 2017.

Dylan Lewis: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It's Friday, Nov. 10, and we're talking about Snap's vanishing market cap. I'm your host, Dylan Lewis, and I'm joined on Skype by fool.com senior tech specialist, Evan Niu. Evan, how's it going? We finally got started after a couple of false starts to the podcast.

Evan Niu: It's going pretty well.

Lewis: Thanks to Heather for all her editing help today. We're pre-recording today's show, and that led to us having a couple of goofs as we intro-ed, and made sure that we got the dates right. But we're here now, and we're ready to talk. Evan, we missed getting the chance to do the Apple show together, because I was traveling a little bit, but we do have the treat of talking Snap. This is another company that we love to discuss, and we eagerly await the quarterly updates that we get from them.

Niu: Yeah, it was a pretty bad quarter. It's good news for me, since I'm short.

Lewis: Yeah, I guess we'll throw that out there now, people who have been following us for a while know, but you do have some options on Snap. Again, in the interest of transparency, we're recording a show on Wednesday. We have our annual Foolapalooza, our company get-together, where we go over some business meeting stuff, and that's Thursday and Friday this week. So, if anything crazy happens between Wednesday and Friday, it will not be reflected in the discussion that we have today. We will hit it next week, though, for sure. So, looking at the actual earnings, yikes, right? This is a company that we've been following closely for a while, it's one that we're always excited to see, and the quarterly numbers look pretty ugly again, Evan.

Niu: Yeah. It was pretty rough. Revenue was up to $207.9 million, but that was well short of analyst expectations, which were closer to $237 million. The net loss, in particular, more than tripled to $440 million, which is a huge widening of the net loss down there. And I think it's kind of ridiculous that, on their press release, Snap, under percent changed, they put NM for not meaningful, which is something they've done in the past, where they're saying, "This percent change is not meaningful." But I think it's pretty meaningful. [laughs] 

Lewis: Yeah, once you start to get into the hundreds of millions of dollars, that's hard to think of something that's negligible.

Niu: Right. And it's not just because you're comparing negative numbers, which, I guess, in theory, you could. They did provide percent change information for other negative numbers. So, there's really no good explanation why they would consider this not meaningful. Net losses are humongous at this point, and this company is so young, and that's very important, it's very meaningful for investors.

Lewis: One thing that's certainly meaningful is their daily active user account. That rose sequentially to 178 million, which was also shy of consensus estimates. What's interesting here is, the consensus estimate from the market was about 182 million daily active users, but the number they posted was also short of the company's own estimates. They did not say what that was, but in the conference call, they mentioned that they were disappointed in what they posted on the user side. I focus on this here because we don't get a lot in the ways of guidance from management with this company. So, for them to admit that they missed the mark on a core business metric like this is nice to hear. It's not nice to hear that they missed it, but it's nice to hear that they at least acknowledged that they missed it.

Niu: Right. There was this weird dodge, and they attributed the shortfall to the way they calculate DAUs, which is different than other companies. They report DAUs based on average throughout the entire quarter. So, they said September was really strong, but July and August were not so strong, so that hurts the average that they report. But they're the ones who choose how they report their metrics, so why are they trying to blame it on reporting when they choose the reporting? Just for context, Facebook (NASDAQ:FB) reports daily active users based on the average of the last month of the quarter. And it's not that there's a right or wrong way, necessarily, to report this, but it's just different. When investors compare these DAU numbers from these different companies, it's good to know the differences in how they report it. But it's weird, they're trying to blame it on how they report, but they're the ones that choose how they disclose it.

Lewis: Like, you guys are making the rules. You can decide how you want to calculate this metric, as long as you tell us how you're doing it. So, yeah, it does seem a little silly that that's but they're blaming it on. Not surprisingly, the market was pretty down on the stock after this release, given all the disappointing numbers they posted. At points, it was down roughly 10%. 

Niu: It was down 15-20%. This morning, they actually recovered some of their losses, because Tencent disclosed that they now have a 10% stake in Snap. And any time you have a big investor coming in to scoop up a big stake in the company, that's certainly a big vote of confidence, and it helped mitigate some of the losses. But, of course, throughout the day, they continued to trend lower. But, that is something that's a meaningful development, that Chinese tech giant Tencent is in here taking a passive stake. And it does appear that they just took a passive stake in open market purchases, as opposed to some type of special offering directly from the company.

Lewis: So, they obviously like something that they see here. I think it's pretty clear that you and I don't. But, looking at the company's results, I think one of the big things we should focus on here is the switch to the auction-based ad fill. We're starting to see the impact of that now. Really, that's going to be the story for Snap for the next couple of quarters.

Niu: Right. They launched their self-serve ad platform earlier this year. I want to say it was in May or March. They've been working on it for the past year or so. This really has the potential to help them scale, because now you don't have to have all your ad sales going through a direct sales force, which is certainly very labor intensive, it's very expensive. This way, if you can switch to self-serve ad platform that's auction based, you can really automate the process a lot more. That definitely helps in terms of the scalability.

Lewis: It helps to reach a lot more businesses. At the end of the day, it gets a lot more advertisers access to the platform.

Niu: Right. I think they said that the entry level ad pricing went down by three orders of magnitude, which would be a thousand times. That's a pretty big reduction, in terms of the minimum cost it takes a potential advertiser to buy in and test out this platform.

Lewis: And this is something that you do want to see a business doing. There's this good quote from Imran Khan, the company's chief strategy officer from the conference call says, "As we transition more and more of our business to auction, it's had a meaningful impact on our overall pricing, diminishes revenue in the short-term, it builds the foundation for long-term scalable revenue. As we onboard more advertisers and multiple advertisers compete for the same ad impressions, we should see higher pricing." So, when you look at their results, you kind of have to keep this in mind. As bearish as we've been on this company, this is a move in the right direction for them, because it will allow more advertisers to play on the platform. The short-term hit of that is, you're going from these negotiated big-ticket ad buys that are handled by sales reps to a market-based ad system. And because of that, with supply and demand factors, the price is going to fluctuate a little bit more, and you lose some of the control there.

Niu: Right. I definitely think it's critical for them to have done this, just in terms of the ability to scale. Like we've been talking about, if all your ad sales are going through sales reps, you can't scale that very well. It's so labor-intensive. But, having it automated allows you to do that. But, how this plays out going forward, and how they execute on actually building this platform and attracting advertisers to the platform, is really going to be what it boils down to. This is just the bones, it's the foundation, but it's not over yet. There's still definitely a lot more to go.

Lewis: We have a very similar conversation when we talk about Twitter (NYSE:TWTR) and Facebook, and Google to the same extent. When you're looking at a digital ad-based business, the main drivers for what goes into your revenue is the number of ads you serve up and the price that you charge for those ads. The things you're going to be watching now that we're moving to this auction based system is, what do impressions look like and what do prices look like? So, for this most recent quarter, you saw impressions were up 400% year over year and 60% sequentially. Prices were down 60% year-over-year and down 20% sequentially. So, those are numbers you're going to want to be paying attention to to get a sense of, are advertisers flocking to the platform? Are they rolling out more ads on the platform and taking advantage of inventory there? Then, also, prices tend to follow ROI. So, if advertisers are seeing a good bang for their buck, you're going to see some floor with prices, and then probably some steady rise. That's what we've seen with Facebook. It's not really what we've seen with Twitter.

Niu: Right. It seems like the key is going to be, can they actually bring a bunch of advertisers to this platform. And part of that will also be delivering on measurement tools and analytics, and showing advertisers whether or not these ads actually work. That's also another thing where Snap is very early on. They're still brand new to this, all of this stuff. And whether or not they can actually do that is going to boil down to execution in the future. It's nowhere near determined at this point if they can actually pull this off.

Lewis: And if you're looking for what to expect in the coming quarters, management did say to kind of expect more of the same. So, increasing impressions as more advertisers get on board, but prices should continue to go down due to auction dynamics, and that transition there that they're making. A few quarters from now, though, we'll have a better feel for, do prices find a floor, and do we continue to see advertisers coming? So, this is something that's going to play out over the next couple of quarters, I think.

Niu: Right. We'll just have to keep an eye on it, see how it grows.

Lewis: Yeah. So, I mentioned that they do not really do much to help the Street with guidance and what to expect with their top and bottom line numbers. One thing I do want to check in on is, way back, I think this was during the IPO road show, or it was while they were booked building, something like that, but I saw these reports, I believe it was from a presentation deck that Snap would hit somewhere between $500 million and $1 billion in revenue in 2017. And you saw a lot of outlets rightfully anchoring to that $1 billion number as this stretch goal, and a big, flashy number for this new platform to hit as it begins to monetize. This is, really, our best ballpark of expectations versus reality for a business, because they haven't provided us with quarter-to-quarter guidance. If you look back at the first three quarters so far, Snap has booked just over $500 million in revenue, about $540 million in revenue. So, if they're going to come close to hitting that stretch $1 billion, they're going to have to have a ridiculous Q4. 

Niu: Which they won't. [laughs] 

Lewis: I don't really expect it to happen, yeah.

Niu: And generally speaking, for a company this young, guidance is extremely important. The market trades on expectations. And companies have a really big role in course correcting and giving some direction to analysts when they set up their estimates. And analysts are the ones that set the market's expectations. By not providing guidance and leaving analysts up to their own devices to come up with their own numbers, then you're going to see a wide spectrum, a wide range of estimates. It just doesn't make any sense why they would do this, unless they simply can't do it because they're so young and they don't have the ability to forecast with much visibility or something. I don't know. The fact that they don't give any guidance is really frustrating for investors who for a company at this stage, it's really important to be able to give some type of forecast.

Lewis: And the non-guidance also really helps explain why we see the market reactions that we do with this stock. Because basically, we're going off of what Street analysts through their own inputs have put together for top and bottom line expectations. There is no company input. It's much more likely that there's going to be some differences in what the company actually reports, because they're not providing any of the inputs for these models. So, that's where you get these really big moves once new results come out, where you have a stock moving 15%, just because there wasn't a lot to hang your hat on there.

Niu: Yeah. I worked in investor relations very briefly. I know there is a lot of back and forth and communication between IR departments and analysts. When they have questions, you can help clarify things. There's a limit to how much you can say to the analysts, but the goal is to give them at least some type of direction on if their estimates are off base. And Snap is not doing that, it doesn't seem like.

Lewis: It's another way that they're making things a little tougher for everyone else to get a sense of what's going on there. Something that was a major theme on their conference call was the idea that there's probably going to be a major redesign coming to the major core Snap app. The big idea here is, they're going to try to make the app more usable and make content discovery a little bit easier for users.

Niu: Right. I think this is a pretty big announcement on the product front. They're taking this long-standing criticism that Snapchat is hard to use, the interface is unintuitive, and it's off putting the first time you try it. This is a pretty big reversal, because just a few months ago they basically dismissed these concerns and were more or less like, "We're just focusing on young people who are good at technology." CEO Evan Spiegel made this weird analogy about trying to teach his grandmother how to use email, and how he gave up on it. It's like, OK, are you just going to give up on trying to bring more people onto the platform? So, the fact that they're acknowledging this, and they are going to redesign it to try to make it easier to use is a pretty big change. It's also a pretty big risk, and they are up front in saying, "We do think this is going to hurt our business in the short-term," but the hope for them is, this will help user growth in the long-run.

Lewis: Is your view there that the risk is alienating existing users?

Niu: Right. It's like what you see with Twitter. Every time Twitter has some product change, the community freaks out and over-reacts. But if the goal is to make the platform or service more appealing to mainstream consumers, I think that's worth the risk of a little bit of backlash from some of your hardcore uses. The real question is, if you make these product changes, are your users going to leave? Or are they just going to adapt? It's way too early to know, because we don't even know what this redesign looks like for Snapchat. But, with Twitter, we know for a fact that it's helping them. They've made a lot of big product improvements. They just made a huge one last week with the 280-character limit. And whether or not these types of product changes can translate into user growth is really how you should gauge if that's the success or not.

Lewis: And when you think about usability, you mentioned the story of explaining email to his grandmother. Well, you look at the success of an Instagram or Facebook, and hitting close to a billion or two billion monthly active users, that comes from being able to cross over demographics and get into the older groups that maybe aren't quite as tech-savvy. You can build a really great platform for 100-200 million users if you focus on stuff that's really appealing to tech-savvy folks, but to really break out and have a much larger addressable market for user base, you're going to have to have something that makes sense to most people.

Niu: Right, exactly. Another thing I know they're working on that's pretty big is, Snapchat has always had a lot of really annoying performance problems on Android, which, of course, is the largest mobile platform on Earth by unit volumes. So, that's a pretty large part of the market. And they've historically had a lot of problems with it, because they've never really focused on Android. They've always focused on the iPhone for development. The iPhone app is a lot better. But, again, if you want to get these big numbers, Android is where the numbers are. So, they're also redesigning their Android app to really focus on the performance. Of course, Android development is really fragmented, because there's tens of thousands of different Android phones out there, versus a dozen iPhones. So, that's how much bigger engineering task, which leads into this other thing that just happened, which is that their head of engineering just quit the company.

Lewis: Yeah. It's kind of tough to say, "We're going to be redesigning and giving our app a facelift and making it a little bit easier to use," and then see that someone who is the head of engineering is leaving the company.

Niu: [laughs] Yeah. They literally were like, "This is going to require considerable engineering resources," and then just yesterday the engineering chief, Tim Sehn, who Snap poached from Amazon back in 2013 when Snap was only two years old. And he was a huge win, because he was a really good software development executive. He told them yesterday, on the day of earnings, that he's leaving at the end of the month. So, that definitely doesn't bode well considering the fact that they have all these hugely important product developments that they need to be focusing on, and now their top engineer is quitting.

Lewis: One other thing that simply doesn't seem to be going very well for this company is the Spectacles segment, this product line for them. We really can't talk about Snap without briefly discussing it, because Snap does consider itself a camera company, at least according to management. But, look at the camera eyewear line. I know, Evan, you in particular are really not too thrilled with some comments that CEO Evan Spiegel made about a month ago, because of how they seem to stack up to business results we saw from this most recent release, which really weren't all that good.

Niu: Right. A month ago, Spiegel spoke at a Vanity Fair conference, and he told everyone very publicly that, first of all, he confirmed the unit sales figure, which, they say that they've sold about 150,000 units to date, which was a month ago. But he also said those sales were ahead of their internal expectations. Which sounded good at the time, but over the past month, we've seen these reports that Snap has hundreds of thousands of units of unsold inventory sitting in warehouses, which, if they have all this unsold inventory, they're going to have to write it down. So, that was pretty expected. Of course, last night, they confirmed that yes, they are incurring a $40 million one-time charge related to Spectacles inventory. And they had a bunch of purchase commitments related to hardware. They had to cancel those. They had some fees and expenses related to cancelling those. To put these numbers more in context, they're writing off $40 million, in the first half of 2017, their total Spectacles revenue was about $13 million. So, they're writing off three times as much as they actually sold in the first half of this year. Unit sales declined from Q1 to Q2. So, there's no way that sales exceeded expectations. And it really seems like Spiegel was misleading investors last month when he said they were beating expectations, when clearly they're not, because you ordered a ton of these things, and you don't order things unless you expect to sell them. It just doesn't make sense. You can't have it both ways.

Lewis: Yeah, you're not going to build out inventory you don't expect to sell. [laughs] 

Niu: He mentioned, they overestimated early demand, and they did place a lot of orders for components that have long lead times. So, that does make some sense in helping explain the $29 million of purchase commitments they had at the end of Q2. But it doesn't explain the fact that they built up so much inventory. I know they can kind of get away with it, but I still think he was really misleading investors by saying that, and I actually submitted an official complaint to the SEC last night. [laughs] 

Lewis: Look at that, you being an advocate for the average investor.

Niu: Probably won't come to anything, but it's still troubling on principle. The most ironic thing about this whole thing is, literally on the same day that he said the sales were exceeding expectations, he also said he needs to communicate better with investors. So, you realize that being a public company has so much more regulatory scrutiny, so much more regulations around communications, disclosures, and you're saying you want to get better, and then you turn around and lie and say these things are doing better than you'd hoped when now, a month later, it's demonstrably false, that you were well below your expectations.

Lewis: I think the thing you have to remember with this, too, is that Spectacles are really not a part of the thesis for this company. Yes, we're nitpicking here, but for him to be overstating their impact, or what's going on with them and how successful they are as a line, when you think about the grand scheme of where their revenue is coming from, it's just an annoying thing to see from management more than anything else. And you couple the success, or lack thereof, in this segment with some news that they had some drone ambitions a little while ago and then decided to walk that back, and they've made some major changes on their hardware team. We talked about, when we went through their S-1, how we felt like their hardware ambitions were a little bit misplaced. I think this is just being borne out right in front of us.

Niu: Right, you're right. Currently, hardware revenue is kind of meaningless. It's really not material, it's negligible in the grand scheme of things. But this is, again, a self-inflicted situation where Snap themselves have said that hardware is going to be important to the future, maybe in a decade or so. They basically want to have more control over how the Snapchat experience is delivered to users. Which, on a strategic level, makes some sense. But, they're the ones that are basically trying to emphasize, we want to get more into hardware. That's why these hardware missteps and mistakes matter more, because they're the ones that said they matter. If they had always been like, "This hardware is a side, fun thing, it's not really a big deal," then investors wouldn't care that much about it. But, the fact that they are the ones that say it's going to be important in the future, that just underscores when they mess up now, do they really have a good chance, fast forward a few years, are they actually going to be able to develop compelling hardware? I don't think so.

Lewis: Yeah, it's going to be tough for them to build out the engineering team to out-innovate a lot of these very deep-pocketed tech companies that they're going to be fighting. We've talked about it in the past, the difference between Apple's engineering team and Snap's engineering team, it's a David and Goliath type fight.

Niu: Yeah. It's really hard to imagine them being compelling. Hardware is extremely hard, and they're just now realizing that, and they're paying the price.

Lewis: Yeah. Evan, you have put together some really excellent coverage on Snap over on fool.com. You already have several pieces up on the site covering earnings, the Spectacles controversy we just detailed. Listeners, if you want any of that, shoot us a note, we'll be happy to forward it along. Do you have any other pieces on Snap in the hopper that folks can look forward to?

Niu: I think I have one scheduled for tonight about Tim Sehn quitting the company, which hasn't published yet. We touched on that earlier.

Lewis: And when you say tonight, you mean Wednesday. So, that will be available, if you're listening to this episode on Friday or anytime thereafter. So, listeners, if you want any of that coverage, shoot us a note and we'll be sure to forward it along to you. Evan, anything else before I let you go?

Niu: No. It's a good time to be short. [laughs] 

Lewis: [laughs] I guess so. Listeners, that does it for this episode of Industry Focus. If you have any questions, or if you just want to reach out and say hey, you can shoot us an email at industryfocus@fool.com, 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 over 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. For Evan Niu, I'm Dylan Lewis. Thanks for listening and Fool on!

John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool's board of directors. Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool's board of directors. Dylan Lewis owns shares of GOOGL, AMZN, AAPL, and Facebook. Evan Niu, CFA owns shares of AAPL and Facebook and has the following options: long April 2018 $17 puts on Snap Inc. The Motley Fool owns shares of and recommends GOOGL, GOOG, AMZN, AAPL, Facebook, Tencent Holdings, and Twitter. The Motley Fool has the following options: long January 2020 $150 calls on AAPL and short January 2020 $155 calls on AAPL. The Motley Fool has a disclosure policy.