One of the risks Snap's (NYSE:SNAP) management lists in its annual report filed with the Securities and Exchange Commission (SEC) is the risk that it will never turn a profit: "We have incurred operating losses in the past, expect to incur operating losses in the future, and may never achieve or maintain profitability."
It's not uncommon for unprofitable companies to list that as a risk in their SEC filings. Twitter (NYSE:TWTR) had a similar risk statement in its IPO registration and it finally managed to turn a profit last year. Facebook (NASDAQ:FB) used wording in its registration filings that it would prioritize long-term growth over profitability. So, Snap has good company when it comes to the risk of never turning a profit.
CEO Evan Spiegel has even reportedly given his team the goal of reaching profitability this year. And upper management went on a spree of layoffs starting late last year to try to cut costs. But those moves aren't going to be enough to cover some of the core issues preventing Snap from reaching profitability.
Where are all the users?
Since going public, Snap has disappointed investors with Snapchat's user growth. Its struggles throughout last year were blamed on the growth of Instagram Stories, a feature taken directly from Snapchat. Facebook quickly copied the feature across its family of apps, and it recently announced that WhatsApp Status crossed 450 million daily users, well over twice as many daily actives as Snapchat.
But Snap's recent struggles are of its own making. After receiving negative feedback on a Snapchat redesign in December and January, Snap's management decided to focus on the good parts and roll out the new app to all of its users. It didn't go so well, and Snap actually saw its active user count drop in March following the full rollout. Management has since backtracked on the redesign, tweaking it in an effort to keep users engaged.
Unfortunately Snap's struggles to attract new users like it once did are translating into much slower-than-anticipated revenue growth. While analysts originally expected Snap to generate over $1 billion in revenue last year, that number came down every time Snap reported disappointing user and revenue numbers. Despite a better-than-expected fourth quarter, Snap's revenue came in at just $825 million for the year.
Last year, Snap started transitioning its ad sales to its automated self-serve platform. While the move is necessary in the long term in order to scale and compete with Facebook and Twitter for smaller advertisers, it's been a huge drag on revenue growth.
Snap has seen its average ad price decline precipitously as many of the ad auctions in the self-serve platform go uncontested. There's simply not enough demand to support the supply of ads in Snapchat, and it's not clear that's going to change anytime soon. Those pricing dynamics could make revenue growth hard to come by in the future.
A hobbling cost structure
While Snap has posted disappointing top-line growth, its cost structure isn't doing it any favors, either.
Last February, Snap agreed to contracts with Alphabet subsidiary Google and Amazon for cloud hosting services. The agreements will have Snap spend around $525 million on hosting this year between the two providers. Snap is on pace to surpass that amount after spending $139 million on hosting in the first quarter.
These hosting costs are absolutely huge, and they move according to usage because of the contract relationship. A company the size of Snap usually builds its own servers to support its products, allowing it to then benefit from operating leverage of increased usage on a fixed cost. Spiegel, however, sees the flexibility of using Amazon and Google as an advantage over peers, enabling the company to quickly launch new features. It also reduces the need to hire people to maintain servers.
Still, it's hard to see how the company could actually save money at its size and scale. Perhaps new CFO Tim Stone, who was previously the financial chief at Amazon Web Services, could convince Spiegel to move away from its dependency on third parties. But Snap's locked into contracts through 2021, so there's not much that can be done in the short term.
Last quarter, hosting costs accounted for 60% of revenue. There's not much room left after that to turn a profit.
Unless hosting costs come down or Snap ad prices turn around, the company is going to struggle to post a profit any time soon.
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. Adam Levy owns shares of GOOG, AMZN, and Facebook. The Motley Fool owns shares of and recommends GOOGL, GOOG, AMZN, Facebook, and Twitter. The Motley Fool has a disclosure policy.