Snap Admits Its Cloud Commitment Was Too Much

Snap (SNAP 2.24%) has stood behind its decision to rely on its cloud infrastructure partners Google and Amazon (AMZN 1.30%) instead of building its own servers. Snap argues the capital-light model will eventually lead to greater cash flow conversion. On the other hand, Snap can't realize as many benefits of scaling.

In order to reduce its infrastructure costs, Snap negotiated two massive long-term contracts with Google and Amazon in early 2017. The contracts were structured with the expectation that Snap's demands for cloud infrastructure would continue to grow rapidly. After several quarters of losing users, Snap admitted it couldn't keep up with its commitments and restructured its deal with Amazon in October last year.

Snap also amended its agreement with Google, but the details of those changes are not public.

Image source: Snap

Comparing the new contract

Snap's original contract committed it to paying Amazon Web Services $1 billion over five years. The new deal totals slightly more than $1.1 billion over six years.

Data source: Snap annual report and S-1 registration filings. Chart by author. N/A = not applicable.

Importantly, both deals use the language: "If we fail to meet the minimum purchase commitment during any year, we are required to pay the difference. Any such payment may be applied to future use of AWS services during the addendum term, although it will not count toward meeting the future minimum purchase commitments under the addendum." In other words, Snap might have to prepay for its cloud-computing service, but it's not forfeiting the money outright.

It's unclear whether Snap faced any fees in its renegotiation with Amazon. Snap may have had to commit to higher overall spending in order to renegotiate without penalty.

In the short term, Snap will save itself from spending $35 million on cloud computing it likely won't need this year. It'll save even more in subsequent years. Additionally, the commitments ramp more slowly, which is important considering the significant slower growth outlook for Snap's user base going forward compared to two years ago.

Check out the latest Snap earnings call transcript.

Is Snap better off?

Snap has spent over $1 billion on cloud-computing servers over the last two years. That's more than 50% of its revenue during that period.

Snap interim CFO Lara Sweet points out the company's cost of revenue is growing much more slowly than its overall revenue growth. Indeed, the company actually saw a sequential decline in its infrastructure costs. Sweet says that's due to "engineering efficiency programs" the company put in place in 2018. But the lower commitment to Amazon may have played a more significant roll than Sweet lets on.

From a long-term operational-efficiency perspective, it doesn't make sense for Snap to spend hundreds of millions of dollars on cloud computing. It could achieve better margins by building out its own data centers and servers, considering the size of its user base. And if Snap is really making improvements in the efficiency of its infrastructure expenses, it could actually benefit from those improvements instead of practically passing on the savings to Amazon and Google due to its commitments.

While Google and Amazon were instrumental in enabling Snap to grow quickly from the start, Snap's now relying on long-term contracts to keep its infrastructure costs under control. That requires a good ability to predict the future, which, as it turns out, is really hard to do.

What's more, those long-term contracts make it hard for Snap to move away from its reliance on cloud infrastructure without facing penalties. Considering there's not much indication that Snap is going to need a significant increase in cloud-computing infrastructure over the next few years -- infrastructure expenses grew just 2% year over year in the fourth quarter -- the vicious cycle of lengthening out its contracts with higher overall spend requirements may continue indefinitely.

Ultimately, that's going to limit Snap's gross margin and its free cash flow -- which is only a fraction of gross profits after all.