Value Investors Club / SNAP INC (SNAP)

Description

Description:

Snap Inc (SNAP) was written up as a timely, well-researched short by jcoviedo on May

28, 2017, and with the stock down from $21 to $7 over the ensuing 18 months, we

think it's pretty clear that the author nailed this one. We've been watching this slow

motion train wreck from the sidelines and while SNAP still leaves much to be desired,

we believe there is a very high likelihood that SNAP will ultimately be acquired by

Tencent, an event that is arguably not priced into the stock.

As most people know, Snap Inc is a camera-centric social media platform that was

incorporated in 2012 and is built around the premise that the camera screen is a

starting point for most products on smart phones. Its flagship product Snapchat is an

app that opens directly into the camera and allows its users to communicate through

short videos and photos, which the company refers to as “Snaps”. Snaps are

ephemeral in that they are auto-deleted after a specified time frame, and are able to be

modified with several creative tools such as Lenses (interactive animations overlaid on

a person’s face), Geofilters (filters that can be applied after a Snap is taken, such as

location, weather or time), and Bitmojis (cartoon likenesses of a user). Snap monetizes

the platform primarily through advertising. Sponsored Lenses and Geofilters are ways

businesses and brands offer unique filters around their product offerings, with the

ability for users to interact with the Snapchat app just as they would with some of the

free filters and lenses.

So what went wrong?

The stock since peaking a couple days after the IPO in 2017 is down over 70%. Much of the blame lies in

its deceleration in user growth following the August 2016 launch of Instagram’s stories feature, which

has only gotten worse, with SNAP’s first quarterly drop in daily active users (DAU) in 2Q18. SNAP also

made a strategic error in focusing narrowly on iOS in its first 4 years or so, resulting in some product

issues in its Android app. As highlighted in jcoviedo’s short piece, SNAP also has a significant

disadvantage vis-à-vis Facebook in terms of targeted advertising capabilities, resulting in an inferior

advertising platform. In late 2017, Snapchat made arguably it’s biggest strategic mistake, rolling out a

new interface that met with so much backlash that 1.3M signatures of users petitioned to roll back the

update. Instead of listening to the poor feedback, Evan Spiegel stubbornly said “it’ll take time for people

to adjust.” Without getting into the details, Spiegel should never have attempted a sweeping overhaul

of its app’s identity. Facebook’s family of apps have survived over the years by changing so gradually

that they have never shocked users into rebellion. Not surprisingly, there has been quite a bit of

executive turnover at SNAP. Since March 2018 Snap has lost lost its VP of Product Tom Conrad, its CFO

Drew Vollero, its Chief Strategy Officer Imran Kahn, its Head of Spectacle Mark Randall, Head of Sales

Jeff Lucas and VP of Engineering Tim Sehn. The downward trajectory of the stock simply reflects the

slow-motion train wreck that is just as clear to investors as it is to the users of Snapchat.

What are we missing?

It’s easy to dismiss SNAP as a fad gone wrong, but hidden amidst the chaos, there are some valuable

aspects that we think are being overlooked. SNAP’s 186M daily users still spend an average 30 minutes

a day on Snapchat. Daily active users visit the app 18 time a day and create about 16 Snaps each day.

Less than half of Twitter’s 326M monthly users are daily, meaning that SNAP’s daily audience is bigger.

Twitter has 2.5X SNAP’s revenue and investors are currently valuing it at 3X the market cap. SNAP grew

revenues 43% last quarter, while Twitter grew 29%. Snap has almost half the monthly user count in the

US and Canada as Facebook (where Facebook generates half its revenue), yet investors value Snap at 2%

of Facebook’s market cap. Yes, Twitter and Facebook users are doing different things from Snapchat

users, with the latter heavily into messaging while the former are browsing tweets, articles and videos

which are more appealing to advertisers, but SNAP has an engaged audience in the coveted 13 to 34

year old demographic, which is especially hard to reach with old media alternatives like TV, magazines,

newspapers and billboards – there is much room for improvement in monetizing this user base.

In addition, 3Q18 results had some promising elements. Revenue was ahead of the Street at $298M vs

$283M expected (up from $262M in 2Q18 and $231M in 1Q18), the EBITDA loss narrowed, coming in at

-$138M vs expectations of -$167M (up from -$169M in 2Q18 and -$218M in 1Q18). Cash burn dropped

sequentially from $234M in 2Q18 to $159M in 3Q18. The company is now targeting profitability in 2019

and there appears to be a viable path to get there.

Finally, the company has replaced its top brass with key players with more industry experience. The

new CFO Tim Stone is a 20-year veteran of Amazon. SNAP also hired Amazon’s Head of Global

Advertising Sales Jeremy Gorman to be its Chief Business Officer, responsible for the company’s “global

business solutions, global online sales, customer operations, and business marketing.” Finally, former

Huffington Post CEO Jared Grusd is joining as Chief Strategy Officer, looking after “content, global

strategy, partnerships and corporate development.” The company should be in a better position to

grow and scale its business with these new hires in place.

Overlooked X Factor: Tencent and Amazon:

Tencent has been one of SNAP’s early venture backers and further increased its stake to 12% in

November 2017 to become one of SNAP’s largest shareholders.

As reflected in its stock price, Tencent ran into a series of issues during 2018, especially in its video game

business. This segment contributed almost 50% of Tencent’s revenue and and accounts for 44% of

China’s market. However, the business showed signed of saturation in 2018 in terms of user growth,

ARPU and profitability. To make matters worse, the Chinese government announced several new

policies to tighten regulations around the video game industry in China. Under the new policy, all new

video games need to obtain a publishing number (i.e. a permit) before their release, however the

government has not approved or issued a single new video game publishing number since March 2018.

The direct impact is that Tencent’s most popular new video games in China now, such as PUBG, can’t

charge a penny and therefore Tencent can’t monetize its vast user base.

To mitigate this headwind, Tencent has shifted its focus on video games towards overseas markets. It

has launched PUBG Mobile overseas and generated $100 million in revenue in the first 200 days after

launch. This result is good but not great vs its foreign peers. For example, Fortnite of Epic Games got

more than $300 million revenue in the first 200 days after launch, and that was just from iOS. It will be

difficult for Tencent to replicate its success overseas because it does not have similar dominant positions

along the value chain of the video game industry as it does in China. For example in China, Tencent has

a dominant online gaming platform called Tencent Games, it has stakes in video game and eSports

streaming platforms Huya and Douyu, and it owns the largest social media and messaging networks in

China, WeChat and QQ). The dominant streaming platform overseas is Twitch, which is owned by

Amazon. In terms of social media, neither WeChat nor QQ has a sizeable user base overseas.

All the above makes SNAP a great fit for Tencent’s overseas strategy for its video games division:

1) SNAP is a key social medial player with DAU of over 180 million. SNAP’s core users are

millennials and generation Z which strongly overlap with the targeted user base of video games.

SNAP could be a distribution and promotion partner with Tencent;

2) SNAP has some similar functionalities to those in WeChat, for example, Stories (Moments in

WeChat) and Discovery (Official Accounts in WeChat). This will make it easier to borrow some

social media business strategies directly from Tencent’s playbook in China;

3) SNAP’s Lens is unique and has already tested some mini games on it. This is quite similar to

WeChat mini games which is very addictive and has become a key component of the WeChat

ecosystem. More importantly, SNAP is rolling out a desktop version of Lens and partners with

Twitch to let streamers and viewers using the unique lenses in video game streaming;

4) One thing that SNAP has not tried but should is video game streaming or a similar function in its

Stories or Discovery section. It has successfully done live streaming for the World Cup and

Olympics. It might be worthwhile to partner with Tencent to live stream Tencent’s popular social

media centric games, such as Arena of Valor (a 5v5 MOBA game played among social media

friends).

Conclusion:

This is not a typical value piece. We could argue that on a market cap to DAU basis, Snap is far cheaper

than peers Facebook, Twitter and Weibo, which trade in the $100s per user vs SNAP’s < $50. With ARPU

of just $6 vs Twitter and Facebook in the teens to mid-twenties, SNAP has much room for improvement,

and is arguably under-monetized. But the point of this piece is to show that there is a potential

inflection point coming, and it starts with key senior management hires, a focus on profitability and cash

flow. Most importantly, we believe that this company will end up in the hands of Tencent in the near

future. We think it makes strategic sense for both parties.

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise do not hold a material investment in the issuer's securities.

Catalyst

Further improvement in cash burn, diminishing loss, stabilization in DAU in 4Q18
Takeout by Tencent

show sort by

			2018	2019
Price:	7.09	EPS	-0.60	-0.43
Shares Out. (in M):	1,310	P/E	NA	NA
Market Cap (in $M):	9,287	P/FCF	NA	NA
Net Debt (in $M):	-1,414	EBIT	-840	-678
TEV (in $M):	7,873	TEV/EBIT	NA	NA