Snap's unhappy honeymoon

By Kevin Kelleher , written on May 11, 2017

From The Earnings Desk

I'll admit it, the first thing I thought when Snap unveiled its magic eraser this week was that a company losing as much money as Snap is should think twice about using that name.

I mean, Mr. Clean sells a magic eraser, but P&G is steadily profitable and besides, who's going to mess with that guy? When Snap introduced its own (kludgy) magic eraser one day before its first ever earnings report, the company basically let the snark write itself: It erases everything but red ink! Facebook is building its own magic eraser to use on Snap! Investors magically erased $(fill in the blank) billion from Snap's market value! And so on.

Snap is a company built on the idea of ephemerality. As Evan Spiegel hosted his first earnings call, he kept laughing nervously, perhaps longing to disappear himself into whatever aether expired snaps travel. To fill in that aforementioned blank, Snap's stock fell at one point more than 25% to $17.15 a share in after-hours trading. Later on, the stock regained some ground to $17.65 a share. Even so, that represents a vanishing of $6.5 billion in a few, panicky hours after Snap's first earnings report.

This is not the happy honeymoon anticipated by investors when they jostled for Snap shares, priced at $17 apiece, in its March IPO.

In the first three months of 2017, Snap lost $2.31 a share, or $2.2 billion. Losing two billion a quarter is a trick known as the Double Uber. Pulling off this trick is painfully difficult but a huge crowd pleaser when it works - the key is to produce such dazzling revenue growth that investors are blind to the mounting losses.

Unfortunately, this is one of the areas where Snap came up short. Yes, revenue at Snap rose 286% to $149.6 million last quarter, and you might think that this would be dazzling enough to execute a perfect Double Uber. But Wall Street wanted more – $158 million to be exact – and Snap ended up jumping headlong into that crossbar, not sailing gracefully above it.

This is how high investor expectations had grown for Snap: The company has brought in $366 million in revenue in the past 12 months. Before Snap reported earnings, investors had valued it at 54 times that figure. Even after the post-earnings selloff, Snap is trading at 41 times revenue. Facebook, that nagging Snap nemesis, is trading at 38 times its net profit. Snap can't be measured by that metric, because it only has a net loss to report, which was also bigger than analysts were estimating.

Snap sees all this as the cost of building out its vision – a world where the camera is a daily cornucopia of personal creativity – but that very cost is nearing questionable heights. It's rare for a tech company to go public without a gross profit – that is, revenue minus the cost of attaining that revenue. Snap didn't just IPO without gross profits, it did so at a huge premium. This being either a measure of how high Snap could fly, or how far it might fall.

In Snap's case, according to its SEC filings, the cost of its revenue comes primarily from third-party infrastructure providers like Amazon and Google cloud services. In its conference call, Snap said it had negotiated lower prices with both Amazon and Google for its cloud costs. Welcome news, to be sure, and yet it still posted a gross loss. Which is not a phrase heard very often in the public markets. A gross loss sounds more like what happens when you vomit up a rich and expensive dinner. Less than three months in, investors in Snap's IPO may already be dreading such a messy catharsis.

Now add in operating expenses like R&D and sales and marketing. Snap may be bragging about how its revenue nearly quadrupled, but its operating expenses are accelerating more quickly. R&D rose 28-fold to $806 million. Sales and marketing costs rose 15-fold to $220 million. General and administrative costs rose 48-fold to $1.2 billion.

I wander into these financial weeds for a reason. The bizarre flora here are so rarely spotted. Nothing kills the buzz an investor gets from quadrupled revenue than the kind of double-digit multiplying in expenses Snap is experiencing. Look at it another way: A year ago, Snap was spending $3.68 for every dollar of revenue it was bringing in. Last quarter, it spent $15.79 for every buck of revenue.

Snap's first-ever earnings report, in other words, was the banner day Twitter has been wishing for. You know the debate about Twitter, how its financial struggles don't reflect its social importance, or vice versa. It may soon prove that the best case scenario for Snap, in light of this financial performance, is that it aspires to a similar kind of debate, where its relevance in daily lives can be countered against its daily flogging on the NYSE's stockade.

The bull's case for Snap is that the massive spending at the company has less to do with the billions its IPO offered and more with an uncanny potential to engage users in new and still-developing ways. This makes daily active users a closely watched metric at Snap. DAU's reached 166 million last quarter, up 36% from a year ago and up 5% from the a quarter earlier. By contrast, on the plus side, Twitter saw DAU rise 14% year over year. On the down side, Facebook saw DAUs rise 3% quarter over quarter (and Facebook has more than 7 times as many daily users as Snap).

For public investors, DAU is an idol that companies are expected to bow down before. Spiegel traveled to that idol, but he didn't quite make it to his knees. “So, ultimately, I think that the way we try to help people understand about how we think about daily active user growth is about creativity and creation,” he told investors.

This is replacing a measurable with an unquantifiable, the kind of bait and switch used in the dot-com era. Spiegel quickly brought it back to mathematics. “The most important thing to understand is that we think of daily active user growth as a function or a derivative of the growth in creation.”

I went to a liberal-arts college, but drawing on my high-school math, I think what this means is this: If Snap builds it, creators will come. And the more creators build what they build, eyeballs will follow, and in their wake advertisers. But Spiegel may have gone a derivative too far with this: “We also talk about DAU growth as it pertains to removing friction from the creative process.” Lens, for example, “really lowered the barrier to creation on our service,” he said. “Because people enjoy looking like a puppy, and things like that.”

Spiegel then laughed nervously, which is fine in a Santa Monica office where you can discreetly signal to some guy at your lunchroom table he's got food stuck in his teeth. In a call where analysts ask questions and investors listen in, this is like papercutting your finger in a pool of sharks. Puppy-eyed is a good look on Snapchat. On Wall Street, it's the look of the damned.

Which brings us out of the financial weeds and into the most entertaining moment in Snap's inaugural earnings call, when an analyst, BTIG's Rich Greenfield, asked Spiegel flat out the question he claimed (rightly, probably) is on every investor's mind. “While Zuckerberg never really said it directly, it really sounds like he wants to bury Snapchat,” Greenfield asked. “Does Facebook scare you? And why or why not?”

Spiegel laughed nervously. “Look, if there's one thing that I want to communicate today, it'sprobably just the overall importance of creativity to our business,” he said. But then Spiegel dropped the talking points and rose to the occasion.

“The bottom line is, like, if you want to be a creative company, you have to be comfortable with and enjoy the fact that people are going to copy your products if you make great stuff. And I think we've seen this happen a lot in technology. When Google came along, everyone really felt like they needed a search strategy. When Facebook came along, everyone thought they needed social strategy.

“And now I think with Snap, we believe that everyone is going to develop a camera strategy... And I think, at the end of the day, just because Yahoo, for example, has a search box it doesn't mean they're Google.”

Okay, first. When Google's search engine appeared in 1998, there were already maybe a dozen search reptiles, like AltaVista and Inktomi, feeding in this pre-historic jungle that scientists later named the dot-com era. Google added an opposable, searchable thumb. But even by then, Yahoo, the colossal portal that bestrode that archaic land of two decades past, had a search box.

Anyway, nevermind. Second. When Facebook came along, everyone felt they needed a social strategy not so much because of Facebook but because of Friendster, which botched its early opportunity. Facebook simply out social-networked the company that established the market. And only after that did everyone realize they needed a social strategy to, um, not die.

Like Snap is trying not to do in early 2017. Spiegel doesn't seem to understand his task is not so much to become the next Google or Facebook, it's to not become the next AltaVista or Friendster.

Forget history. Or better, clear history. The present dilemma is that, in some way, Wall Street still doesn't get Snap. Spiegel said on the call that the company's first success came by allowing content where “people are expressing themselves and they don't feel like they're part of a popularity contest.” The post-IPO market is the antithesis of that. Luckily, the market provides its own magic eraser: deliver not just on the growth you promised but much, much more.

Then the past will be as good as deleted. Just ask Mark Zuckerberg.