We examine the rumored Snap valuation ahead of the IPO and conclude that while the overall market concerns about DAU growth may be justified, it is likely the market undervalues the company’s growth prospects in ARPU. Snap is a buy for us.
Growth is the Answer
Initial reports focused primarily on Snap’s purported value compared with its revenues. When reached to other companies, it looks expensive (Table 1).
This analysis is flawed in two key ways. Snap’s peers are not all directly comparable. For example, Google is a search engine, and Amazon is an internet retailer. It is more accurate to limit the peer universe of Snap to its most directly comparable peers: Facebook and Twitter (charts 1, 2).
Even if one limits the comparison to Facebook or Twitter, it is important to take into account the different maturity profiles. It would be more accurate to compare the metrics of all three companies pre-IPO (charts 3, 4, and 5). The relative valuation will appear less expensive than the previous charts, even though it is still high.
However, there are timing issues that arise with this comparison. For comparison, Facebook had been around for eight years and Twitter seven when they launched their initial public offerings. Snap is just five years old, but with another 2-3 years of growth, Snap may be a completely different company.
Snap, on the other hand, is a mobile-only platform. Facebook and Twitter were publicized in an era when desktop delivery was still dominant. Snap, which is now a mobile-only platform, is entering a market that has a growing number of users (mobile is taking over desktop share) and a platform with increasing engagement from the users (charts 5, 6).
Snap’s valuation is difficult to assess because of the differences in maturity profiles and delivery platforms. This applies both at the IPO and now. Snap’s valuation may seem high when compared with its peers, but this is not the best approach.
In light of the above, an analysis that focuses only on Snaps makes sense. This analysis should be almost exclusively focused on growth. Growth is fundamental to Snap’s valuation, and two factors will affect it going forward:
DAU growth: Doubts Loom
Many of the insightful analyses that emerged in the weeks following the filing focused on DAU. The hawks have gathered in large numbers. Snap’s initial performance in terms of user growth was impressive (chart 7), but there has been a dramatic drop in the number of new users in recent months. Snap outperformed both Facebook and Twitter when it came to user growth during the six quarters prior to its IPO. However, quarterly growth rates dropped from double digits to only 7% by Q3 16 and to a paltry 3,3% by Q4 16.
The growth rate of daily active users was flat during the first part of the quarter ending December 31, 2016, and then accelerated during December. We have experienced lumpiness before in our growth of Daily Active Users. However, the flat growth we saw in the first part of the quarter is primarily due to the accelerated development of user engagement earlier in 2016.
In the first half of 2016, the rate of net additions to Daily Active Users increased compared to the latter half of 2015. This was largely because of increased engagement among users from new product launches and higher adoption rates in older demographics as well as international markets. The higher base of Daily Active Users in the third and fourth quarters made incremental net additions more difficult, even with strong growth year-over-year. In mid-2016, we released several updates and launched multiple products, which caused a number of technical issues to affect the performance of our app. These performance issues, we believe, led to a decrease in our Daily Active User growth. This was especially true for Android users and in regions where there is a high percentage of Android devices. We also experienced increased competition in 2016, both domestically as well as internationally, with many of our competitors launching products that were similar to ours.
This explanation highlights two potential causes of the slowdown: issues with their Android products and increased competition.
While the former is problematic, it would not be of great concern. One would assume that a company with a $2.6bn budget and almost 2000 employees, many of whom are in Engineering, would be able to solve this problem and return the company’s course of growth to where it was at the start of 2016.
The competition is the most worrying issue. Snap is under increasing pressure from its competitors, especially Facebook and Instagram. If this problem is not resolved, it could limit DAU growth in the future. It is not surprising that Snapchat’s numbers started to decline in Q3 16 as Instagram introduced Stories – a copycat of Snapchat.
Snap’s competition worries are only exacerbated by data on DAU growth by geography. On a geographic basis, the majority of Snap’s DAUs appear to have slowed down in the “Rest of World”, according to chart 9. Instagram has a much larger international user base ( 80 percent of Instagram’s 300m DAUs is international). It’s easy to see why the incentive to install Snapchat will diminish as Instagram and other competitors begin to offer key features Snapchat has sold itself on.
Snap’s DAU growth is not good. Snap’s Q4 2016 growth was the slowest since its first publicly available quarter. It was also slower than Facebook, which is a much more mature company. Snap must convince investors of its ability to address the decelerating DAU growth quarter-over-quarter if it wants to reach the publicized valuation figures.
What will be the future of Facebook?
In light of the above, we expect Snap to experience user growth more in line with Twitter than Facebook. Snap’s international expansion will continue to be limited by the competition of Facebook, Instagram, and other competitors.
Table 2 shows that our base case has an average annual growth rate of 14.1%, which is almost exactly in line with the average yearly growth rates for Twitter and Facebook, 10.3% and 19.1%, respectively. Twitter’s growth premium is primarily due to Snapchat’s superior ability to innovate product features.
