Snap and the Ephemerality of Alpha

No one is quite sure what to make of Snap. The company had a disastrous run this past week with shares plunging 21% on news of missed revenue estimates and less-than-substantial user growth. The main problem is that Snap’s business model is being cannibalized by its rivals. Meanwhile, the company’s slowing user base, financial losses, and stock volatility are driving analysts to complain that the company is more hype than hope. As Sig Susquehanna’s Shyam Patil suggests, the euphoria surrounding Snap is disconnected from the fundamentals.

The major question on people’s minds is whether Snapchat (the company’s messaging app) has simply peaked. NYU’s Scott Galloway grumbles that no responsible investor should own shares in Snap. But as Walter Isaacson(author and expert on Steve Jobs) observes, Snap is a disruptive technology and therefore difficult to forecast. Snap’s growing focus on content development suggests that the company may have new plans ahead. This might help to explain why so many big hedge funds have bought in to Snap even as analysts remain sharply divided.

For venture firms like Sway, Snap represents an interesting conundrum. The company was worth nearly $30 billion during the first day of its public market debut, where it raised $3.4 billion from public investors— making it the largest IPO since Alibaba (BABA). But if you’re a shareholder who is unhappy with the company’s direction or the fact that Snap is bleeding cash, well, there’s really nothing you can do about it. Stockholders have no voting rights and investors have no say on board composition, executive compensation, or the company’s direction.

Founded in 2011, Snap is an upstart social media company that many liken to Facebook. Unlike Facebook, however, Snapchat is less a platform for accumulating status recognition, and more a real-time messaging system. Photos or short videos (“snaps”) are shared between users and automatically deleted. With most of its users under the age of 25, the company has been uniquely effective at carving out a social media space for itself. Snapchat supports 166 million daily active users, an increase of 36% year-over-year— the majority of whom are millennials— an extremely coveted demographic group.

Snap’s SEC filing in February revealed $404.5 million in revenue in 2016 (six times the revenue of the previous year) but also substantial net losses— to the tune of $514.6 million. Even as early investors devoured shares of Snap’s IPO last March, analysts have since assigned the stock a “sell” rating. Opening with 200 million shares, its share price swelled and then shriveled to its current $21. There is of course precedent for this. Twitter’s stock dropped below its $26 IPO price in 2013 and now trades at around $15. And Facebook’s 2012 IPO, opened at $42 per share, only to close at $38.

Together, co-founders Evan Spiegel and Bobby Murphy own the vast majority of Snap’s voting stock, giving them complete control over the company’s future. The company’s executive team includes Imran Khan, a former Wall street investor with strong connections to Alibaba, now Snap’s Chief Strategy Officer. And Chairman of the Board, Michael Lynton, former CEO of Sony Entertainment with ties to Hollywood. Regardless of the strength of its leadership team, however, the view of many analysts is that Snap lacks direction and a path to profitability.

Snap’s critics maintain that poor leadership and extremely high operating costs has made Snap an unpredictable gamble. For this reason, the stock’s recent tumble has been met with a cacophony of boos and cheers. Even as Snap remains a “unicorn” (tech startups with private valuations of $1 billion or higher), most analysts believe that the stock is overvalued. Notwithstanding Snapchat’s strong user engagement, its main competitors (Instagram, Facebook, and WhatsApp) have already begun replicating its best ideas.

Looking past its stock volatility, the main challenge for investors considering owning Snap remains its potential profitability (or lack thereof). As Laura Martin, an analyst at Needham warns, there is no real likelihood of profitability before 2020. Snap has a deeply engaged audience but the only question is what the company will do to monetize it. Facebook figured out how to monetize its users through advertising. Snap will need to do the same.

Whether or not Snap blossoms into a revenue-generating platform that mirrors the meteoric rise of Facebook, remains to be seen. The main issue facing the company is that it’s simply not building on its young user base. Snap is a very young company with a strong user base. But the key issue will be its leadership and their capacity to innovate. To be sure, the company’s rapid growth and young user base represent a huge business opportunity in advertising.

Snap’s key advantage thus far has been understanding the ubiquity of smartphones as a medium for cultural experiment. Snapchat’s messaging system has given millennials a new channel for real-time communication. Unlike other social media platforms like Facebook, Twitter, and LinkedIn, Snapchat is less about “networking” and more about cultivating conversation. The company refers to its platform as an ephemeral messaging app, because messages are deleted following a timer set by the user. Notwithstanding the truth of this claim, the app has become the darling of a new generation of social media consumers who are drawn to its capacity for visual communication.

It is this capacity for visual communication that Snap’s founders will need to build on. Indeed, as Christian Madsbjerg argues, the main challenge for technology companies like Snap is not primarily about algorithms, but about cultural fit. Snapchat has been effective at delivering innovation for a new generation of savvy consumers. But with new technologies like artificial intelligence (AI) on the horizon, disruption will be critical to Snap’s future. The company’s long-term growth is entirely dependent on advertising, and clearly, disruptive technologies like AI will be key to expanding and monetizing its user base.