July 24 2020 - Snap: Shorts Will Lose More Money

Summary

Snap Inc. is a camera company.

Snap is still investing to drive growth. This is impacting its profitability factor. Regardless, its augmented reality strategy remains compelling.

Its improving ad engine capabilities will drive more revenue growth and cash flow. With more goal-based bidding options, advertisers will rotate more ad spend to Snap.

As long as DAU and platform engagement metrics continue to grow, betting against Snap due to potential earnings weakness remains a gamble at best.

How Fresh Content and Games Has Spurred Snapchat

Source: The Wrap

Bears continue to misinterpret Snap's (SNAP) growth story. The fundamental premise of most bearish prints is centered around Snap's cash burn and waning competitive prowess. Yet, it is abundantly clear that Snap is successfully executing its short and long-term goals. Bears make the common mistake of valuing Snap like a social media company or an advertising company. The first sentence in the business section of its IPO prospectus, which has been left unchanged in its yearly Form 10-K, states that " Snap Inc. is a camera company." Believing that Snap is something else will prevent investors from enjoying the game of investing in Snap. Calling itself a camera company is highly strategic as its brand positioning dictates its long and short-term goals. It also dictates its capital allocation strategy and competitive positioning.

Our Q2 financial results reflect our priorities of growing our community, making focused investments in the future of our business, and scaling our operations efficiently in order to drive towards profitability and positive free cash flow.

That's why the first sentence made by its CFO during the last earnings call was centered around Snap's focus on strategic investments for the future. This explains the recent debt issuance and emphasis on its cash trove (plus untapped credit facility), which put its overall capital position at B. This update is more than sufficient to confirm that Snap has the working capital to keep executing in the short term. As Snap deploys its cash trove to drive innovation, it won't be focused on fighting for market share with Instagram or TikTok. It will be focused on expanding the market gap that is best filled using its augmented reality (AR) technology and premium video content. This market positioning is unique because the inaccessibility of non-digital attributes has hindered the online success of most digital products. This explains why Snap highlights Adidas (OTCQX:ADDYY) during its quarterly conference calls. For example, apparel fit is a non-digital attribute. Direct to consumer apparel sales is best achieved via technologies like AR. Investors following the news will realize that Nike's (NKE) future strategy aligns with driving direct to consumer sales. This growing trend will boost demand for Snap's ad inventory as more brands rely on digital marketing channels to sell non-digital products.

And based on publicly available data, we reach more people in the U.S. than Twitter and TikTok combines. And in Q1, we reached more 13 to 34 year olds in the U.S. than Facebook or Instagram

If Snap is going to be outpunched by Instagram in its effort to target Gen X and Baby Boomers in delivering digital marketing solutions, its present and future potential with Millennials and Gen Z shouldn't be discounted. Last earnings, Snap highlighted a 40% increase in engagement with Discover content among Snapchatters over the age of 35. This highlights its growing potential to capture the Gen X market. This trend is important because Snap hasn't been appreciated for its capabilities beyond the younger age demographics.

Investing in Snap on the premise that it is a social media company that is burning cash with fewer users compared to Instagram or Twitter (TWTR) will guarantee that investors miss the evolution of its camera platform, which leverages its innovation in AR to differentiate it from competitors. Snap only competes with other media platforms for attention and talents. That is why it reports DAU, and it also explains the huge stock-based compensation expense on its income statement. In terms of ad inventory type, Snap is mostly unique (Lenses, Filters, Story Ads, and Commercials). Given that augmented reality is a nascent technology, it's easy to understand why many continue to miss the true story. Most investors will only use ARPU and DAU growth to drive their short-term thesis. Interestingly, DAU (+17% y/y) and ARPU (flat y/y) have been above expectations in recent quarters if we back out the impact of COVID-19.

Going forward, Snap has made a lot of product updates that are beginning to yield positive returns. These updates will sustain the DAU and ARPU growth trends.

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Source: Snap

Snap's focus on content localization is driving DAU growth in its ex-North America markets. This will weaken the thesis that Snap has no strength outside North America. Throw in the upcoming rollout of 5G networks, and the declining cost of smartphones and the bearish rest of world thesis is effectively neutralized. I expect international programming expansion in Europe and the Middle East to continue to impact margins. This will be temporary in addition to the supply chain and cash transaction limitations observed in the rest of the world. That is why it is important to pay attention to content engagement rate in Europe and the rest of world segment. ARPU outside North America isn't a metric to be fixated on as it is obvious it will be weak due to the impact of COVID-19.

Since COVID-19 leads to fewer companies participating in ad auctions, CPM rates will continue to fluctuate. This will impact monetization and ARPU. This is positive for Snap because the attractive CPM rates will give brands in digital economies more confidence to rotate more budget to experiential ad platforms (digital) like Snap. Snap's pace of innovation will also assist its growth factor as direct response advertisers continue to demand more goal-based inventories. The availability of measurable goals (pixel-based) like app installs and website conversions will make Snap attractive to advertisers of all kinds. The recent release of dynamic ads will also increase the reach of its ad platform. It is interesting to know that ROAS based bidding has been launched. This will help advertisers maximize their return on ad spend. ROAS is one of the most sought after advertising objectives.

As bears continue to fixate on cash burn, they will miss the huge pace of innovation in content creation and ad engine optimization to empower users and advertisers. The strong user retention and platform engagement rate underline the effectiveness of Snap's recent initiatives. Via Snap Games (includes over 100 million Snapchatters), retention, and engagement rates will grow as friends collaborate to participate in fun games without the need to install new apps. Gamers should check out Bitmoji for Games and Bitmoji Paint. These updates make it easy for gamers to collaborate on Snap. Snap is working with studios like Zynga (ZNGA), Game Closure, and more to release more games. These partnerships will make it easy for gamers in top metaverses to discover Snap. This will further drive DAU and platform engagement.

Snap is also working with content creators to make more premium video content (Snap Originals has reached more than half of the US Gen Z population). Snap Originals is available to users who depend on their mobile phones for quick delivery of entertainment. Innovation like motion tracking lenses will make it easy for users to be a part of some of the shows they consume. This means Snap will continue to make a compelling case to advertisers to rotate more TV ad budget to its video content. To further drive user engagement, Snap is partnering with news organizations to deliver breaking news to its users. This is dubbed Happening Now. Happening Now will reach over 125 million users (mostly Gen Z) who have watched Snapchat stories this year. These updates will take market share from traditional TV platforms. If Baby Boomers and Gen X continue to leverage traditional media platforms to consume information, there is no doubt Gen Z and Millennials will use their smartphones to fulfill the same purpose.

We're adding Places to the Snap Map so you can easily find the spots that are popular with our community, no matter where you are. We're adding millions of listings for businesses around the world.

New updates to Lens studio include the possibility for developers to include their machine learning models via SnapML. This creates endless opportunities in areas like Local lenses. Via Scans, users not only recognize dogs, brands, and plants, but they will also start identifying local businesses. This capability will be a solid fit for Places. As users share more local content, they will also discover more local businesses. Using Snap Map, users will get directions, call businesses, and take deliveries. These capabilities will complement Snap's ad business. It will also empower small businesses.

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Source: Snap

Snap Kit now offers a lot of ways for users and developers to integrate Snap with other web apps. As more developers try out its offerings, Snap has the potential to enjoy "Network Effects 2.0." Snap Kit includes Camera Kit to help developers and brands add AR features to their apps. The announcement at its last partner summit features over 800 integrations to its platform. Login Kit enables users to sign up and log in to web apps using Snap. Ad Kit helps app creators to monetize their apps by featuring Snap ad inventories in their apps. Developers and users can also find creative ways to express themselves using Snap Minis, Dynamic Lenses (Creative Kit), Bitmoji Kit, and Story Kit. Via Snap Minis, Snap was able to collaborate with Headspace to offer tools to help users check in on their friends as COVID-19 shut down economies. As developers and content creators embed these kits on their platforms, more users will naturally interact with Snap's creative content.

Given that Snap is still in the growth phase of its business lifecycle, the focus should be on its pace of innovation compared to potential AR rivals. Therefore, short-term margins fluctuation will be of little concern. Macro uncertainty (induced by COVID-19) will only have a temporary impact on revenue and user growth. Despite the investments in content, gross margin (non-GAAP) improved to 47% (vs. 46% in 2019). Snap is focused on driving operating efficiency and positive free cash flow. The improvements to its direct advertising platform mean brands now have more confidence in making upfront cash commitments. This is the period bulls have been waiting for. As Snap improves its measurement technology, CMOs (Chief Marketing Officers) will have no problem justifying the return on ad spend of their Snap campaigns. This will drive competition for premium ad slots from products that rely on augmented reality to sell their non-digital attributes. This untapped market will be effectively unlocked if the shelter in place measures remain as customers can't rely on offline stores (webrooming) to verify the fit of the items in their online shopping carts.

Conclusion

Snap isn't buying back shares. Snap is investing in deepening the capabilities of its platform to add more value to users and advertisers. Exit strategies should put this in context.

Snap only competes with social media platforms for ad budgets. In terms of its innovation strategy, Snap is a lone wolf executing to build a unique platform that has never been imagined before. Until we observe a massive reduction in DAU or content engagement, betting against Snap solely on its financials will be a half baked investment idea.

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