Snap's Big Cloud Deals Are Already Paying Off

By Adam Levy Markets Fool.com

Snap (NYSE: SNAP) isn't like most social media companies. Instead of building out its own servers to host its tens of millions of users -- which can be very capital-intensive -- it relies on the infrastructure of even bigger companies. Snapchat was originally built on Google's cloud platform, and the company signed on with Amazon's (NASDAQ: AMZN) Amazon Web Services last year.

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Snap's cloud computing expense is its biggest cost.

Earlier this year, Snap updated its agreements with Amazon and the Alphabet (NASDAQ: GOOG) (NASDAQ: GOOGL) division. In exchange for a discount on its current rates, Snap committed to spend $2 billion with Google over the next five years and an additional $1 billion with Amazon. The commitments are steep, but they're already saving Snap a bunch of money.

Image source: Snap.

A review of Snap's deals

Snap's contract with Google is relatively straightforward: It will spend $400 million per year in each of the next five years. In any of the first four years, Snap can elect to defer up to 15% of that $400 million to a subsequent year. The deal with Amazon ramps up slowly over time, starting at $50 million this year and growing to $350 million in 2021.

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For 2017, Snap has committed to spend at least $390 million on cloud computing with Google and Amazon. That accounts for the 15% deferral allowance. Considering Snap spent $99 million on hosting in the first quarter, and daily users and engagement continue to grow, it's a safe assumption that Snap will reach its commitment without dipping into too much (if any) of the deferral allowance.

Saving more than $14 million right away

The $99 million Snap spent on hosting in the first quarter is a $14 million sequential decline from the fourth quarter before its new contracts went into effect. Those deals didn't start until February, so we're only seeing the impact of two months' worth of the new contracts.

Additionally, Snap grew its daily users by 8 million and said engagement improved, with users spending an average of over 30 minutes per day on the platform. So, even with more users spending more time on the app, Snap's hosting costs actually went down.

The new rates aren't the only impact, either. With a more robust agreement with Amazon, Snap is able to move some tasks from Google's cloud to Amazon's. "Recently we've moved some of our operations to an Amazon Datastore that's a little bit less redundant than a Google Datastore, for example, but saves us a bunch of money," CEO Evan Spiegel told analysts on the conference call.

There's still more room for improvement as Spiegel talked about containerization, which would allow Snap to easily migrate pieces of its app from one service to the other and optimize for performance and price. That's a long-term goal, Spiegel says, but it's still a long way from becoming a reality. Snap's huge cloud expense, though, gives it a significant incentive to make it happen.

A big commitment

Snap's commitments to Google and Amazon don't show up on the company's balance sheet, but they nonetheless cast a shadow over the company. If Snap fails to execute, user growth slows, engagement declines, brands buy fewer ads than anticipated, or a combination of any of those factors occurs, Snap is still on the hook for nearly $3 billion.

Snap is saving money now, but it's taking on significant risk to save that money. Google, likewise, is taking on a bit of a risk with Snap, considering its contract represents a huge portion of its cloud revenue. Google's cloud business may be closely tied with Snap's success for the next few years. Snap's deal with Amazon is a nice boost, but considering its size, not a deal breaker if Snap can't meet its commitments.

Snap's deals are paying off now, but hopefully, they won't come back to bite it.

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Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool's board of directors. Adam Levy owns shares of Amazon. The Motley Fool owns shares of and recommends Alphabet (A and C shares) and Amazon. The Motley Fool has a disclosure policy.