Snap Needs to Admit That It Has a Growth Problem

By Evan Niu, CFA Markets Fool.com

The first step is admitting you've got a problem.

Continue Reading Below

Unfortunately, it appears that Snap (NYSE: SNAP) CEO Evan Spiegel is unwilling to do just that. The Information is reporting new details about Snapchat's growth woes. When confronted with hard data last year that user growth was decelerating rapidly, Spiegel "initially refused to accept there was a growth problem at all," according to the report. The young executive insisted that the data was misleading, and that the real culprit was a decision to deactivate an older version of Snapchat's Android app.

Image source: Snap.

Spiegel then thought a different feature was the source of the growth problem and ordered engineers to scrap the feature, despite the fact that there was no supporting data for the decision. He also brushed aside ideas on how to bolster engagement through push notifications, a strategy that Spiegel recently derided as "growth hacking."

The most data-averse tech company

Spiegel is notoriously averse to data, instead preferring to run Snap based on hunches and expected impacts on the user experience. That's a rather bizarre stance for a tech company to take, particularly one that relies almost entirely on ad revenue -- and ad businesses are fundamentally data-driven. What's even more inexplicable is that it's abundantly clear to public investors that Snapchat has a growth problem, based on its own public disclosures about daily active users (DAUs).

Continue Reading Below

Data source: SEC filings. Chart by author.

Without a doubt, Snap has even more internal user data that the public is not privy to; investors can only presume that Snap isn't sharing some of these metrics -- things like monthly active users (MAUs), for example -- because they're not flattering.

Decelerating user growth is not necessarily a problem in itself

Here's the thing: Slowing user growth in and of itself is not necessarily a problem. You can build successful businesses on the fringe of the mainstream, provided you don't over-invest in growth and have an appropriately sized cost structure. The problem is that Snap is over-investing in growth, and its cost structure, which is dominated by hosting costs, is decidedly not scalable.

Excluding stock-based compensation (SBC) expenses, which were artificially high last quarter due to the IPO, total costs soared over 150% in the first quarter.

Cost Metric (ex-SBC)

Q1 2016

Q1 2017

Growth (YOY)

Cost of revenue

$75.6 million

$143.3 million

90%

R&D

$25.5 million

$83.7 million

229%

Sales and marketing

$14 million

$58.8 million

321%

General and administrative

$22 million

$64.5 million

193%

Data source: SEC filings and author's calculations. YOY = year over year.

To be fair, Snap is still building its nascent ad business and improving monetization of its existing user base, so it can and should be able to grow revenue even without user growth. But any product improvements that Snap comes up with only boost costs higher if those improvements translate into higher engagement within the DAU base, since Snap pays variable cost pricing for usage irrespective of its ability to monetize that usage with ads.

It gets worse. Beyond cost concerns, the most glaring problem that Snap faces with decelerating DAU growth is that its lofty valuation is predicated on insane growth expectations going forward. The outsized cost structure is one thing, but the underlying issue is exacerbated if public investors are expecting too much. Trading at nearly 50 times sales, Snap's slowing DAU growth is a problem, and Spiegel needs to accept that.

10 stocks we like better than Snap Inc.
When investing geniuses David and Tom Gardner have a stock tip, it can pay to listen. After all, the newsletter they have run for over a decade, Motley Fool Stock Advisor, has tripled the market.*

David and Tom just revealed what they believe are the 10 best stocks for investors to buy right now... and Snap Inc. wasn't one of them! That's right -- they think these 10 stocks are even better buys.

Click here to learn about these picks!

*Stock Advisor returns as of May 1, 2017

Evan Niu, CFA has the following options: long January 2019 $20 puts on Snap Inc. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.