Did Snap Make a Mistake With Its $3 Billion in Cloud Contracts?

When Snap (NYSE: SNAP) filed its IPO registration with the SEC, it revealed that it recently signed a $2 billion deal with Google, the Alphabet (NASDAQ: GOOG) (NASDAQ: GOOGL) subsidiary, to use its cloud platform to support Snapchat. Snap then went out and signed a $1 billion deal with Amazon (NASDAQ: AMZN) to use Amazon Web Services for additional cloud hosting.

These contracts have certain stipulations that require Snap to spend a certain amount with each company every year through 2021. And while they've been very beneficial to Snap's hosting costs per user, Snapchat's sluggish user growth puts a big question mark over whether Snap will meet its spending commitments with Google and Amazon.

How much is Snap on the hook for?

Snap's commitments with Google and Amazon are a bit different. The Google deal is for a relatively flat amount every year while the Amazon deal ramps up each year.

*Snap can defer up to 15% of the amount to a subsequent year

The deals make it so Snap is committed to spending a bare minimum of $390 million on hosting fees this year. Snap's hosting fees for the first and second quarters were $99 million and $106 million, respectively. Those amounts will continue to climb as Snapchat adds more users and features, so it seems like Snap will hit the bare minimum this year.

But Snap discloses its commitments in its 10-Q every quarter, and it says it still has $243 million left in contractual hosting commitments for 2017. That's down from $350 million in the first quarter. Snap's commitment disclosure implies that it doesn't plan on using any of the slack in its Google contract to defer its hosting costs at this point. But it also implies a significant ramp in cloud spending over the second half of the year, and it's unclear if Snap's data usage will climb that much. If it doesn't, it will have to push back some of its commitments into the next year, raising the bar for user growth and increased engagement on Snapchat.

If Snap fails to meet its minimum obligation with Google, it forfeits any amount below that 15% buffer. Amazon's deal is a bit more lenient in that it allows Snap to prepay for AWS hosting to meet the minimum commitment.

Another reason Snap needs to grow its self-serve ads platform

Snap doesn't necessarily need all of its hosting costs to come from users. It could come from its customers. Snap launched its self-serve ad platform earlier this year and it's rolled out several new tools to make it easier for small businesses to create, target, and measure ad performance on Snapchat.

Snap is aggressively courting businesses to its automated ad buying platforms and that could help make up some of the gap in cloud hosting costs in the second half of the year. All of those video ads and measurement data need to be stored somewhere.

That said, it's not clear how great of a return Snap is getting on its self-serve ads. Management noted the auction format of its automated ad buying platform resulted in lower average ad prices for Snapchat in the second quarter. It expects ad prices to rebound in the long run, however, as more businesses join the auction for ads. But it could incur a lot of expenses, including hosting fees in the meantime, as it onboards a lot of new customers.

It'll be interesting to see if Snap actually uses the full $400 million commitment to Google in 2017. Investors should keep an eye on any disclosure in the third or fourth quarter about deferring some of its commitment to 2018. It does have some leeway, but unless it starts attracting a lot of new users and a lot of new advertisers, it might have to admit it's bitten off a bit more than it can chew.

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