Snap Built Way Too Many Spectacles

Earlier this month, Snap (NYSE: SNAP) CEO Evan Spiegel confirmed that the Snapchat operator had sold "over 150,000 units" of Spectacles since the product was launched last year. That figure wasn't all that surprising in itself, since investors could have estimated around 106,200 units sold in the first half of 2017 based on Spectacles revenue.

It turns out that there's a lot more where that came from, but not in a good way -- most of those units are sitting around collecting dust.

Snap was too bullish on Spectacles

The Information reports that Snap now has "hundreds of thousands of unsold units sitting in warehouses" after being overoptimistic in its demand forecasts. Snap believed that demand would remain robust even after 2016's holiday shopping season, which goes to show how unfamiliar the company is with the fundamental seasonality of consumer hardware. In other words, Snap has more units on hand than it has sold to date.

Recent layoffs and restructuring notwithstanding, Snap's hardware team has now swelled to 150 people, according to the report. The company has also evidently walked back its plans to develop a drone.

A writedown is coming

Demand forecasting and inventory management are among the hardest parts of any hardware operation, even for experienced companies. Snap has no such experience, so making a mistake of this magnitude is hardly surprising. To put some numbers to it, if Snap had 200,000 units on hand valued at the retail price of $130, the carrying value would be approximately $26 million. Every additional increment of 100,000 units translates into additional carrying value of $13 million.

Snap does not directly disclose its inventory on its balance sheet, since hardware is still a fairly small part of the business. The company's inventory must be accounted for in its "Other assets" line item, since there's really nowhere else it could be. Snap had $61.7 million in "Other assets" at the end of the second quarter. If "Other assets" were hypothetically all Spectacles, that would represent nearly 475,000 units.

That line item can't be all Spectacles inventory though, but at least investors have an upper limit. We're probably talking about 300,000 to 400,000 units. Snap will likely have to discount its Spectacles inventory in order to move those units, which will also result in a writedown based on a lower net realizable value.

Furthermore, Snap has additional purchase commitments related to hardware:

So not only does Snap already have too much Spectacles inventory, there's a good chance that it's on the hook for even more, if that $29 million commitment is referring to Spectacles. That commitment could theoretically relate to some other hardware product in the pipeline, but that seems unlikely since Snap wouldn't need to be buying $29 million worth of components for prototyping and development purposes.

Either that, or Snap is vastly overestimating demand for its $80 dancing hot dog Halloween costume, its only other current hardware product. Seasonality spoiler alert: Demand for Halloween costumes faces a precipitous drop every year starting Nov. 1.

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Evan Niu, CFA has the following options: long April 2018 $17 puts on Snap Inc. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.