Snap Just Became One of Google's Most Important Cloud Customers

One of the many interesting details revealed in Snap's S-1 filing with the SEC is that it agreed to a $2 billion contract with Google Cloud in January. The agreement with the Alphabet (NASDAQ: GOOG) (NASDAQ: GOOGL) subsidiary spans five years with relatively equal payments scheduled for every year.

Snap has used Google Cloud since its creation, but had been spending considerably less than the $400 million per year it's slated to spend through 2021. For the first few years of its existence, it spent less than $30 million per year on Google Cloud. Last year, however, it started seeing its hosting costs increase considerably, up $192 million for the year.

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Google's cloud service competes against the larger Amazon (NASDAQ: AMZN) Web Services and Microsoft (NASDAQ: MSFT) Azure. A $2 billion infusion could help it catch up to the competition.

What does $2 billion mean to Google Cloud?

Alphabet isn't exactly forthright with its cloud revenue. It lumps Google Cloud in with Google's other revenue line item, which also includes Google Play and hardware sales. In 2016, the three categories produced $10.1 billion in revenue. Google Play likely accounts for the bulk of revenue.

The cloud unit had an estimated run rate of just $1 billion as of the end of 2015, according to RBC Capital. Snap's new contract likely makes it Google's biggest cloud customer.

While Google has made several advancements in its cloud services over the past year, so have its competitors. Microsoft boasted that its Azure revenue increased 93% last quarter, but Morgan Stanley analyst Keith Weiss estimates the unit brought in just $1.6 billion. Bernstein's Mark Mordler estimates Azure's run rate at $3 billion as of last quarter.

Meanwhile, Amazon just reported AWS sales topped $12 billion in 2016. Sales surpassed $3.5 billion in the fourth quarter alone, although that fell short of analysts expectations.

Google still needs to diversify

The growth of Snapchat has been a major boon to Google's cloud services, but it's still actively seeking to pull customers away from its competitors and take market share. The hiring of cloud-computing veteran Diane Greene to lead the division has helped the company attract numerous high-profile customers, but there's still more work to do.

On Alphabet's fourth-quarter earnings call, Google CEO Sundar Pichai said, "We have truly differentiated offerings in four key areas: data analytics and machine learning, security and privacy, tools for application development, and the ability to create connected business platforms." Snap can take advantage of at least three of those four factors, so it's clear why it was willing to lock down a long-term contract.

At the same time, the contract is not exclusive. If Snap wants to enter China, for example, where Google doesn't operate, it could tap one of Google's competitors.Or it could build its own servers.

Snap recently hired Jerry Hunter from AWS, who ran global data centers for the cloud-computing giant. In Snap's S-1 filing, management notes, "In the future, we may invest in building our own infrastructure to better serve our customers."

If Snap continues to grow at the pace it has been for the last few years, it may make economic sense for it to switch to its own cloud infrastructure, which would be a huge blow for Google.

What this means for Snap

Snap is now on the hook for $400 million per year in cloud costs. There is some wiggle room: The contract says it can postpone up to 15% of expenses for a year, so it only has to spend $340 million this first year. Still, that's a huge amount for a company that generated just $404.5 million in revenue last year.

It also means that switching service providers will be difficult, considering it would either have to eat the contract as a loss, or leave at least some of its operations on Google Cloud in order not to waste the money. That makes the economics of building out its own infrastructure within the next five years even costlier.

On the flip side, analysts expect Snap's revenue to continue growing at a rapid pace, approaching $1 billion this year fueled by continued user growth and product expansion that will surely put additional demands on Google's servers. It has plenty of capital to cover the expense, and if last year's growth is any indication of what to expect, it will need to spend at least $340 million on cloud infrastructure this year. The deal with Google ensures that it gets the lowest rates possible, so it can to make the most of its spend.

Overall, it's not a bad deal for Snap, but it does tie the company to Google for a long time.

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Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool's board of directors. Teresa Kersten is an employee of LinkedIn and is a member of The Motley Fool's Board of Directors. LinkedIn is owned by Microsoft. Adam Levy owns shares of Amazon. The Motley Fool owns shares of and recommends Alphabet (A shares), Alphabet (C shares), and Amazon. The Motley Fool has a disclosure policy.