Twitter (NYSE: TWTR) and Snap (NYSE: SNAP) both reported earnings in the past few weeks, and both companies popped significantly as a result -- while still having some pretty substantial long-term issues.
In this week's episode of Industry Focus: Tech, host Dylan Lewis and Motley Fool contributor Evan Niu take a close look at Snap's and Twitter's reports and explain why long-term investors should be cautious about these results. Find out how Twitter finally managed its first quarter of GAAP profitability, and what that means for the company; how Snap's new redesign might be hurting its business and platform; some of the biggest problems with Snap's spending habits; whatever became of Snap's Spectacles business; and more.
A full transcript follows the video.
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This video was recorded on Feb. 23, 2018.
Dylan Lewis: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It's Friday, February 23rd, and we're recapping the past few weeks in tech earnings news. I'm your host, Dylan Lewis, and I'm joined on Skype by senior tech specialist, Evan Niu. Evan, I think I took a pretty uneventful few weeks away from the stock market while I was in India.
Evan Niu: Yeah. How was India? I've never been.
Lewis: It was pretty amazing. I was traveling with a couple of friends on my way to another friend's wedding, and one of the folks that I was traveling with has aunts and uncles that live in Mumbai. So, we visited them, hung out with them for a while, then made our way over to the wedding in Delhi and stopped in several cities along the way. Saw the Taj Mahal, got to dance a bunch, can't really ask for much more than that.
Niu: Sounds pretty cool.
Lewis: Yeah. I'm particularly thankful that I didn't get sick. I was like, fingers crossed the entire time, tried to be careful, and got treated to some pretty amazing Indian food. I was thankful to come back, though. My first meal when I came back was a Five Guys burger. I couldn't resist. Austin, how did you manage to occupy yourself with all of your free Fridays since we weren't taping Industry Focus shows?
Austin Morgan: I actually went snowboarding both of the free Fridays.
Lewis: Look at that. Did you go on The Fool's trip?
Morgan: They canceled it.
Lewis: They canceled it?
Morgan: It was too warm. So I went by myself.
Lewis: It's been a tough season.
Niu: Where do you ski near D.C.?
Morgan: Liberty and Whitetail are the closest ones, and they're right on the border of Pennsylvania. But last week, I went to Snowshoe. It was the last good snow. We got six inches while I was there.
Lewis: And then we had an 80-degree day, my second day back.
Morgan: Yeah. I left six inches of snow to come back to 80 degrees.
Lewis: Maybe we'll have a nice March chill for you.
Niu: It's like 15 here in Denver.
Lewis: [laughs] Less of a concern for you over there, Evan. So, I missed quite a bit, being away. There was only a minor 3 or 4% market sell-off, there was only all of the big tech names reporting earnings. We're going to try to catch up today on some of the stuff that we missed.
Why don't we start out by looking at updates from Twitter? Today, we're going to talk about Twitter and Snap specifically. Both these companies trading above their IPO price after reporting earnings. The market is seemingly pretty enthusiastic about both of them. Shares of Twitter, Evan, are at highs that haven't been seen in over two years. What did the company do, that the market was so happy?
Niu: The big one is, Twitter posted its first GAAP-profitable quarter ever, which on the third-quarter earnings, for their outlook, they had predicted as much. Which, investors, back then a few months ago, in their last quarter, they were pretty excited about this when Twitter forecasted and said, basically, "At the high end of our guidance, we think we can actually be profitable." And not just on a non-GAAP adjusted basis after you back out all these costs, but on a GAAP basis. And they were able to deliver. So, I think that's a pretty big milestone. Twitter has been around for 15 some odd years, and this is now finally their first profitable quarter on a GAAP basis. That was the big storyline from their fourth-quarter earnings report.
Lewis: And it looks like the company also managed to return to revenue growth, as well.
Niu: Barely. That's the thing. This profitability was primarily delivered by cost-cutting and not revenue growth. Revenue was up 2%, but costs were down 28%. So, you put those numbers together and that's pretty much exactly how you actually squeeze out a profit finally. Within that top line, ad revenue was up 1%. Ad revenue is really kind of flat, whereas the data licensing business was up 10%. That's a small part of the business, but up 10% is nice, a nice little progress there.
Lewis: And the growth story is kind of similar when you look over at users. There's posted growth, but it isn't really all that encouraging.
Niu: Right. Monthly active users was 330 million, flat sequentially, just a minor shift in the mix between U.S. and international. One went up a million, the other went down a million. So, nothing too meaningful there. More or less, the user base is still about flat. It speaks to, monetization is OK, it's not huge gains there, but, again, it's really all about cost-cutting.
If you look specifically within the costs, costs of revenue, R&D, sales marketing, they're all down around 30%, plus or minus a few percentage points. So, the cuts were pretty broad-based and consistent across the board. It's not like one particular department was getting a disproportionate amount of cost cuts. But, yeah, I think that's a pretty big step there.
Lewis: Something that I think is worth noting in looking through their earnings release, you talked about what's going on in their advertising business and how growth wasn't all that great, both with their advertising business and in the composition of user growth, the American market was actually struggling and posted declines. Most of the growth that we're seeing, both in advertising and in users, is coming from international markets.
Niu: Right. And the U.S. market for Twitter is pretty mature. Their user numbers there have flatlined for years around this 68 million figure on the monthly active users side. So, not really a lot going on there.
Lewis: Which, you think about the value of different markets, and North American market is the most compelling one for advertisers. It's where you get the highest average revenue per user. So, any losses there on the user side are going to be the most valuable users that you can possibly lose.
Niu: Right. Pretty much all the other social media companies, if you look at their monetization by geography, absolutely. North America and the U.S. is always by far the most profitable and best monetized.
Lewis: Another metric that management touted was that it's the fifth consecutive quarter that the platform has posted double-digit year-over-year daily active user growth. Unfortunately, this is a song we've been singing quite a bit, Evan, that's all we got on the news of daily active users.
Niu: Right. This quarter, it was up 12%, but hard to really have that number hit home if you don't know what it's coming off of.
Lewis: Yeah. This is something we talked about back in the mid-2017 with Twitter, and frankly it's probably one of my biggest grievances with management and the platform: They talk about how important daily active users are for the platform, and how it's a core metric for them, and one that management monitors as a sensitive engagement, and yet they won't tell investors what that number actually is. They only provide growth rates for it.
Niu: And even the FCC has had issues with this. The FCC has sent Twitter letters being like, "Hey, can you explain this? Because it seems like it's important." And they just go back to the same crappy excuses. "Oh, it's not that important." It's hard to justify how they can say it's important but not tell investors. But, what can you do?
Lewis: They actually got a question via Twitter during their conference call, Lindsay Barber asked, "Will there ever actually be figures for DAU?" And Twitter's response was basically this jumble of corporate speak, talking about how they only focus on the most important metrics that they want to provide, and they don't want to make any changes during fiscal years that they're providing commentary on because they want to be able to provide consistent comparisons for investors. Maybe that's to say they'll consider doing it in a fresh year. Personally, I doubt it.
Niu: Maybe. I mean, especially with COO Anthony Noto recently leaving the company. He was kind of the de facto CEO in a lot of ways, and I think he had a lot of influence over their disclosure. It's very possible that with him leaving, because he got poached from SoFi, that personal wedding start-up, last month, to be their CEO. With him leaving, it does kind of open them up to the possibility of various types of changes at the top levels of Twitter.
Lewis: Needless to say, you and I would be thrilled if they decided to start disclosing that. One other thing that we've focused on the past as a point of concern with Twitter is what's been going on with their cost of ad engagements. They were down 42% year over year this quarter. And that figure has posted double-digit year-over-year declines every quarter since Q3 2015. This is something that we've talked about plenty when looking at their earnings. You think of the calculus for an ad-based business, you basically have the number of ads that you show people and what you charge for those ads. If ads continue to decline in price, you can only make it up on volume for so long. That's why they've really struggled to post overall revenue growth.
Niu: Right. That's going to be a key issue going forward, particularly as it seems like monetization and engagement and all these things seem to be peaking. It seems like Twitter is hitting the ceiling with some of these fundamental metrics that all contribute to the ad business. So, it is going to be tricky.
More broadly, though, if they can really keep these costs in line, for example, there's been years of speculation that Twitter needs to sell itself, they need to find a buyer, they're going to fail, they're going to go bankrupt, because they lose so much money. But I've argued before that I do think Twitter could be a viable, sustainable company if they just right-t-size the cost structure. And we're finally seeing the company do just that. I do think it can survive if it keeps its growth expectations in check, doesn't spend a bunch of money chasing things it can never achieve. Not to say that I think Twitter is going to be a great business worth investing in that will beat the market in the long run, but I do think it's carved out a unique place for itself within social media. And I think they can be a viable stand-alone company and be sustainable. And they've demonstrated that this quarter, mostly through cost-cutting, because as you mentioned, the top line isn't doing a whole lot.
Lewis: That was basically what I was about to ask you here, Evan. Shares are up 50% in the past month, basically on this news, and the idea that we're seeing them become profitable, maybe this is the turnaround that we've long waited for. It seems like you are not convinced that this is a business worth owning right now.
Niu: No. I've never owned shares, I probably never will. I just don't think Twitter is ever going to be this incredible business that's going to beat the market and really put up these really strong numbers. But, that doesn't mean I think the company is going to fail and go under or necessarily needs to be bought. Of course, there's constant speculation of, so and so wants to buy Twitter. And Twitter has a lot of problems, for sure, on its platform. But I don't have any concerns about them going away or dying.
Lewis: Yeah. I think they're probably here to stay. What keeps me away is, you look at basically what they're valued at now, given this recent run-up, they're at 10 times sales, and that's a company that's not really posting meaningful top-line growth. So, if they're eking out profitability by cost savings, and they have this core user group that really likes the service but they're not growing that meaningfully, it's hard to justify that premium for a business that's not posting big growth.
Niu: Right, exactly. And certainly, it's a relief to see them putting up some decent numbers, and the stock is going up as investor sentiment improves. But at the end of the day, if this is just a one-quarter bump, you have to wait and see how they perform going forward, and can they really consistently put up profits. And even then, it goes back to the question of, are you actually growing the business, are your profits actually growing? And even if they can hit profitability, if those profits are flat, then you probably shouldn't be fetching 10 times sales, or any other good valuation metrics, if you're not actually growing.
Lewis: Evan, one of the other big social media companies, Snap, also had a pretty busy month. Why don't we talk about what's been going on with them? They had their quarterly update. Their annual 10-K is now available for investors. They've been in the news thanks to Wall Street analysts. Kylie Jenner chimed in on what's going on with Snap. There's all this hoopla about the platform's long-awaited redesign. Which one of those items do you want to hit first?
Niu: They did report fourth-quarter earnings, and user numbers did come in better than expected. Daily active users is now 187 million. They did add nine million users during the quarter. That's certainly much better than people were expecting, and better than they've done over the past year. There's definitely some good news here. Most of those user gains are coming from improvements on the Android side, because Snapchat's Android app has long had performance issues and they've really been trying to make the performance better. Retention of new Android users trying Snapchat for the first time was up 20%, so they're definitely making some progress there.
Lewis: Looking at the financials for this business, in the most recent quarter, revenue came in at $286 million. That's up 72% year over year. If you look out at full-year 2017, the company pulled in just under $830 million. I know when they were doing their IPO roadshow, this number was floated, it's hard to know which side it came from, whether it was the bookrunners or Snap themselves, talking about this idea of maybe $1 billion in revenue in 2017. They're falling a little bit short of that, but you go back to the two most recent quarters and build that out, it was $500 million over the course of Q3 and Q4 for calendar 2017. So, they're getting closer to that, but they're still valued at 25 times sales as a business, especially given this most recent run-up. So, it's still a very rich business here.
Niu: [laughs] I mean, just the fact that I laugh out loud when you talk about their valuation metrics should tell you enough. I think this business is stupidly overvalued for what they're actually capable of doing and how young this company is and how much uncertainty there is.
And like you mentioned before in this episode, with Kylie Jenner this last week, the bigger issue is this big redesign at they're rolling out in the first quarter. There's been so much user backlash. There was a bunch of negative reviews, there was this hoax that went viral on social media, I'm not sure if you saw it because you were out traveling, but basically, someone on Twitter tweeted this fake message saying, "If I can get retweets, Snapchat will go back to the way it used to be." And they got 1.2-1.5 million retweets. I mean, it's obviously a hoax, but obviously there's a lot of interest there. There's even a change.org petition that has 1.2 million signatures. And the other day, Kylie Jenner, who's one of the most popular Snapchatters, tweets that she doesn't use the app anymore, the stock goes down.
And perhaps more importantly, particularly financially, on the publisher side, yesterday, Maybelline tweeted that its Snapchat use has "dropped dramatically" following the redesign, and it's not sure if it wants to stay on, if Snapchat is the right platform to connect to its consumers and its customers. It asked its followers with a poll, "Should we stay on Snapchat or switch our focus to Instagram?" which means shifting, i.e., our ad budget. And 80% of respondents said Instagram. Those aren't really encouraging data points for Snapchat. Maybelline has since deleted the tweet and issued a statement saying, "Oh, that was just one employee, it doesn't reflect our views." The company's view is, Maybelline has a strong partnership with Snap, and a bunch of PR response. But, the broader point is, if this redesign is that universally hated among users, that's not going to be good for engagement or the business.
Lewis: There's some irony there in Kylie Jenner and Maybelline polling people or expressing sentiment on Twitter about Snap. There's something kind of funny about that. But, to go back to what you were talking about with publishers, there's a decision that anyone with an ad budget has to make, and it's, where am I going to get the most value for my dollars? And I think the concern both for Twitter and Snap for the longest time has been, it seems like Facebook and Google are better places for ad budgets, and marketers are seeing a better ROI on what they're spending there. And unless these platforms are able to convince marketers otherwise, they're going to have a really hard time retaining all of their customers that are buying up ads and helping find floors for these prices.
Niu: Exactly. When you talk about an ad business, it's all about your ability to target. Targeting ties into the relevance to the users, and that's all based on user data. That's why user data is so important to these businesses. If you think about Twitter and Snapchat, you don't put as much user data about yourself on those platforms as you do on Facebook or Google. So, I think there is a fundamental disadvantage there. How much information do you share with Twitter that they can use to target you with ads? Of course, there's some, but if you compare it to Facebook where you put so much information about yourself, it's not even close.
Lewis: If you're looking for bright spots in some of the recent numbers that we've seen from Snap, I think you can look at gross margin and say, we're kind of pleasantly surprised with the expansion that we've seen there. You look at revenue and cost on a per-user basis, and of course, the company backs out some costs like stock-based comp, depreciation and amortization, but, Snap posted a gross margin of 36% in the most recent quarter on a per-user basis, and that's up from single digits in early 2017. Which is pretty impressive to me.
Niu: Right. They're definitely making a lot of progress there on the cost side as well, kind of like Twitter but not in the same way. Snap, as we've talked about many times before, their biggest cost is the hosting cost they pay to Amazon Web Services and Google Cloud. Google is their biggest cloud infrastructure provider. But, they've been able to leverage this dual relationship to pit these two companies against each other if they negotiate and score some pricing concessions, which helps them on the cost side. That's helping and really contributing to this gross margin expansion, because they're able to keep these costs in check while the ad business is growing, and they are making some definite progress on that side, too. They're really shifting to this programmatic self-serve ad platform. 90% of ads purchased last quarter were done so programmatically. Which is better for scaling, better for costs. So, there are some things that they are doing that they're making progress on.
But I still think this hosting cost strategy is terrible in the long term. If you look at it, they spent almost $500 million in 2017 on hosting costs alone, and about $85 million on capital expenditures. So, they're spending so much money for something that, they're just renting this capacity as opposed to owning it. Generally, any time you rent something, you don't have anything to show for it afterwards. And they argue that their low capex helps their free cash flow, which is technically true, but even with this capital-light model, they've burned over $800 million in negative free cash flow last year, mostly because operating cash flow is negative. They burned $180 million a quarter on average in operating cash flow last year. So, it's hard to really believe their argument that this is the right strategy.
Lewis: Yeah, it's a bold strategy. We haven't really seen too many tech companies of their size try things this way, where they have basically variable costs for hosting that are going to fluctuate with how much people are using it. It makes that leverage you were talking about a little bit tougher to reach. Evan, looking at the 10-K, I know you wrote a piece pulling out some of the most important stuff from the 10-K. It's on fool.com. Listeners, if you want it, just write into the show. Anything else from the 10-K that really stood out to you?
Niu: One news item when they filed, a lot of people were pointing out that Evan Spiegel got a $640 million bonus, but that wasn't really news because that was disclosed at the time of the IPO. Snap gave Spiegel a gigantic bonus for taking the company public, which is valued at about $640 million. That's not really new news, but it popped up again in news feeds, the news cycle. And the weird thing about that bonus is that Snap recognized it all immediately and it vested immediately. So, he could leave the company and still have all those shares, which is kind of a weird thing.
We've also always known that public investors get zero votes, which is ridiculous from a corporate governance standpoint. But, they gave another update in terms of, Evan Spiegel and Robert Murphy are the two co-founders, CEO and CTO respectively. They have a combined voting power of 95%. [laughs] Which is just insane. So, their grip on this company is so absolute. You have no way to change anything. Which is hilarious, because in their filing, they even have these statements like, "Our board of directors thinks corporate governance is really important." It's like, no you don't! [laughs] That's just not true.
Lewis: Yeah. If you're a Snap investor, you really need to buy into the long-term vision that Spiegel and Murphy have, because they are going to be able to basically exert their will on the company.
Niu: Yeah, you have to absolutely trust them. And with what they've done so far, I don't know if they deserve that trust. It doesn't really seem like they have shareholders' best interests in mind. There's other yellow flags. For example, their general counsel left last year, and then they hired a guy from Spiegel's dad's law firm. And they're paying him $500,000 a year to be general counsel, which is way above market rates. He got a $200,000 signing bonus. There's all these things that, in my mind, feel like Snap is only trying to enrich Spiegel, his friends and family and insiders, and not public investors. I would not touch this company.
Lewis: And when you put all of the corporate governance on top of a business that really hasn't made the case that it's investment-worthy, at least to me, you have something that I'm not going to touch. I'm kind of in the same camp as you, especially at the valuation it's currently at, given what we're seeing on the user growth side and some of the struggles that they're going to have making costs work and making margins work for them long-term. It will be interesting.
I think the thing to watch for this business in 2018 is, how do things go with programmatic ads? If they get to a point where the auction system is working, they're getting good volume and prices find a floor and wind up being pretty competitive, they might avoid a lot of the problems that Twitter has had on the revenue growth side.
Niu: Yeah. They're definitely making some progress, specifically with these financial numbers. But it's hard to believe anything that this company says, because everything they say is basically not true. Spiegel, in an internal memo a few months ago, was like, "We're scaling our business really well." But, but it's like, no, you're not. You're scaling a little bit, but your costs and revenue are not heading in the right direction to argue that you're scaling. They say they like corporate governance, but that's not true. They say that the capital-light model works better for them, that's not true. There's all these things that they say that are demonstrably false if you break it down and look at the numbers. And when you're asking investors to trust you completely and you keep sending these messages that just aren't really believable, it just doesn't add up.
Lewis: I'm going to give you the opportunity for one more parting shot here, Evan. Were there any mentions of Snap's Spectacles business or camera ambitions in the most recent 10-K?
Niu: No, I didn't see any. Spectacles, they've basically tried to forget about. They don't talk about them at all anymore. They used to disclose revenue on the calls. They haven't really talked about hardware at all. I think that's more of a long-term plan.
They are moderating headcount growth, which, they had been hiring so aggressively for the past couple of years that they kind of overshot, and specifically the things they were hiring for fell flat. So you have to backtrack and lay those people off. And now, they're trying to focus on making their workforce more productive. They're still going to hire where they need to, but they're going to try to be more disciplined. And we know that some of those layoffs were related to hardware, because Spectacles was such a disaster. But yeah, we just have to see where they go from here.
Lewis: It's sounds like we're getting a slightly more focused Snap in 2018.
Niu: Slightly. [laughs]
Lewis: [laughs] Evan, anything else before I let you hop off?
Niu: No, I think we got it pretty well.
Lewis: Listeners, that does it for this episode of Industry Focus. If you have any questions or if you just want to reach out and say hey, you can shoot us an email over at email@example.com, or you can tweet us @MFIndustryFocus. If you're looking for more of our stuff, you can subscribe on iTunes or check out The Fool's family of shows over at fool.com/podcasts. As always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against stocks mentioned, so don't buy or sell anything based solely on what you hear. Shout out to Austin Morgan for all his work behind the glass. For Evan Niu, I'm Dylan Lewis. Thanks for listening and Fool on!
John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool's board of directors. Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool's board of directors. Dylan Lewis owns shares of Alphabet (A shares), Amazon, and Facebook. Evan Niu, CFA owns shares of Facebook. The Motley Fool owns shares of and recommends Alphabet (A shares), Alphabet (C shares), Amazon, Facebook, and Twitter. The Motley Fool has the following options: short March 2018 $200 calls on Facebook and long March 2018 $170 puts on Facebook. The Motley Fool has a disclosure policy.