Snap's Priorities Aren't Inspiring Investor Confidence

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Snap (NYSE: SNAP) stock sank last week following some less-than-inspiring quarterly earnings numbers and management commentary.

In this clip from Industry Focus: Tech, analyst Dylan Lewis and senior tech specialist Evan Niu discuss the three main priorities that Snap outlined in its earnings call, and why they're so at odds with the concerns that investors and analysts have about the company's long-term growth prospects.

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A full transcript follows the video.

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This video was recorded on Aug. 11, 2017.

Dylan Lewis: They have outlined some of their main priorities, though. These are some things that investors can watch in the coming quarters to see how the business is tracking. The big three for them, driving both revenue and ARPU growth while expanding gross margins; No. 2, moderating capital intensity of its business to ensure strong EBITDA to free cash flow conversion; and then No. 3, investing in front-of-house resources and M&A to build up RapidScale in innovation and monetization. Anything really jump out at you from this report with respect to any of those, Evan?

Evan Niu: This is a topic they brought up last time, the last call, as well. With their capital intensity bit, I think it's really misleading the way that they frame their capital intensity strategy. They basically constantly brag about how low their capital expenditures are. Last quarter was, like, $20 million or something. And that's primarily just expanding facilities and stuff like that, it's not actually building infrastructure, because they completely outsource all of their cloud infrastructure. So, on one hand, they're bragging about low capital expenditures. The flip side is, their hosting costs are enormous, and consume the vast majority of the cost of revenue, to the point where, we've talked about this many times before, they have a really hard time scaling. They're making progress because they're getting better pricing on some of the hosting fees. But hosting fees are consistently in the 70%-80% of total cost of revenue, and that just doesn't seem scalable to me. Those are all variable costs, because the more people use the platform, the more that Snap has to pay for the usage fees while they're simultaneously trying to sell enough ads to cover those costs, and try to come up with a positive gross margin, which they are very inconsistent on. They've done it occasionally, had a positive gross margin. They did it this quarter. But a lot of the times, these hosting costs are more than their revenue. I just think it makes no sense for them to be like, "Hey, our capex is really low," but then they just ignore the fact that the other side to that is, their hosting costs are completely out of control.

Lewis: The way that they've set up that business doesn't really allow them to enjoy the leverage of adding users that a lot of businesses at their scale do, right?

Niu: Yeah. In general, one of the reasons why investors love tech, in a lot of ways, is because online services are supposed to be able to scale incredibly well, to the point that when you really start to get that operating leverage, your profitability just explodes. But Snap will never do that, because they have no operating leverage.

Lewis: Yeah, that's true. One thing that I am curious to see, I don't think we're going to see it any time in the next couple quarters, but it might be something that in a year or two from now, we start to get some color on, is ad rates, particularly as they move more and more to a marketplace-driven ad fulfillment solution. That's something that we get from most of the major digital media players, and certainly Twitter and Facebook. So, it'll be interesting to see what's going on there. They've talked about how the market dynamics have driven down ad prices and made them more affordable for folks. One of the problems that we've seen with Twitter is that the ad prices have continued to fall precipitously over time, and it's been tough for them to make up revenue on volume. Down the road, it would be great to get some color on that from Snap.

Dylan Lewis owns shares of FB. Evan Niu, CFA owns shares of FB, and has the following options: long January 2019 $20 puts on Snap Inc. and long January 2018 $120 calls on FB. The Motley Fool owns shares of and recommends FB and TWTR. The Motley Fool has a disclosure policy.