The Pros and Cons of Snap's Hosting Strategy

Snap's (NYSE: SNAP) cloud infrastructure strategy is unique for a company its size. The company's Snapchat platform relies entirely on third-party vendors for hosting. In this segment from Industry Focus: Tech, Motley Fool analyst Dylan Lewis and senior tech specialist Evan Niu, CFA, talk about the pros and cons of such a strategy.

A full transcript follows the video.

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This video was recorded on May 12, 2017.

Dylan Lewis: You also think the company's hosting strategy as well is short-sighted, as well.This issomething that a lot of companies haven't done. Rather than investing in their own infrastructure, whether it'sbuilding out their own data centers, or doing co-locatedfacilities for their servers, Snap isrelying entirely on third-party cloudinfrastructure providers. That'skind of new. I know you've been a skeptic of that in the past.

Evan Niu:Yeah,it's a very unique strategy. If youlook at it from Snap'sperspective, thebenefits they're saying of why they do it this way is, I think one isreliability and resilience,because AWS and Google Cloud areextremely powerful. That way,they can ensure theservices are up-and-running. If you rememberTwitter in the early days, it hadoutages all the time because they had so much trouble scalingbecause people were coming to the service so quickly, it wasoverwhelming Twitter's own servers, and theirin-house infrastructure that causedconstant outages. So, by relying on AWS andGoogle Cloud, Snap can avoid that, because those clouds are so strong that it'sreally unlikely they're going to be hit with an outage. Of course, it could happen. But there'smuch less risk of that happening. The other piece of it is, they're trying to saveall this money on capital expenditures. Capital expenditures last quarter werevery low. They're always low for Snap,because that's just how they approach their cloud stuff. It was $18 million or something.

On the call, they mentioned, "We estimate that using a capital-light approach has saved us billions of dollars in capital expenditures," which is true, but if youturn around, they've also committed to spending $3 billion at AWS and Google Cloudover the next five years, combined. You'renot really saving that money, you're still spending it, you're just,instead of spending money on capital expenditures andhaving that asset on your balance sheetwhere you depreciate over time and it's yourinfrastructure, now you'rerelying completely on these third parties. Those are variable costs. That's going to be a really big challenge for scaling, because those costs are going to scale, too. They did renegotiate their contractpricing during the quarter with bothAWS and Google Cloud. They did say thatlower contract pricingdid help theircost structure a little bit.

And if you'relooking at it fromAmazonorGoogle'sperspective, Snap is a hugecustomer in the space. They'reprobably one of the biggest customers out therewith these types of spending commitments. These are the two biggest cloud providers, so of course they'regoing to be bidding pretty aggressively andcompeting for this contract, and I'm sure Snap ispitting them against each other andreally leveraging that in negotiating. So, yeah,they are getting some better pricing now. But,it justdoesn't seem like a good long-termstrategy. If youreally want to have good long-term growth,you just build infrastructure yourself, eat the costs up front, but thenyou can scale so much better.

Lewis:Yeah. You talked about it beingvariable and somewhat subjective to pricing negotiations. Thismost recent quarter,hosting costs ate up70% of revenue, andthat's actually down fromthe last couple quarters where it was up near 80% a few quarters ago.

Niu:Ayear ago, it was like160% --hosting costsexceeded revenue a year ago.

Lewis:Yeah,I'm not sure how much further that's going to fall. Wemight continue to see itmove down into the high 60s, or something like that. But, I don't knowhow much lower that floor is going to be. But, it really speaks to how theircost structure is very different than a Facebook, a company that has decided to build out, what, seven data centers at this point?

Niu:Nine.

Lewis:Nine? Wow. So,rather than have that fixed cost,like you said,as they have more people using the platform, andmore people using the platform longer, the cost for them doing that is going tocontinue to go up, which issomething that could be good or bad, itdepends on your outlook andwhat you value for the business.

Niu:It gives them more flexibility ifthings start heading down,if people stop using the platform and users startabandoning Snapchat. Then it's better,in that situation, because you're not stuck withall this infrastructure you have built, and your costs will scale down. But,obviously, Snap ishoping things go up, in which case, it's really hard. They'regetting squeezed by these costs, andI think it's really short-sighted. But to be fair, they have hinted that they mightpursue their own infrastructure at some point in the future. But,they were very vague about it in the prospectus. Theydidn't specify timing, and, of course,they do have spending commitments for five-plus years. Soit doesn't seem like if they do it on their own,it would be within the next five years, at least.

Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool's board of directors. Dylan Lewis owns shares of GOOGL and FB. Evan Niu, CFA owns shares of FB. Evan Niu, CFA 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 GOOG, GOOGL, AMZN, FB, and TWTR. The Motley Fool has a disclosure policy.