I was widely encouraged to invest in Snap Inc (NYSE:SNAP) when the stock IPOed in March. Many of my friends made the mistake of assuming a good and popular product makes a company’s stock a good investment. But as Snap’s problems come to light, it becomes clear that, despite the popularity and growth of the Snapchat app, the stock may do the opposite of growing unless management makes some big changes.
Snap Inc’s business model is flawed by its dependence on third-party digital infrastructure and abysmal gross margins. Snap’s cost of revenue is much higher than similar companies at the same point in time after going public.
Third-Party Infrastructure & Negative Margins
Snapchat is a good product, but it isn’t necessarily monetized through a good business model. In many ways, Snap Inc. has the characteristics of a company that will remain permanently subscale and would make more sense as a part of a larger company’s – like Facebook – portfolio instead of existing as a standalone entity.
As Snap Inc. is a company built on monetizing a smartphone application, it naturally follows that Snapchat’s management team would be tempted to double down on its inherently third-party dependent business by outsourcing as much digital infrastructure as possible. But while it makes sense for a subsidiary business or a digital asset in a portfolio to be dependent on third-party infrastructure, it is less sensible for a high-growth company with a $23-billion-dollar market cap to employ this strategy.
To be fair, Snapchat is not the only tech company built on Amazon Web Services and Google Cloud, but it is one of the largest. And history has shown us that, while this strategy saves capital expenditure costs in the short-term, it doesn’t scale well over the long term and precludes the development of an asset base that would increase the book value of the company and provide tax benefits through depreciation.
Snap’s management boasts about saving billions in capital expenditures through its third-party hosting, but the company’s margins are abysmal.
In the most recent quarter, Snap generated $404 million in revenue for a Cost of Goods Sold (COGS) of $452 million, giving Snap a negative gross income. The vast majority of Snap’s COGS expense comes from hosting payments to Google Cloud and Amazon Web Services. The problem is that instead of being a -somewhat- fixed cost like Facebook’s COGS (due to in-house hosting), Snap’s COGS will be highly variable and increase dramatically as revenue increases. Unfortunately, Snap’s low gross margins belie my earlier expectation that Snap’s stock would perform similarly to Facebook’s stock over the long term.
It is important to note that Snap’s low margins are not just “growing pains” – they are the result of a fundamentally flawed business model. In comparison, Facebook and Twitter both managed to maintain gross margins above 50% since IPO while Snap is almost at negative 10%.
Snap Inc’s dependence on third-party infrastructure may prevent the company from benefiting from economies of scale. Hosting costs will increase proportionately to revenue, suppress gross margins, and preclude profitability. But this problem has a silver lining. Despite the flaws in Snap’s business model, the core product, Snapchat, is still one of the most valuable assets in the world.
Snap appeals to the lucrative teen demographic, and its user engagement is extremely high and growing. On top of this, the company is building up a trove of user data that will be invaluable to marketers.
I think Snapchat is clearly worth more than the company’s current market cap of $23 billion – and in the right hands, this company could be worth at least double. Snap is not overvalued at $20 per share. If anything, it’s undervalued. The only thing holding back Snapchat is its un-scalable business model and tight margins. Thankfully, these problems can be fixed. But I won’t buy the stock until they are.