SummaryEdit

Source of opportunity

Snap is a venture stage investment in the public markets, something unseen in recent years where nearly all internet companies waited until later stages of growth and profitability to go public. While this clearly carries a higher risk profile, we believe it also comes with higher reward potential. With Snap’s large, valuable, and highly engaged user base generating ad inventory and the monetization path in mobile now well worn, we believe the potential for outperformance as the company continues to innovate against the growing mobile opportunity outweighs those early stage risks. Therefore, we initiate coverage with a Buy rating.

Catalyst

User engagement. Snap’s 158mn daily active users are highly engaged visiting the site 18 times daily for an aggregate 30 mins. While DAU growth decelerated materially in 2H16 (15mn net adds vs. 36mn in 1H16), we see early signs of reacceleration in comScore data (MAUs increased 18mn in 4Q16 vs. 12mn in 3Q16), despite increasing competition from larger social platforms. This remains the biggest risk to Snap’s future, in our opinion. Monetization. While extremely early stage, particularly in developing the critical targeting and measurement technologies expected by mobile advertisers, Snap’s high value audience and the engaging advertising inventory they create should allow the company to monetize similar to other platforms over time.

Valuation

Our $27, 12-month price target is based on 18x 2018E EV/Sales, a slight premium to peers on a growth-adjusted basis, given our expectation for sustained hyper growth and potential upside risk to our estimates.

Key risks (-) increased competition, volatility and unpredictability of key reported metrics like DAUs, execution risk given rapid expansion of workforce

PM SummaryEdit

Snap is a venture stage investment in the public markets, something unseen in recent years where nearly all internet companies waited until later stages of growth and profitability to go public. This clearly carries a higher than normal risk profile – Snap generates negative gross margins, is burning more cash than it is generating revenue, and we do not expect it to break even on an adjusted EBITDA basis until 2019. The company also has an unusually concentrated voting structure, senior management with no prior C level experience, and faces significant competition from platforms like Google and Facebook that are considerably larger, more profitable and better resourced.

That said, Snap has a large, valuable, and highly engaged user base that occupies a unique space in the demographic (Exhibits 7/8). That engagement generates high value advertising inventory that should allow Snap to follow the now well-worn path of mobile monetization. While the public market has no recent experience valuing an internet company at this early a stage, at this scale, we believe the opportunities from growth in users, engagement, and monetization more than offset the considerable risk inherent in what is essentially venture investing through public equity. Therefore, we initiate coverage with a Buy rating and a 12-month target of $27.

Key Investment issues

User growth. Snap’s ability to maintain and grow its audience will be the key determinant of valuation for the company, in our opinion. Currently, Snap’s 158mn daily active users are highly engaged visiting the site 18 times daily for an aggregate 25-30 mins on average. That said, user growth decelerated materially in 2H16 (Exhibits 28/29) as competitive offerings and execution issues at SNAP impacted new user additions and engagement, though we have seen early signs of reacceleration (Exhibit 11) despite competition from larger social platform intensifying. While we believe Snap’s differentiated offering of creative content that disappears after viewing (ephemeral content) by the individual or small group it is shared with encourages a frequency of casual engagement that we believe will be difficult to replicate on other platforms known for storing life’s most treasured moments and sharing them with larger more public audiences.

Monetization. The path to monetizing mobile advertising inventory is well worn at this point. While Snap’s efforts are extremely early stage, most of their ad units are less than a year old, companies like Google, Facebook, and Twitter have all developed the sales channels, partnership networks, and targeting and measurement technologies Snap will need. While we don’t expect Snap to reach the level of engagement monetization that those companies have (Exhibit 12) in the near term due to differences in usage, audience, and data, we believe that Snap’s video and user endorsement based inventory will prove extremely valuable to advertisers if management can effectively build out that sale, partner, and technology ecosystem.

Competition. The competition for users’ time and advertiser’s dollars is intense and while the pool of both is growing, for companies growing at Snap’s and other online platforms’ rate, to maintain that pace competitive share gains are necessary. Snap has succeeded in those gains by innovating new products and seeking to differentiate its use case.

Summary of fundamentals

Snap Inc., began as a mobile photo sharing and messaging app (Snapchat) that allows users to send pictures, videos, and text messages (called “snaps”) to friends, which by default delete themselves after they had been viewed by the recipient. Snapchat rebranded itself in October of 2016 as Snap, “a camera company,” and subsequently introduced Spectacles – wearable sunglasses with an embedded connected camera that allow users to “snap” hands-free.

The Snapchat app has 158mn Daily Active Users (DAUs), 57% of which were international as of 4Q16, and 78% of which were age 18+. Total DAUs grew 48% in 2016. While Snap is, in our view, well positioned to continue to take share of users’ media time and advertising dollars as new content features, network effects, and a growing platform ecosystem drive usage growth and new ad formats, technologies, and adoption drive monetization, the company is in the very early stages of these efforts. Snap’s monetization efforts really only began in earnest in 2Q16 (2016 monetization was a fraction of peers; Exhibit 1) and the company reported negative gross margins and negative operating income well in excess of 100% of revenues for FY 2016. While gross margins turned positive in 4Q16 due to seasonal and one time revenues, we expect the company will return to negative gross margins in 1Q17.

We forecast CAGR over the next 5 years of 78% as the company monetizes its existing base of users, growing ARPU from $2.81 to $27 (Exhibit 2), and growing DAUs from 158mn to 278mn. At that scale we estimate that the company can generate gross margins of 77% and adjusted EBITDA margins of 27%. That said, given Snap’s early stage the range of outcomes over the forecast period is far wider than normal (Exhibit 14).

Valuation and key risks

Our $27 12-month price target is based on 18x 2018E EV/Sales, a slight premium to peers on a growth-adjusted basis, given our expectation for sustained hyper growth and potential upside risk to our estimates.

Key risks to our investment thesis include increased competition, volatility and unpredictability of key reported metrics like DAUs, corporate experience and execution risk given rapid expansion of workforce as well as the relative inexperience of the management team. We further explore the risks and valuation methodology beginning on page 32.

Company backgroundEdit

Snap Inc. defines itself as a camera company, primarily because its flagship smartphone app, Snapchat, leverages the smartphone’s camera to create content, which is then shared with others. Content shared on Snapchat is ephemeral, remaining visible for only 24 hours, after which it is deleted from the platform. Snapchat averaged 158mn Daily Active Users (DAUs) in 4Q16, with 43% in North America (including Mexico and the Caribbean), 33% in Europe, and 25% in the rest of the world. The company generates revenue through advertising, with various ad types sold as Snap Ads and Sponsored Creative Tools. In late 2016, the company also introduced Spectacles – sunglasses with an embedded camera that captures short videos (10-30 seconds) and transmits them to the user’s phone via Bluetooth.

Snap uses a tri-class share structure, with public shares having no vote. Co-founders, Evan Spiegel and Bobby Murphy together control nearly 90% of voting power, and Mr. Spiegel was given a stock grant in conjunction with the IPO that (as shares are delivered over the next 3 years) could potentially vest sole majority voting power in him, depending on whether he, or others, sell voting shares. Voting shares automatically convert to non-voting shares upon sale or transfer. Lastly, management has provided no formal guidance on financials, or user metrics like DAUs or ARPU, and has stated it has no intention of doing so as a public company.

Snapchat encourages raw content sharing and frequent contact

The Snapchat app was launched in 2011, with its key differentiator being its ability to enable one-to-one and one-to-many communication through ephemeral content. The app allows users to capture images, video, and text and share that content with others, with the expectation that the content will be only be viewable for 24 hours, and usually only held on Snap’s servers for 30 days. Pictures and videos created on the platform are referred to as ‘Snaps’. The ‘Memories’ feature, introduced in 2016, allows users to preserve their own (but not others’) snaps indefinitely. The company claims that the ephemeral nature of shared content, and the small network size encourage sharing of more raw content, as users would be less concerned with a network of 1,000+ people seeing their Snaps, and less concerned with those pictures and videos persisting indefinitely online.

Some key Snapchat terms include:

  • Snaps – pictures and videos created by users and shared on the platform. Snaps disappear from the app after 24 hours
  • Stories – collections of Snaps that are aggregated and shared by users that disappear on a rolling 24-hour basis. For example, if a user posts one snap to stories every 2 hours, their User Story will contain the 12 most recent snaps at any given time. Stories can be viewed by all of a user’s friends/followers.
  • Memories – An area of the app where a user can save Snaps indefinitely. Snaps can be sent from Memories, but users cannot save friends’ Snaps to their own Memories.
  • Lens – an in-app augmented reality tool that leverages facial recognition to let users alter their pictures, most often by superimposing digital content on top of the user’s face (dog ears/muzzle, digital wigs/glasses, etc). Advertisers can sponsor unique lenses.
  • Filter – photo editing tools that allow users to customize their photos after taking them, by adding a digital frame, stickers, text, etc. Advertisers can sponsor filters.
  • Geo-filter – a specific filter that is only available to users within a defined geographic location. Can be created for communities, or sponsored by advertisers. Individual users can also design and purchase custom geo-filters via self-service.
  • Snapcode – a unique graphic similar to a QR code assigned to each user. Users can scan a Snapcode to add the associated user to their friend’s list.

The app itself is structured to optimize content creation, rather than consumption, with key areas of the app set at the four cardinal directions from the home camera screen. The app opens on the camera, and a user can take a picture and post it to “Stories”, or send to a friend in seconds, with 4 taps on the screen. Opening on the camera emphasizes the creation of content vs. other platforms emphasizing consumption of content by opening on the news feed, or its equivalent. From the home camera screen, users can swipe up to see their profile, down to see Memories, right to see Stories, and left to see Chats (Exhibit 3). Swiping right twice opens the Publisher Stories/Discover Platform with partner’s stories, articles, and videos. Publisher partners include ESPN, BuzzFeed, MTV, Cosmopolitan, The Economist, Vogue, Esquire, Entertainment Weekly, among many others.

Pace of Innovation

One of Snap’s differentiating factors is the pace at which the company has been able to develop and roll out new products and features to its core app. The company has accelerated its pace of innovation as well, having introduced more major features and products in 2016 than it did in 2014 and 2015 combined. While some of the new features were added by way of acquisitions – Bitmoji, some lens capabilities, snap codes, and Spectacles came by way of acquisitions – we believe the majority of the innovation on the platform has been fostered in-house.

Snapchat has highly engaged users, but relatively short average session times

Snapchat’s daily users spend an average of 25-30 minutes per day on the platform. According to comScore, monthly users spend an average of 8-9 minutes per day on the platform, but this figure would include days in the month when users did not visit the platform, which explains the discrepancy between comScore data and the figures reported by Snap. On average, DAUs visit the app 18 times per day, and over 25% of Snap’s DAUs post their personal Story every day.

Given the 25-30 minutes spent, and the 18 daily visits, this would imply that the average session length for a visit to the app ranges from less than 1.5 minutes to 2 minutes. This may be indicative of the use case – users who leverage Snapchat primarily to send and receive messages will have far shorter session times, while those who visit the app to read and watch content will have longer session times. We believe that Snap’s ability to improve its monetization will depend to a great extent on its ability to drive usage to more content and away from pure messaging, where opportunities for advertisements are fewer, in our view.

Snap’s most engaged users skew young relative to other social platforms

Snapchat’s user demographics and engagements will vary somewhat depending on whether the base is segmented according to DAUs (how Snap discloses) or MAUs (as many 3rd-parties measure the base). The DAU metric is significantly more volatile than the MAU metric favored by some competitors, as well. As an illustrative example, if a base of 100 users uses a platform every day in a given month, DAUs and MAUs for that month would each be 100. If the user behavior in this example changes to 6 days a week vs. every day in the month, the MAU figure would be unchanged at 100, but the DAU number would decline by 14%. This phenomenon also helps to explain the changes in demographic data from Snap vs. 3rd-parties like comScore who only report metrics based on monthly users.

We also believe that new users are less likely to be as engaged as established users with mature friend networks, so monthly users are likely to increase at a faster rate than, and serve as a leading indicator to, DAUs. According to comScore monthly unique users have increased at an average yoy rate of 117% over the last three months, while minutes per user have declined by an average of 13%.

Snap has disclosed that over half of its DAUs are in the 18-34 demographic. However, the 18-24 segment makes up the largest portion of Snapchat’s DAUs. Snapchat also has more users who are under 18 than it has users who are over 35. These segments imply a median disclosed age of ~24 for Snapchat’s base of DAUs, though this metric may be somewhat skewed as well, as there is no mechanism in place to verify a user’s age other than the birthdate the user enters when initially downloading the app.

Snap’s engagement skews significantly toward younger users, but the average age of its user base is rising – In the US, over 50% of daily new users are over 25. ComScore data from January 2017 shows nearly half of Snapchat’s monthly users are over 35, vs. the 15% of its daily users as reported by the company. This may indicate that younger users are more likely to engage on a daily basis, while older users may engage from time to time, but not frequently enough to comprise a larger proportion of the DAU base. As further evidence, Snap disclosed that DAUs under 25 visit the app more than 20x daily, while DAUs over 25 visit an average of 12x daily. The discrepancy between Snap’s reported DAUs and comScore’s reported MAUs may simply indicate a difference in data collection, skews from methodology in comScore’s measurement, or other unknowns. Regardless of the metric used, however, Snap’s user base skews younger than other social platforms. While this may limit the platform’s attractiveness to certain advertisers, it also presents an opportunity for many advertisers to find an audience that is increasingly difficult to reach on other social platforms.

According to comScore (among US users), Facebook was by far the favoured social platform among all age groups in January 2016. However, when limited to mobile traffic only, comScore shows a dramatic shift among younger users over the last year, as Snapchat and Instagram both show higher daily minutes per user relative to Facebook in the 18-24 demographic (Exhibits 9 & 10). Based on our conversations with advertising partners, many advertisers view Instagram and Facebook as interchangeable, given the common ownership and shared technology, but those conversations also indicate encouragement among advertisers that there is another viable platform in the market now, through which younger demographics can be effectively reached in creative ways.

Multiple levers for growth, but Snap must execute on all of them Snap reports its revenue as a function of DAUs and Average Revenue per User. While Snap generates the vast majority of its revenue through advertising, that advertising is sold based on audience size, engagement, demographic data, and other metrics that the company does not plan to disclose. As such, we model revenue growth based on the growth in DAUs and the growth in ARPU, by geography.

Snapchat DAUs increased 48% yoy in 2016. North America DAUs increased 42%, Europe by 53%, and the rest of the world by 63%. We expect the company to invest in sales and marketing to drive adoption and improved monetization. We expect S&M investment to increase from $124mn in 2016 to nearly $350mn in 2017 and over $1.6bn in 2021. We expect ARPU to grow more rapidly than DAUs for the foreseeable future.

Snapchat saw a marked drop in the pace at which it added new DAUs beginning in 3Q16, which coincides with two major events:

  1. Instagram launched its Stories feature, which we believe had a negative impact on engagement among Snapchat users. We do not believe there were a material number of Snapchat users that abandoned the platform, but given the sensitivity of the DAU metric (as discussed on page 10) anything that potentially takes attention away from Snapchat could have a material impact on DAUs in any given period.
  2. In addition to increased competition, the company also introduced several new features during 3Q16 that, according to the company, had a negative impact on the performance of the app – slow performance, app crashes, etc. – which adversely impacted engagement temporarily. The company believes that all of these technical issues have been resolved.

The slowdown in net adds in 3Q16 was more impactful in the rest of world segment than it was in North America and Europe. Net new DAUs in North America declined from 7mn in 2Q16 to 3mn in 4Q, with a similar decline seen in Europe. In the rest of the world, net adds declined from 7mn in 2Q16 to 0 in 4Q16. Users in geographies outside of North America and Europe over-index on lower-end Android devices, which Snap claims were most heavily impacted by the technical issues. We believe this provides further evidence that the slowdown in net adds was driven at least in part by technical performance issues.

We also analyzed comScore’s US-only data over that time period. While the data provides no insight into the international trends seen in 2H16, we believe it does provide some credence to management’s discussion of technical issues causing the slowdown. According to comScore’s US monthly unique visitor metrics (which correlate with an rsquared of 0.91 to Snap’s reported North America DAUs, historically) the deceleration in net adds has been almost entirely on Android, with yoy growth in iOS monthly users accelerating in 10 of the last 12 months.

The company’s strategy involves targeting the highest-value users in geographies with mature advertising markets, deemphasizing lower monetization ad markets in order to limit losses. Despite that focus, we believe that there remains a significant opportunity for Snap to add users within North America and internationally. Snapchat is a resource-intensive mobile app, with heavy data, memory, and bandwidth usage that is difficult to accommodate on lower-end smartphones more prevalent in developing geographies. Additionally, limited 4G network build-out makes it difficult to service users in many parts of the world. Given the higher costs, lower performance, and lower monetization rates of users outside of Snap’s target markets, the company has stated its clear strategy is to drive improving monetization of users in N. America and Europe rather than optimizing the strategy for user growth globally.

Snap’s model is highly sensitive to DAUs and ARPU

We performed a sensitivity analysis around Snap’s 5-year revenue potential. Given the company’s stated focus on driving revenue and user growth in North America and Europe, we focused our analysis on these geographies. Our sensitivity analysis assumes DAU growth ranging from a 5-year CAGR of 2% to 11% through 2021 vs our base assumption of 10%. For monetization, our sensitivity analysis assumes an ARPU range of $5 to $65 in 2021 vs our base assumption of $37. For context, we estimate a weighted average (across North America and Europe) 2017 ARPU for Facebook approaching $60, while we estimate Twitter’s US and International ARPU figures at $42 and $9, respectively. While we recognize a broad range of potential outcomes outside of our analysis here, these DAU and ARPU assumptions generate a potential 2021 revenue range of $650mn to $13bn, which illustrates the widely varying possible trajectories for Snap, given the current, very early stage of its life cycle.

Monetization vehicles

Snap generates revenue through Snap Ads, Sponsored Creative Tools, and Spectacles. While we believe there is potential for Snap to introduce new products and services that would serve as incremental monetization vehicles, our model assumes the vast majority of revenue growth will come through user growth, and increased monetization efforts through the products that currently exist.

Snap Ads

Snap ads are vertical, full-screen advertisements of various types served on the Snapchat app. On average, over 60% of Snap ads are viewed with sound on, creating a competitive advantage for Snap relative to other social/mobile advertising platforms where videos are more commonly viewed with sound off. Additionally, Snap Ads can be sold “with attachments”, which serve as extensions of the advertisement allowing the user to swipe up to view longer-form videos, install an app, read additional content, or take some other action. Snap Ads can be created in various formats, including video, articles, app install interstitials, and web view advertisements. Given the varied nature of the organic and partner content on the platform, we believe advertisements are more difficult to distinguish from native content on Snapchat than they are on many other platforms.

Snapchat’s ad inventory

We classify Snap’s ad inventory (excluding sponsored creative tools) in two categories – organic inventory, and partner inventory.

Organic Inventory – We define organic inventory as ad slots placed among content on the platform that is created by, and shared among, the actual users on the platform. The principle example of this would be a Snap Ad that appears between friends’ Stories.

Partner Inventory – We define partner inventory as ad slots that are placed adjacent to partner content, whether that content appears as “Featured” Stories below friends’ Stories, or among partner/publisher stories on the Discover platform.

Ad placement on partner content varies based on the type and nature of the content. Many publishers on the platform create content consisting of a series of Snaps (separate short videos, still images in a story board format, text slides, etc.) with many of the Snaps giving the option to swipe up to see more content. The economic impact of ads placed on partner inventory also varies based primarily on whether Snap or the partner sold the ad. Snap shares ad revenue with the partners on whose content the ad appears, recognizing the revenue gross if it sells the ad itself, and recognizing it net of the partner’s share if the partners old the ad. In 2016, the company paid $57.8mn to partners under such agreements, vs. $9.6mn in 2015. While the company has not disclosed the economics of those agreements, assuming a 50/50 split would imply that 29% of 2016 revenue was generated on partner content and recognized gross.

The company has not disclosed any metrics regarding ad load, nor has it disclosed the proportion of its revenue that is generated through sponsored creative tools. We believe ad load varies materially between users, based on geography, demographic, and the user’s level of engagement. Our model assumes that DAUs see an average of one for every 8-10 times they open the app. We expect this metric to trend up over time as user engagement and session times expand. We expect users to see (on average) one ad every 4-5 times they visit the app by 2021, with the average number of daily app opens slowly declining from 18 currently, to a global average of 15.5 in 2021.

Targeting, Reporting, and Measurability

Snap leverages internal technology and an ecosystem of third-parties to provide targeting, reporting, and measurement statistics for advertisers. In addition to targeting users based on demographic data (age, gender, etc.) the app can target based on precise location data, as the location function on the user’s device must be turned on in order to use some of the apps most popular features, like filters. Snap also has an Audience Match function that allows advertisers to use their own CRM data to target specific individuals, similar to what is offered by large-scale competitors.

Snap partners with Innovid, Google DDM, and Sizmek for third-party ad verification, and leverages Moat’s video score for measurement on video ads. Snap partners with Nielsen mDAR and Millward Brown to measure reach and frequency of ad campaigns, and with Oracle Data Cloud to measure post-ad purchase activity. Snap has an ecosystem of partners including Tune, Adjust, Kochava, and others for the measurement and reporting of app-install ads.

Sponsored Creative Tools

Snap also offers advertisers the option to sponsor creative tools like lenses and filters that can be used to enhance Snaps before they are shared on the platform. Common free lenses include augmented reality tools that superimpose a dog’s face on the user’s photo, or create the illusion that a rainbow is coming out of the user’s mouth. Advertisers can pay to create unique sponsored lenses like those that were used in a promotion for a recent XMen film that made users look like different characters from the film, complete with superpowers. Filters allow users to enhance photos after they have been taken, adding stickers, time or temperature stamps, or other effects. Geofilters are filters that are only available to users within specifically defined geographic areas (ranging from 20k to 5mn sq. ft.), and can be purchased by advertisers or users via self-serve through Snap’s website (Exhibits 17-21 outline the self-serve process).

Spectacles

Snap Spectacles are sunglasses with an embedded camera that connects to the Snapchat app on the user’s smartphone via Bluetooth. Snap announced the launch of Spectacles in September 2016, in conjunction with its corporate re-branding as a camera company (and changing the name of the company to Snap Inc.). Originally, Spectacles were only available through custom vending machines called Snap Bots, that were strategically placed, for one day each, in cities across the US. Through February, there was only one persistent location (in New York City), but that location has since closed. Spectacles have been available online (with a 1-2 week wait time) since February, and retail in the US for $130 (Exhibit 22).

Snap has not disclosed the unit sales or revenue contribution from Spectacles, other than to say that revenue from the sunglasses has been immaterial. The company has disclosed that it is selling Spectacles at a loss, and that it expects to continue to do so for the immediate future. Given the early nature of the initiative from Snap, and the immaterial revenue generated to-date, we have only very modest assumptions in our model for revenue and costs associated with Spectacles. Should Snap generate material revenue or see broad adoption of Spectacles, there would be corresponding upside risk to our numbers.

We believe that Spectacles represent an opportunity for the company to drive further engagement and public awareness of its Snapchat app. Should Spectacles see broad adoption, we would expect engagement, DAU growth, and revenue above our current estimates, however increased engagement through Spectacles would also increase infrastructure costs as users generate and consume more HD video and leverage more storage. Snaps created through Spectacles are automatically added to Memories, which increases the storage expenses for Snap relative to snaps created within the Snapchat app itself.

Investment frameworkEdit

Within our investment framework, we look for companies exposed to the strongest growth drivers, high degrees of leverage in the business model, management focus on innovations that are disrupting a large underlying industry, and, in an industry that offers few of them, real competitive barriers or sustainable advantages in technology, scale, and/or business model. In particular, we look for strong network effects, a high ratio of revenue to customer acquisition costs, and strategies to exploit the growth in internet as a whole and mobile, social, and local in particular.

Upon determining attractive and sustainable business models, we layer on valuation to determine our best investment ideas. We look for attractive valuations relative to the growth rates and returns on invested capital that we believe the companies can sustain. Those are the companies we believe investors will be best served owning, particularly when their current growth multiple undervalues those opportunities in our framework.

Based on our growth, leverage, innovation, and competition (GLIC) framework analysis and the stock’s current valuation, we believe SNAP warrants a Buy rating.

To provide a quantitative guide to this process we rank the companies across our coverage by the four factors of the framework, namely, Growth, Leverage, Innovation, and Competitive Advantage (Exhibit 24). We elaborate how we view Snap on each of the factors below:

Growth. Within our framework, we measure growth using a 2016-2019 sales CAGR. Snap leads our coverage in terms of next three years’ sales CAGR with ~100% expected sales growth, driven by a 16% increase in DAUs and 70% increase in ARPU over the same time period. Snap benefits from a large and expanding addressable market and we expect the revenue growth to come through user growth, and increased monetization efforts through the products that currently exist.

Leverage. We measure leverage as incremental margin, which is calculated as (NTM adjusted EBITDA – LTM adjusted EBITDA) / (NTM sales – LTM sales), using GS estimates. Snap ranks lower in our coverage on operating leverage as its faster sales growth is more than offset by the lack of its profitability given its resource-intensive nature and focus on improving monetization. The company had negative adjusted EBITDA margins in FY16 as it ramped up R&D and marketing investments. The company is not expected to break-even on an adjusted EBITDA basis until 2019 as it would continue to make these investments to drive adoption and improve monetization.

Innovation/disruption. We use a 50%/50% blend of TTM product development expense and TTM product development expense as a percentage of gross profit to quantify the level of innovation at a company. Snap falls into the top quartile of the coverage with rank 7 in terms of innovation. Snap spent $184mn on R&D expenses in 2016, a growth of 123% yoy. We expect Snap to almost double R&D investment in 2017 and grow it to $1.8bn by 2021. Snap ranks second, just behind Zynga in terms of product development expense as a percentage of gross profit, reflecting the investments required for an early stage company to stay relevant in a highly competitive environment. We believe Snap has the potential to reach 70-80% gross margins as a mature business with higher monetization. Therefore, for comparison with our coverage, we have assumed a gross margin of 75% for our calculations despite the company’s negative gross margins in 2016.

Competitive advantage. We measure competitive advantage using a 50%/50% blend of (i) a qualitative (1-4) rank where 4 represents high levels of competitive advantage and (ii) LTM market share for the respective addressable markets. Snap ranks 22nd in our coverage in terms of competitive advantage given the company is in early growth stage. We rank Snap as 3 on a scale of 4 based on the pace of new features and products introduced by the company, higher engagement compared to most of its competitors. We calculate Snap’s market share using FY16 revenue as a percentage of total global ad spend. Though there are other ways to look at Snap’s market share including share of time spent on platform, unique visitor traffic, we believe total global ad spend is a better metric for comparison with other online advertising companies in our coverage.

Industry context and revenue growth potentialEdit

Total Addressable Market for Snap

We estimate the size of the global digital ad market at $206bn in 2017, growing to $300bn in 2020. We expect mobile digital advertising to account for $109bn in 2017, growing to $206bn in 2020. Based on SNAP’s 2016 reported revenue of $404mn, and our 2017 estimate of $980mn, SNAP had 50bps of global mobile advertising market share in 2016 and we expect it to grow to 90bps of global market share in 2017 (Exhibit 26). Snap plans to focus its growth efforts on geographies with mature ad markets and developed infrastructure, however. According to IDC, The United States, Japan, UK, Germany, France, Australia, Brazil, Canada, and Italy accounted for nearly 60% of total ad spending in 2016, and roughly 2/3 of mobile ad spending. China is the 2nd-largest ad market in the world, but Snapchat remains banned, removing that market from Snap’s addressable total.

We believe that digital advertising, and mobile advertising in particular, will continue to gain share of ad budgets, as advertisers increasingly look to leverage targeting, measurement, and reporting capabilities that are less mature in other media like TV and radio.

Our analysis of population data across North America and Europe (Snap’s primary target geographies) shows nearly 750mn potential users. We leveraged data from Nielsen and eMarketer for smartphone penetration and Facebook’s penetration by age group to further refine the analysis. We assume in an ideal scenario, Snap could match Facebook’s age group penetration and capture 87% of the 12-24 age group, 84% of the 25-44 age group, 71% of the 45-64 group, and 37% of the 65+ group, in the long term. This limitation still results in nearly 500mn potential users for Snap – implying a current user penetration rate of 26% as of 4Q16. We believe Snap can grow its user base across North America and Europe to a combined ~200mn by 2021, which would imply 43% penetration.

Competition

In recent months, several of Facebook’s subsidiaries have launched products that emulate many of the key features of Snapchat. Instagram Stories launched in August 2016, allowing users to capture images and video, edit them and share in exactly the same way they would on Snapchat Stories. Instagram Stories also disappear after 24 hours. Facebook reported on its 4Q16 call that Instagram Stories had scaled to 150mn DAUs by December. In February 2017, WhatsApp provided an app update that enabled the sharing of ephemeral content that would disappear after 24 hours in its WhatsApp Status feature. In March, Facebook Messenger followed suit, introducing Messenger Day, which allows users to post pictures and videos which will be deleted after 24 hours. In addition to Facebook’s various platforms, Snapchat competes for user time and attention with other platforms like YouTube, Line, and WeChat, though the latter two will only impact Snap’s growth in Asian markets, in our view.

We believe competition will continue to be one of the key points of focus for investors. As competitors increasingly focus on replicating Snapchat’s key features, Snap will have to maintain an aggressive pace of innovation in order to maintain a competitive advantage over larger social platforms like Facebook and Instagram. However, there is some data that reinforce the supposition that the slowdown in 3Q16 was temporary. While the company will only report DAUs on the basis of a quarterly average going forward, Snap has disclosed monthly DAUs under the end-month methodology for historical periods. When examined under the end-month methodology, net adds actually increased qoq in 4Q (Exhibit 29), lending credence to the idea that temporary technical issues had more to do with the slowdown than competition. We believe the 1Q17 DAU figure will be critical to determining more conclusively what the impact of increased competition has on Snapchat’s user base, particularly given the additional competitive announcements seen in the quarter.

Cost structure and profitability potentialEdit

We expect gross margins to be positive for the full year 2017, though we see seasonal revenue effects driving negative gross margins in 1Q17. We expect gross margins to expand aggressively as revenue scales, improving nearly 40pp in 2017 to 26%, and reaching 77% in 2021. We believe Snap will break even on a non-GAAP EBITDA basis in 2019, and we expect positive GAAP operating and net income in 2021.

Cost of revenue and gross margins

Snap outsources its infrastructure costs (hosting, storage, compute, memory, etc.) to Google Cloud Platform, having committed $400mn in annual spend for each of the next five years. In addition, Snap is increasing its use of Amazon’s AWS, having committed $1bn in spend over the next five years ($50mn, $125mn, $200mn, $275mn, and $350mn annual minimums, scaling from 2017 through 2021). Most of Snap’s competitors, in contrast, have leveraged capex-heavy models where owned or leased data centers are purpose-built, with higher initial cash outlays, but potentially lower recognized expenses. Given the very low monetization of its users in 2015-16, the associated costs from Google Cloud, and revenue share agreements with content partners, gross margins were negative in 2015 and 2016, though we expect higher monetization in 2017 to drive positive gross margins this year.

Snap’s cost of revenue is largely made up of three components:

  1. Infrastructure costs – these costs represent what Snap Inc pays to third-party, public cloud vendors (primarily Google Cloud, but increasingly AWS). We estimate this accounted for 75% of Cost of Revenue in 2016. These costs are driven by infrastructure needs, and costs will scale with users. Additionally, these costs could fluctuate based on patterns of usage on Snapchat – as users create and consume more video content, and store more Snaps in Memories, infrastructure costs per user would increase, all else being equal. We expect user behavior to shift increasingly toward resource-intensive activities, with increased costs offset by expected price reductions from public cloud vendors. We expect infrastructure costs to represent 64% of cost of revenue (CoR) in 2021.
  2. Partner revenue share – When advertisements are placed on partner content (featured Stories, Publisher Stories, and Discover platform), Snap recognizes revenue differently based on whether Snap or the partner sold the ad. For Partner-sold ads, Snap recognizes the revenue net at 100% contribution margin. If Snap sells an ad placed on partner content, Snap recognizes the revenue gross, and remits the partner’s share to the partner, recognizing it as a cost of revenue. These remittances accounted for 13% of total cost of revenue in 2016, and we expect that to grow to 26% by 2021 as revenue growth (and thus partner share) outpaces CoR growth.
  3. Publisher tools and other – this includes the cost associated with the tools Snap has developed to assist publishers and advertisers in developing content and advertising creative on the platform. It also includes the costs associated with the manufacturing of Spectacles. We estimate these other costs accounted for 12% of CoR in 2016, and we expect that to shrink to 10% in 2021, even as the absolute costs associated with Spectacles and Other increase.

Operating expenses for Snap are largely a function of headcount. The company had 600 employees at the end of 2015, and more than tripled that figure in 2016 to 1,859. We expect the company to continue its rapid pace of hiring for the foreseeable future, though we expect per-head expenses to slowly increase beginning in 2019 as hiring stabilizes and marketing expenses continue to ramp in absolute terms. We expect gross margins to be positive in 2017, adjusted EBITDA margins to turn positive in 2019, and FCF to turn positive in 2020. We do not foresee a need for further funding, as we expect the net proceeds from the IPO to be sufficient for the company to reach positive cash flow. We believe Snap’s long-term adjusted EBITDA margin could reach 30-40% as a mature, fully scaled business.

Valuation and RisksEdit

Our $27, 12-month price target is based on 18X 2018E EV/Sales. On a growth-adjusted basis, SNAP is currently trading roughly in line with peers, Alphabet, Facebook, Twitter, Amazon, and Netflix (Exhibit 38). Our price target implies a slight premium on a growth-adjusted basis, which we believe is warranted given our belief that there is potential upside risk to our near-term fundamental estimates, as well as the sustained hyper-growth that we expect over the next several years.

Snap is a very early stage company with very few (if any) corollaries among prior Internet IPOs. When compared to past IPOs Snap is much earlier in its life cycle than comps such as Facebook and Google were at the time of their respective IPOs. Our estimated $980mn in Snap revenue in 2017 compares to Facebook’s $5bn+ and Google’s $2bn (over $3bn gross revenue).

Additionally, Facebook’s adjusted operating margin was 44% the year it went public, while Google’s was 57%, compared to the negative 68% we expect for Snap this year. Twitter’s financials during its IPO year most closely resemble Snap’s, as Twitter’s revenue was $665mn with negative 3% operating margins (Exhibits 36 & 37).

We believe there are material risks to our estimates, price target, and rating.

Upside risks include:

  • Improving DAU growth – an important investor concern is the competitive landscape and whether Snapchat will be able to accelerate DAU net adds in 2017. If Snapchat is able to accelerate its pace of net adds in 2017, we believe it would do much to mitigate that investor concern, leading to improved sentiment around the name and potential multiple expansion, in addition to the direct impact it would have on fundamentals.
  • Outperformance on monetization – our model is highly sensitive to ARPU, given the large user base. Should Snap improve its monetization at a faster pace than we anticipate, it could reach scale and profitability sooner than we predict.
  • Innovation – Snap has a strong history of feature and product innovation, as well as a history of quick pivoting away from features that were negatively viewed by users (such as the lens store). If Snap is able to accelerate its pace of innovation and introduce new features and products that are well received by users, or introduce new ad types that are well received by advertisers, we would expect user growth, engagement, and monetization to improve.

Downside risks include:

  • Competition – Snap competes primarily with Facebook and Google, including Facebook’s Instagram, Messenger, and WhatsApp platforms, and Google’s YouTube platform. All of Facebook’s major platforms have introduced replicas of Snap’s key ephemeral content feature, as well as Stories clones. Competition will probably not draw many current users away from Snapchat entirely in our view, but could negatively impact engagement which could cause a decline in DAUs. Increased competition will also make it more difficult for Snap to attract incremental new users to the platform.
  • Highly sensitive model and volatility – our financial projections are very sensitive to several metrics, including ARPU, DAUs, and CoRPU. The DAU metric, is itself a very sensitive measurement, given that user behavior and seasonality could cause material swings, as discussed on page 10. If the company underperforms on any one of these metrics in a given quarter, it could materially impact revenue and profitability. Given that management does not plan to provide any guidance on financial metrics or user metrics such as DAUs or ARPU, we see added sensitivity to reported figures, and potential for a wide range of estimates included in consensus.
  • Execution risk – Snap’s executive team does not include any individuals with prior C-level experience at public companies. Additionally, the company has a short operating history, and plans to rapidly scale its operations and workforce. Less than 1/3 of the workforce has been with the company for a year or more, and we expect new hires (tenure less than 12 months) to make up the majority of the workforce through at least 2018. We see material risk to execution as the company expands internationally, and ramps up its sales force and engineering efforts.

ActionsEdit

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