Some quick numbers:
2016 Revenue: $515M (up about 6x year over year due to artificially restricted advertising revenue prior to 2016)
2016 Expenses: $919M
2016 Operating Loss: $404M
To justify a $20B valuation, the market is suggesting that, at some point in the future, Snap would need to generate financials that look something like this (assuming no discount for risk/time):
Revenue: $10B
Operating margin: 20%
Operating profit: $2B
P/E multiple: 10x
Growing revenues and profits by about 10% / year each
I don’t see any way Snap’s current business can achieve these numbers. Revenue needs to grow 20x, and margins must expand dramatically. I won’t dive into cost structure in this blog post, but let’s think through how Snap could grow revenue 20x.
Snap’s revenue is a function of two numbers: number of users, and average revenue per user (ARPU). In order to achieve 20x growth, Snap needs grow both of those metrics 4–5x. Let’s look at each figure.
User Growth
Snap’s user growth came to a near stop after Instagram launched a direct clone called Stories in September of 2016:
Snap’s daily active users grew just 3% in Q4 2016. At its current growth rate, it will take Snap 47 quarters = 141 months = 11.75 years to grow its user base 4x. It’s possible that growth could accelerate in the future, but given the law of large numbers and fierce and unrelenting competition from Facebook — read this excellent anecdote from a Snapchat influencer — this seems unlikely. Snap’s first earnings report as a public company will be telling. User growth will be, by far, the most watched number.
ARPU
Next let’s look at Snap’s ARPU growth. See the gray line in the chart below from Stratechery. ARPU is the grey line plotted on the right-hand axis.
ARPU, the grey line, is growing quickly. By looking at this graph, one can see how ARPU could grow 4–5x in the next few years, maybe more.
However, there is some fundamental limits at play that’s not visible in that line. ARPU is a function of time spent in the app. The more time people spend in Snapchat, the more ads Snap can show them. This is significant because there’s a fundamental maximum ARPU since Snap is competing for a fixed pool of time. People still have to eat, work, etc. so there’s a natural limit to ARPU.
This begs the question: how much time do users spend in Snapchat today compared to other social networks, and how will that number change over time?
Facebook just reported that users spend on average 50 minutes per day (United States only) across the Facebook apps — Facebook, Instagram, Messenger, and WhatsApp — and that this number is growing. It’s up from 40 minutes in July 2014. However, it’s premature to suggest that Snapchat will follow a similar usage model. Even by July 2014, Facebook’s core application had effectively saturated the US market, with more than 80% of US adults on Facebook. It’s seems very likely that the growth in time spent in app per user was driven not by the early majority, but by the late majority and laggards (see below chart below from the famous book Crossing the Chasm about how to think about which customers are adopting a given product).
Facebook doesn’t breakout usage by time-driven cohort, but intuitively, this makes sense. Among my millennial peers, I don’t think usage has grown by 50% in the last few years. But I can certainly see that Facebook usage has indeed grown among my mother’s and grandmother’s peers. 2 years ago my grandmother didn’t have Facebook. Now she’s on it every day!
Moreover, Facebook’s reported daily engagement numbers include Instagram. Had Facebook not purchased Instagram, Facebook’s aggregate numbers likely would have dipped as millennials have largely abandoned Facebook for Instagram and Snapchat. So there’s real risk to Snap that the innovators and early adopters may not maintain their engagement in the future.
My point is this: as Snap grows its user base, it’s unlikely that the early and late majorities will spend as much time in the app as the innovators and early adopters. That means it’s likely that Snap’s average time spent in app per user is likely to decrease, which will be a significant strain on Snap’s total ARPU. Facebook was able to buck this trend, but that’s because Facebook purchased Instagram. Snap has no guarantee that its users won’t migrate elsewhere, or that it’ll be able to purchase its analogous Instagram. As Snap grows, they’re likely to find that the next 150M users simply will not use the app as much as the first 150M users.
In summary: Snap’s current business doesn’t justify a $20B valuation. Snap’s user growth has nearly stopped, and although ARPU is growing at a healthy rate, there are very real risks that could slow or stop ARPU growth. And to top it all off, Snap isn’t offering voting rights to public market investors, which should discount the stock price further.
How can one justify a $20B valuation for Snap?
Innovation at Snap
Directly from Snap’s S-1:
“We invest heavily in future product innovation and take risks to try to improve our camera platform and drive long-term user engagement. Sometimes this means sacrificing short-term engagement to introduce products, like Stories, that might change the way people use Snapchat. Additionally, our products often use new technologies and require people to change their behavior, such as using a camera to talk with their friends. This means that our products take a lot of time and money to develop, and might have slow adoption rates. While not all of our investments will pay off in the long run, we are willing to take these risks in an attempt to create the best and most differentiated products in the market.”
Snap has introduced a panoply of well-regarded features over the years: stories, face and location filters, memories, discovery channels, etc. Their track record in product innovation has been superb:
All of these features have been designed to drive engagement in the current line of business, which ultimately exists to increase time-spent-in-app, which drives ARPU, which has natural limits as discussed above. These innovations have been great, but within the confines of the current business line, Snap is going to push up against natural ceilings that will ultimately suffocate growth.
Snap is asking investors to bet on its ability to innovate its way into revenue. The product that could most likely justify Snap’s $20B valuation is Spectacles.
These are exactly what you think they are — sunglasses with a camera that automatically upload to Snapchat by connecting to your phone via Bluetooth. That’s it. The functionality is intentionally limited.
The Massive Market Opportunity For Spectacles
Apple CEO Tim Cook recently told the media:
“I regard [augmented reality] as a big idea like the smartphone. The smartphone is for everyone, we don’t have to think the iPhone is about a certain demographic, or country or vertical market: it’s for everyone. I think AR is that big, it’s huge. I get excited because of the things that could be done that could improve a lot of lives.”
Global smartphone revenue is about $420B. The CEO of Apple is suggesting that the opportunity in AR is on the order of $400B. Many tech pundits think the market opportunity in AR could be even larger than that.
What’s The End State For Augmented Reality?
The end-state for desktop computing was achieved in the early 1900s: a folding laptop with a screen, keyboard, and trackpad that control files and applications using a virtual desktop metaphor. The end state for smartphones is a multi-touch piece of glass with a grid of icons and a rich notification system.
The likely end state of augmented reality, in raw hardware functional terms, is conceptually simple: a set of glasses or contact lenses that can render any virtual 2-d or 3d object or text in 3-dimensional space, with or without physics that interact with physical or virtual objects. If you were wearing legit augmented reality glasses, you should be able to blend the virtual and physicals worlds seamlessly… or not if you wanted to “break” the laws of physics J.
But we’re a long way away from this dream. Although the rendering engines and computer vision are rather mature, we’re still years away in terms of packaging all of this in a sleek glasses-like form factor. The primarily bottlenecks are battery and heat dispersion (CPU/GPU can be offloaded to the cloud, and 5G should be fast enough for real-time, cloud-driven computer vision).
To be clear, I can’t forecast the details of how an augmented reality OS should work. How should Google search results appear, how should you navigate them, or how should you read a CNN article versus a Kindle book? I don’t know. But I can say with confidence that the augmented reality OS of the future will have to incorporate everything outlined above as those are some of the key experiences that are unique to augmented reality glasses.
The details of how an augmented reality OS should work are incredibly complex — far more than desktop or mobile computing. With an effectively infinitely large canvas and almost no restrictions, there are far more ways to deliver a crappy user experience. This actually works in Snap’s favor. I’ll touch on this more in a bit.
Snap’s Path To AR Dominance
Controlling the underlying OS will be paramount to capture value. As users look around and interact with the world, the OS vendor will dictate the rules in which applications and cloud services can interact with the real world and the user.
To capture any material part of the $400B that Cook is forecasting, Snap will need to control the underlying operating system on which the glasses function. There are two ways Snap can do this: manufacture their own glasses and bundle their own operating system- a la Apple — or offer an OS to other manufacturers — a la Microsoft and Google. They could in time transition from one model to the other; just because they’re manufacturing their own hardware today doesn’t mean they have to in the future.
In short, Snap faces an extremely tough battle in which they are both under resourced and in which they must catch up on many fronts. But they may have one strategic, “ladder-up”, path that could allow them to vault past the competition.
Apple is obviously working on augmented reality in earnest per Cook’s comments. It’s been widely reported that Apple has had hundreds of engineers working on AR and VR for some time.
Google obviously is as well with the recent launch of Daydream VR. Google also likely has the best computer vision experts, datasets, and algorithms on the planet.
Microsoft has been working on this for about a decade. The first real implementation is the Hololens.
The same can be said of Facebook and its acquisition of Oculus, along with its recent full-frontal assault against Snapchat AR filters and lenses. And again, Facebook has extensive image and computer vision data and expertise.
These companies will invest 10–100x the resources that Snap has to commercialize augmented reality in pursuit of hundreds of billions of dollars of revenue.
Snap is not only out-resourced, but they must also play catch up. Although they’ll likely fork Android, which is open source, for basic OS components, Snap doesn’t have anywhere near the level of cloud services footprint that Apple, Google, Microsoft, and Facebook do. Snap will need to build foundational cloud service APIs that tech giants have been building for 5–10 years such as maps, identity, authentication, etc.
Snap’s Ladder Up Strategy
But Snap does have one major asset that the giants lack: a more clear ladder-up strategy to get there. What is a ladder-up strategy? From Stratechery:
“Netflix started by using content that was freely available (DVDs) to offer a benefit — no due dates and a massive selection — that was orthogonal to the established incumbent (Blockbuster). This built up Netflix’s user base, brand recognition, and pocketbook
Netflix then leveraged their user base and pocketbook to acquire streaming rights in the service of a model that was, again, orthogonal to incumbents (linear television networks). This expanded Netflix’s user base, transformed their brand, and continued to increase their buying power
With an increasingly high-profile brand, large user base, and ever deeper pockets, Netflix moved into original programming that was orthogonal to traditional programming buyers: creators had full control and a guarantee that they could create entire seasons at a time
Each of these intermediary steps was a necessary prerequisite to everything that followed, culminating in yesterday’s announcement: Netflix can credibly offer a service worth paying for in any country on Earth, thanks to all of the IP it itself owns. This is how a company accomplishes what, at the beginning, may seem impossible: a series of steps from here to there that build on each other. Moreover, it is not only an impressive accomplishment, it is also a powerful moat; whoever wishes to follow has to follow the same time-consuming process.”
Amazon has pursued a similar strategy as they built out the Everything Store, and AWS.
Amazon started off by selling just books because books were easily shippable, easy to search for, and because shipping was slow and readers would be ok with slow delivery of books vs other goods. The next categories were CDs, DVDs, VHS, and video games because they fit the same general criteria. As Amazon built its logistical and server infrastructure, it systematically moved into one new vertical at a time: shoes, kitchen appliances, etc.
By the early 2000s, Amazon had built such a massive server capacity for the holiday season that they had massively under-utilized server assets for 85% of the year. So they began selling that excess server space in the form of Amazon Web Services, which is today far more profitable than Amazon’s retail operations although AWS is about 13 years younger than Amazon’s retail business.
It would have been impossible for Amazon to launch as the Everything Store on day 1. And it would have never made sense to build out a data center as large as Amazon’s just to rent out server space back in the early 2000s. Amazon has continually laddered up.
Back to Snap. Snap knows it’s under resourced, and materially behind its competition in raw technological development. But Spectacles could offer the unique ladder-up strategy that could help it control the augmented reality glasses market.
There are a few steps between Spectacles and the end-state of AR. It makes sense that these will progress through the lens that Snap CEO Evan Spiegel has described: as a camera company.
2016/2017 Spectacles — capture video on the glasses. Manipulate, share from the phone.
Another layer — add a transparent screen that just layers Snapchat-like geo and face filters (possibly other broader “life” filters) into Spectacles. Move some basic image/video manipulation functions from the phone to the glasses.
Another layer — hand detection / finger control / ring control for more rich interactions with filters.
Another layer — full blown general purpose computer vision in which you can manipulate and interact with any digital object in a physical world.
The layers I’ve described are vague, but give you a sense for how the product could evolve. However Spectacles end up evolving, they’re likely to be extremely camera focused. Spiegel has repeatedly described Snap first as a camera company, not as an ephemeral social network.
It’s likely that in the early days, glasses will be inferior to smartphones for most computing tasks that smartphones currently perform: reading, messaging, capturing images/videos, sharing content. It’s very clear that Spectacles today are just focused on the latter 2 jobs.
Similarly, although the iPhone was a general purpose computing device, it launched as just a really nice phone. Apple could never have forecasted how people would use apps like Instagram, Uber, Flipboard, or any of the myriad games. They key was getting the general model for touch and mobile computing in front of people, and iterating from there and unlocking more value over time through software and hardware tweaks. Spectacles are taking the same evolutionary approach. Get the product out there with a very specific use case — capturing and sharing videos — and iterating from there.
This is problem that the other tech giants have. Apple needs to find 1–2 super compelling use cases to drive people to purchase their glasses. Perhaps that use case is capturing images/videos and sharing them on any social network other than Snapchat. Recall that this was one of a few things Google really emphasized with Google Glass. And that’s exactly Snap’s opportunity — people share many more images/videos on Snapchat than any other social network due to the fundamental nature of the app (camera first, not text first, ephemeral) and network.
Google Glass faced exactly this problem. Although the device was broadly capable, it wasn’t excellent at anything, and because it looked strange, consumers never wore it. Snapchat really understands the image/video capture use case better than anyone, and will optimize smart glasses around that first, and then add general purpose compute later. I spent a long time thinking about consumer applications for Google Glass, and watched hundreds of people try on Glass for the first time. By far, the most compelling use case for most people was frictionless image capture. Snap has a massive lead on this front, and will likely double and triple down on it to pioneer the smart glasses revolution.
$SNAP, The Call Option On Spectacles
If Snap nails Spectacles and can control the augmented reality OS for a significant fraction of the market, $20B will be a bargain. But if it can’t, it’s going to take Snap a long time to the achieve financial performance necessary to sustain a $20B+ valuation.
In the interim, the most important number to watch is user growth. If user growth doesn’t re-accelerate, it seems extremely unlikely that Snap will ever grow its audience to be large enough to justify its current valuation.
