Tech

Shira Ovide is a Bloomberg Gadfly columnist covering technology. She previously was a reporter for the Wall Street Journal.

Earlier this week, I commended Snapchat for bucking Silicon Valley convention and going public at a relatively young age, while other high-profile startups such as Uber do everything possible to avoid IPOs. 

After seeing parent company Snap Inc.'s financials and its strategy, I have changed my mind.

Snapchat would have been better off staying in the lush forest of magical startup unicorns, at least for a bit more seasoning. 

It's not that Snapchat won't be a successful and lasting public company. Snapchat genuinely has created a clever new way for people to document their lives and communicate with each other, and it has turned typically fickle teens and twenty-somethings into rabid Snapchat chat addicts. The company quickly grew adept at making money from marketers attracted by its youth movement and wowed by its novel ads.

Bridging the Gap
Just before its IPO, Facebook was generating about $3.20 in revenue for each of its users in North America. Snapchat's relatively young business has quickly gotten to about two-thirds of Facebook's 2011 figure
Sources: Facebook filings for 4Q 2011. Snapchat's financial disclosure for 4Q 2016.
Note: Facebook figure incorporates the U.S. and Canada. Snapchat figures include those countries, plus Mexico and the Caribbean.

The issue is Snapchat is going public with serious, unanswerable questions about its business. The company's financial model requires a leap of faith, and it has an unproven strategy to concentrate on a smaller audience than the typical highly valued internet company. That puts pressure on Snapchat to professionalize and grow its digital advertising business fast to compensate for its weaknesses.

And because Snapchat is going public relatively young, investors are bearing the risks -- and the potential reward -- of Snapchat figuring all this out. Investors' margin for error is slim, too: Snapchat has the valuation of a company that has figured all this out, and then some. 

Not Cheap
Snapchat's revenue multiple at its IPO could be higher than other tech companies at the point they went public
Source: Bloomberg Intelligence
Note: Uses potential Snapchat IPO market value of $25 billion and estimated 2017 revenue of up to $1 billion.

Snapchat's biggest selling point, and its biggest risk, is its number of users is not likely to grow very big, by internet standards. It had 161 million daily users in December, and the growth rate has slowed way down. (Facebook averaged 1.23 billion daily users in December.) Snapchat has made it quite clear it's not shooting for anything close to Facebook's size.

Instead it has opted -- or rationalized its reality -- to stick to a small number of places where it is popular already, has the biggest pots of advertising dollars to attack, and can afford to keep running without breaking the bank on computer costs. About 43 percent of Snapchat’s users are in North America and the Caribbean. That’s good, because the U.S. is the world’s biggest market for advertising. That is also not good.

We have never seen a big public internet company go for niche rather than mass. Most other advertising-supported internet companies in the zone of Snapchat's market value or larger -- Twitter, Facebook, Google, Yahoo -- are global and trying to get bigger. There's business logic behind that: Advertising revenue for internet hangouts is a function of number of users, how much time they spend and advertising prices.

If Snapchat’s user numbers aren't big, then the company has to maximize ad prices and make sure people who use Snapchat keep using it more and more, so the company can have more openings to sell ads. None of that is a layup. 

Snapchat's financial structure puts it especially under the gun to boost advertising sales quickly. For each dollar in revenue in the fourth quarter, Snapchat’s cost of revenue was 93 cents, on average -- the biggest share of which was payments (presumably to Google) for computing costs to store and send every snap and story posted by its users. 

In comparison, Zynga Inc. -- another internet company whose operating costs were tied to its computing needs -- reported cost of revenue of only 27 percent in the nine months before its IPO.

Other big internet hangouts handle computing chores on their own networks, and therefore bear the expense in capital spending, not operating expenses. But even on the basis of free cash flow -- which incorporates capital spending costs, and makes Snapchat comparable to internet peers -- Snapchat's figure in the latest quarter was negative $188 million. Revenue was $166 million. 

Cash Fire
On the basis of free cash flow, Snapchat is far more in the red than other internet companies were just before they went public
Source: Company filings
Note: Figure for Snapchat is for the three months ended Dec. 31. Zynga and Twitter figures are for the nine month period prior to their IPOs. Facebook figure is for the quarter before its IPO.

The financial leverage could turn to Snapchat's favor eventually, as it won’t bear the burden of its computing networks. But the structure requires extra work for IPO investors, who will have to assess how much Snapchat’s expenses scale with its growth, and at what point the company gets right-side up on costs.

The shock is Snapchat opted to go public before it's really able to show early signs that its strategy of a concentrated audience and its margin-crushing financial setup will work out for the best. It's a throwback to a pre-Facebook technology era, when companies went public on promise, not on financial reality. 

That does mean regular-Joe public stock investors, who missed a lot of the upside in Facebook's ride to a $375 billion market cap, are getting in for the "promise" part of Snapchat's ride -- for better or for worse.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Shira Ovide in New York at sovide@bloomberg.net

To contact the editor responsible for this story:
Mark Gongloff at mgongloff1@bloomberg.net