Did the Snapchat IPO narrative just get scarier following Snap Inc's pre-IPO roadshow?

Snap Inc, the company that owns the popular ephemeral messaging service Snapchat, has occupied centerstage lately as the company seems headed for what could be one of the biggest tech IPOs of our times. And as you'd expect, with Snap Inc's management team meeting the investor community in New York, more information is coming under the scanner. While Snapchat's growing success over the years has made the Snapchat IPO as interesting as it has become, there's still much debate about whether you should buy into the IPO at all. Fresh news has emerged since our previous coverage of the Snap Inc IPO, which evaluated Snap stock following its toned down valuations. And now the question is, did the narrative just get scarier? Let's find out.

What's hurting Snapchat's user growth?

Well, there are at least two different theories, and there's no easy way to tell which of the two is scarier. First, let's look at the one that's probably being spoken about much more - the one that attributes the decline in user growth to Facebook's (Nasdaq:FB) Instagram. Instagram, the popular photo sharing app, got its very own version of the "Snapchatty" Stories feature in August last year. For all practical purposes, Instagram basically copied the concept, name included, from Snapchat. And, at least partly by virtue of its significantly larger user base, Instagram turned the feature into a roaring success on its platform. So much so, that its engagement numbers dwarf those of Snapchat's.

Very recently, Facebook CEO Mark Zuckerberg announced that Instagram had taken its Daily Active User (DAU) tally to 400 million. That compares with Snapchat's significantly smaller DAU base of 158 million. Clearly, Instagram, with its much larger user base, was in a better position to promote the Stories feature, and that's exactly what it did, apparently. As per recent estimates, about 150 million DAUs on Instagram used its adapted 'Stories' feature, which compares with Snapchat's tally of ~40 million DAUs. And possibly because the launch of Stories on Instagram coincides with the decline in user growth on Snapchat, observers like Josh Costine of TechCrunch, have opined that "Instagram Stories is stealing Snapchat’s users". Well, he's not alone. A lot of prominent voices seem to concur with Costine's opinion. Besides, it's not the least bit surprising or hard to believe.

Coming to the other theory that we were talking about - it's the one that Snap Inc's management offered in response to questions pertaining to slowing user growth. Reportedly, Snapchat blamed its Android app for the decline in user addition, and frankly, that's pretty scary:

"When asked about a slowdown in new users on its Snapchat photo-sharing mobile app in the fourth quarter, the company blamed a product issue with its Android version, according to investors who attended the company’s initial public offering roadshow presentation Tuesday in New York."

There are two parts to why this is a little disconcerting. The first is well explained by an analyst who attended the event:

“Pointing to problems with Android is not addressing the elephant in the room, which is Instagram,” said Sean Stiefel, a portfolio manager at Navy Capital, who attended the presentation. “They sort of danced around the issues with user growth.”

Secondly, that's not the kind of explanation you want to hear from a company that has set itself the ambitious target of going public via the biggest tech IPO in many years. It's not the kind of excuse you want to be making if you're gunning for a valuation in excess of $20 billion. More so because that's Snap Inc's primary business - running an app. And if it can't do that as well as it should, a prospective investor might find that unnerving. It's not something businesses can afford to do in this day and age,  much less social media businesses that rely so heavily on user acquisition, experience, and the network effect.

Facebook is mounting even more pressure on Snapchat.

Further, the explanation only holds for the fourth quarter, suggesting that the 7% sequential growth in Q3 wasn't because of any such glitches. So, is 7% the kind of DAU expansion investors should expect after buying a stock that's valued at 47 times trailing twelve months sales? Besides, the fact that this growth rate declined from as high as 17% during the first half of the year brings us back to the growing concern around competition from the likes of Instagram. And as it appears, Facebook won't cut Snapchat any slack. The social media giant is now set to launch its latest salvo via WhatsApp, introducing a 'Stories' like feature on the messaging platform. In fact, Facebook has also reportedly been testing a 'direct' private messaging equivalent of the same on its core app, which allows users to send photos and videos straight from the camera interface. And again, like in Snapchat, these photos and videos can be viewed twice before they vanish forever.

The good part for Snapchat is that reportedly, the company is closing in on a big advertising deal, worth about $200 million. And Snapchat needs many such deals to bump up its revenue per user, to offset the close ties between its revenue and cost of revenue. With its current business model, growing engagement, which translates to higher revenue, also means growing payouts to partners like Google Cloud and Amazon. Quoting from a post on Fortune:

"Chief Strategy Officer Imran Khan asked investors to gauge how much users engaged by looking at Snap's cost of revenue. Traditionally, investors focus on metrics such as daily active users or minutes spent on the app. Snap's cost of revenue is primarily driven by how much the company has to pay to partners such as Alphabet's Google and Amazon.com to support data and bandwidth. This is based on how often users engage with the app and the types of features they use."

Be that as it may, not everybody seems entirely convinced after Snapchat's roadshow:

'There was so much hubris there it scared me away... This felt like the late technology bubble roadshows,' one of the investors said, referring to the IPO bonanza of the dot-com boom in 2000.

One other positive for Snap Inc is that reportedly, the company has started selling its "Spectacles" online for $130 a piece. What that does well is to de-link Snap Inc's revenue to some extent from its cost of revenue. What Snapchat has going for it is stellar top-line growth, and if the company is to grow into its mammoth valuations, it'll need a lot of those big ad deals, and hardware sales to bump up its revenue per user. For now, the Snapchat IPO looks fraught with risks, making it a very high risk reward bet. As things stand, it seems that Facebook could gain the most from the Snapchat IPO, with a little bit in it for Twitter as well.