Snapchat aimes for the sky, promises little in $3 billion IPO pitch

Snapchat owner Snap Inc shot the opening salvo in its $3 billion initial public offering on Thursday, outlining aggressive expansion plans but offering new investors no say on how the company is run and no promise of profits.

Snap's publication on Thursday of its IPO registration document sets the stage for its upcoming marketing campaign to convince investors to look past its widening losses and the firm grip of its founders, and focus on its rapid growth of active users.

The number of Snap's daily active users grew to an average of 158 million at the end of December, up 48 percent year-on-year, Snap revealed. However, its net loss widened to $514.6 million in 2016 from $372.9 million the year before.

While Snap will have time to polish its marketing pitch in the run-up to the IPO planned for March, some analysts were taken aback that the company was just beginning to reap cash from its product.

"What surprises me the most is that it is still very early days when it comes to Snap making money," said Rohit Kulkarni, managing director at private securities investment firm SharesPost.

Snap had confidentially registered with the U.S. Securities and Exchange Commission for an IPO late last year. It kept the filing under such tight wraps, even some of its IPO underwriters had not seen it prior to publication on Thursday, sources familiar with the matter previously told Reuters.

Snap said in the IPO registration document published on Thursday it would become the first U.S. company to go public with shares on offer not granting voting rights to stock market investors. Its founders, Evan Spiegel and Robert Murphy, will keep control of the company.

Snap could be valued at between $20 billion to $25 billion, according to sources familiar with the situation who asked not to be named because the matter is confidential. That would give the company the richest valuation in a U.S. technology IPO since Facebook Inc.

Snap, which launched itself in 2012 with an app that sends disappearing messages, rebranded itself last year as a camera company and started selling $130 video camera glasses. It generates the majority of its revenue from advertising, seeking to challenge the dominance of internet giants such as Facebook and Alphabet Inc's Google.

"The industry has been crying out for new advertising units" says Ian Schafer, founder and chairman of ad agency Deep Focus, referring to the tight hold Facebook and Google have on the digital advertising marketplace.

In its IPO registration document, Snap cited Apple Inc, Google, Twitter Inc, Facebook and its photo-sharing platform Instagram as its competitors.

Tight control

Spiegel, the 26-year-old Snap co-founder, last year earned $503,205 in salary, with a $1 million bonus. Imran Khan, Snapchat's chief strategy officer whom it hired from investment bank Credit Suisse Group AG in 2014, earned $241,539 last year with a $5.2 million bonus. In 2015, Khan also received $145.3 million worth of Snap shares as a sign-up bonus.

Spiegel and Murphy will maintain tight control over Snap's stock through a unique three-share class structure. The structure will give Spiegel and Murphy the right of 10 votes for every share. Existing investors will have one vote for each of their shares, while new investors will have no voting rights.

Snap said it couldn't predict if the structure would "result in a lower trading price or greater fluctuations" in the stock.

Keeping tight control is common in companies closely associated with their founders, who often prefer to grow their business without being questioned by a broad array of investors. Still, offering a class of stock with no votes in an IPO is unprecedented.

Though the structure has drawn some criticism for not giving stock market investors the opportunity to have input, some people close to the company have argued that investors can "vote with their feet" by not buying into the IPO if they are not comfortable with the arrangements.

"Investors have to decide, am I going to avail myself of the opportunity to buy the stock, and forget about the fact that somewhere down the road they are likely going to run into trouble?" said James McRitchie, an independent corporate governance activist who has pressed for more equal voting rights at companies including Facebook.

Paying Google

Snap had $404.5 million in sales in 2016, up from $58.7 million in 2015. However, it had adjusted losses before interest, tax, depreciation and amortization last year of $459 million, compared with $292.9 million in 2015.

Snap's biggest losses stem from "hosting fees" which it pays to cloud computing companies such as Google to use their infrastructure for its data. It will pay Google $2 billion over the next five years to use its cloud computing services.

Because Snapchat users rely heavily on data-heavy pictures and video, the cost of these service is high. Still, the proportion of the company's costs to its revenue has been declining. Its strategy has been to bargain for better hosting rates as its growing number of users buoys its negotiating leverage.

"They are adding infrastructure ahead of growth, and that is why you have some front-loading of losses," said SharesPost's Kulkarni.

Some companies such as Facebook have their own hosting platforms, though this model can be more costly.

Facebook's Instagram, which recently introduced disappearing video content similar to Snapchat, had 600 million users as of late last year. Like Snapchat, Instagram sells advertising on its platform.

Snap's aggressive expansion is reflected in its staff numbers. By the end of last year, it had increased its number of employees to 1,859 from 600 in 2015.

Snap said it would use the proceeds from its IPO for general purposes, including working capital, operating expenses and capital expenditures.

Snap said it will list on the New York Stock Exchange under the ticker SNAP. Morgan Stanley, Goldman Sachs Group Inc, JPMorgan Chase & Co and Deutsche Bank AG are leading the offering as underwriters.

Revenue problem

Snapchat’s initial public offering filing seemed to show a company with a basic math problem: the company's cost of revenue for 2016 - the amount it had to spend just to keep the messaging service running - was $47 million higher than its $405 million in sales.

The high cost of revenue, which in Snap's case consists mainly of payments to Alphabet Inc's Google for hosting the service, means that, on an annual basis, Snap lost money on every one of its 158 million users in 2016, even before accounting for salaries, office rents or anything else.

But the cost side of the problem may not be as serious as it seems. The company's hosting costs are broadly in line with other social media companies. Its cost of revenue per active daily user was 97 cents in the last quarter of 2016, not much higher than the 85 cents that Facebook Inc paid for each of its 1.23 billion daily users in the final quarter of 2016.

Further, while Snap’s cost of revenue was higher than sales on a yearly basis in 2016, the company drastically tightened up hosting costs over the course of the year. While costs were nearly double revenues at the start of the year, by the fourth quarter, when Snap hit 158 million users, the company eked out a small gross margin.

Snap’s bigger math problem is how much revenue it generates per user. The $1.05 per user for the last quarter of 2016 was a massive increase from the 31 cents per user it drew in the same period in 2015. In its IPO filing, Snap said it hopes to increase its revenue per user by focusing on more lucrative advertising markets, like North America, where its revenue per user was $2.15 at the end of 2016, nearly double the global rate.

But even those higher rates for Snap pale in comparison to the $7.16 in revenue per user that Facebook brought in in the fourth quarter.

“Snap’s issue is not cost, but user growth and revenue per user,” said Ethan Kurzweil, a venture investor with Bessemer Venture Partners who backed startups such as Twitch and Periscope but has not backed Snap. “If they can get revenue per user into the kind of territory they think is possible, the cost of hosting will be a hit to gross margin but it’s not going to be an issue.”

Facebook provides the example. Even though its cost per user rose 7.4 percent between the last quarter of 2016 versus a year earlier, its revenue per user grew at a much faster 27.5 percent, a difference that helped drive its $10.2 billion in profits for the full year.

All of that does, however, mean that Snap has little leeway in delivering dramatic revenue growth in light of the high underlying cost of delivering all those pictures and videos.

The cost of revenue figure, noted analyst Brian Wieser at Pivotal Group, "was notable for what it indicates about the expense of running Snap."