Snapchat: From Social Media Darling to Market Struggles

Introduction

With 330 million people using it on a daily basis, Snapchat is one of the most successful social media companies of our time. They were a huge pandemic beneficiary as people turned to the image sharing app to connect with their friends and family remotely. At its peak last year, the company was valued at 140 billion dollars, giving founder and CEO Evan Spiegel a net worth in excess of 20 billion dollars.

It looked like Snapchat was taking over the world. They were hiring thousands of new engineers and continuously upgraded their app and made new innovations like their augmented reality spectacles. Of course, building all these new innovations isn’t cheap, and the company was burning hundreds of millions of dollars per year in net losses. But when you’re on a mission to change the world, losing a few billion dollars in the journey is a small price to pay, at least that’s what investors thought last September when they bid the company’s stock price up to a 140 billion dollar valuation.

But of course, all good things must come to an end. On Tuesday May 24th, Snapchat released the regulatory filing. The purpose of the filing was to warn investors that their revenue and profitability was rapidly deteriorating and that they expected to miss the current quarter guidance that they issued just four weeks prior. The next day, the stock price fell by 40%, the largest single day decline in the company’s history. This brings their losses as the all-time high to more than 80 percent.

Today, just about every one of the company’s investors has lost money. If you bought shares at their IPO all the way back in 2017, you would have lost half of your investment. So what’s going on? With over 300 million users, Snapchat has become such a socially important platform, especially among the younger generation. How could they experience such a rapid and dramatic fall from grace?

Snapchat early days

SnapChat was founded in 2011 by Stanford students Evan Spiegel and Bobby Murphy. There was also a third co-founder called Reggie Brown, but we’ll get more into his role later. The idea of the app was to send pictures to your friends where the picture would be deleted after 10 seconds.

This would reduce the user’s inhibitions. You don’t really care how you look or what you’re doing in the picture because it will only be seen by your close friends and deleted after a very short period of time.

They launched it in 2011 and it instantly went viral. Young people love this interactive form of communicating with their friends and just one year after its launch, it crossed a 1 million daily active users mark. Recognizing the tremendous opportunity, Spiegel dropped out of Stanford to focus on a startup full-time.

They raised hundreds of millions of dollars from Venture capitalists to buy a bunch of houses in Venice Beach, California, which they use as their corporate offices. Instead of working in cubicles or cramped office spaces, Snapchat’s early employees get creative inspiration by watching the sea lions on California coastlines.

Evan Spiegel became chief executive officer while fellow co-founder Bobby Murphy became the company’s Chief technologist. As Founders, they gave themselves 60 and 40 ownership respectively. While the app’s popularity was skyrocketing, it wouldn’t be all smooth sailing for Spiegel and Murphy.

Reggie Brown controversy

Remember, there was a third co-founder called Reggie Brown. According to Brown, him, Spiegel, and Murphy were all classmates at Stanford and even members of the same fraternity. Brown initially came up with the idea of an app to send self-deleting photos. Spiegel thought the idea was brilliant and they decided to make a company out of it.

But neither of them had the computer science expertise to make an app, so they went to their fellow frat bro Bobby Murphy, who was majoring in computer science, to fulfill this role.

According to the Business Insider reports, Spiegel was skeptical about Brown’s technical capabilities to contribute to the app but let him tag along in the very early days because Reggie was a friend. He didn’t want to make him feel bad. However, he and Bobby Murphy eventually sidelined Reggie.

They kicked him out of the startup and did not give him any Equity stake. Spiegel claimed that Brown worked with them only in capacity as an unpaid intern and was not a co-founder. Any contributions that he made were supposedly minimal.

This is kind of a weird Arrangement. Why would you work with your classmates as an unpaid intern for an idea that you yourself came up with? Once Snapchat became successful, Reggie sued to get what he viewed as his fair share. His two former friends initially said the lawsuit had no merit and Reggie was not responsible for building the company. However, Reggie Brown was able to produce damning evidence.

In 2011, Spiegel sent an email saying “I just built an app with two friends of mine. They are certified Bros. Our frat just got kicked off of Campus.” He was apparently referring to his fraternity Brothers Bobby Murphy and Reggie Brown.

It’s impossible to know exactly what happened in Stanford 11 years ago, but it appears that Reggie’s case did have some Merit. Snapchat eventually settled with him out of court, paying Reggie 157 million dollars and finally admitting that he contributed to the founding of the company.

Rapid growth and IPO

Now that this legal trouble was out of the way, Spiegel and Murphy could focus all their attention on growing Snapchat into a dominant social media platform. They came up with new innovations such as the countless filters that you could use to make crazy pictures and videos of yourself. This became extremely popular with middle school and high school age kids. Their daily active users continued to soar, reaching 166 Million by the end of 2017. Not bad for a company less than six years old.

In 2017, they IPO’d on the New York Stock Exchange to Great fanfare. The IPO was 12 times oversubscribed, meaning that there was far more investor demand than shares being issued. Predictably, the shares traded up by 44% by the end of the day, giving the company a 33 billion evaluation. This is despite the company being years away from profitability and having burned half a billion dollars in the prior year.

Investors were attracted to the young demographic of Snapchat users, with the majority of them being under the age of 24. Young people generally don’t have much disposable income, but if you hook them onto your app when they’re young, they’ll hopefully continue to use it as they grow up and advance in their careers. Eventually, they’ll have plenty of income and be very valuable to advertisers. So even if they aren’t making much money now, as long as you can grow and maintain their user base, investors should be handsomely compensated in the long run.

The post IPO honeymoon period didn’t last long. Over the next two years, the stock price fell from 27 down to five dollars, wiping out eighty percent of the market cap. So what happened? Throughout 2017, their growth slowed on a percentage basis as they ran into a law of large numbers, but at least it was positive.

2018 redesign

In early 2018, they completely overhauled the design of the app. The redesign was not taken well by consumers, and their daily active users declined by 5 million over the next year. This was the first time the app had lost users in its history.

When an early stage company is losing money, the only thing supporting its valuation is its growth potential. The second the growth rate decelerates or even worse becomes negative, the stock will immediately be crushed. So what was Snapchat trying to accomplish with its redesign and why was it such a disaster?

Under the new design, the social and media aspects were separated into two different sections. On the left side is the friends section where you see user generated snaps from your friends. The right side became the Discover page, which shows content from creators and Publishers, including branded content that Snapchat has paid to show you.

While Snapchat said that the redesign was meant to make the app easier to use, many speculate that the real reason was to make the platform more Advertiser friendly, as the Discover page could be better used to push ads to the users. While the new design was in some way simpler and easier to use to new users, existing users felt alienated by such a dramatic change to the app that they had already spent years getting used to.

Celebrity Kylie Jenner put out a tweet expressing her dissatisfaction with the update, saying that she no longer uses the app. More than one million people signed a petition to change.org demanding that Snapchat walk back the redesign and go back to its original form.

Android version

Another problem was the poor quality of Snapchat’s Android app. Even if the camera on an Android phone is as good or better than an iPhone, the image quality on the Android app was much worse than the iPhone. That’s because there are many different models of Android phone. This makes it much more difficult to optimize the software on each one.

Having limited software development resources, Snapchat decides to focus most of their efforts in developing a really good iPhone app while making a lower quality generalizable Android app that worked on all Android phones but had poor picture quality. This may have been a good decision in the early days, but there are far more Android phones than iPhones in the world, so the inferior Android app greatly limited their growth potential.

Instagram competition

To make matters even worse, Instagram launched a feature called stories a couple years prior. Stories allow users to share a video that self-deletes after 24 hours, a clear competitor to Snapchat. By 2018, 400 million people were using the feature on a daily basis, more than twice the number of people using SnapChat.

It looked like Facebook, which owns Instagram, was crushing Snapchat. Snapchat was still years away from profitability, and now that their user base wasn’t even growing, it looked like game over.

Snapchat turnaround

Despite the headwinds, Spiegel didn’t give up. They pushed their engineering team to upgrade the Android version and bring it closer to parity with the iOS version. They continued innovating with new filters and other features, which became very popular with users. By 2019, things were finally starting to turn around. Their number of daily active users started growing again.

Their growth was further accelerated by the pandemic. The app gave a fun and convenient way for people to stay connected from home. In addition to gaining more users, their revenue per user increased as they improved their ad platform. From 2018 through 2021, their average revenue per daily active user more than doubled from about $1.50 per quarter to more than three dollars.

This is still much lower than Facebook, whose equivalent metric is about ten dollars, but Snapchat is clearly heading in the right direction at its peak in 2021.

Bubble valuation

Their share price more than quadrupled from the pre-COVID levels. Part of this growth came from strong Revenue growth, but they also benefited from the general bubble in tech stocks, which saw valuations rise across the board. Snapchat’s price to sales ratio increased to more than 35 at the peak.

This is their market cap divided by the previous 12 months of Revenue. Keep in mind that this is a multiple on Revenue, not earnings. At this point, the company was still losing money, so it didn’t even have a price to earnings ratio. Their market cap per daily active user increased to over 450 dollars. This level of per user valuation is reminiscent of the dot-com bubble.

Snapchat’s senior executives seem to be just as optimistic as their investors. They went on an aggressive hiring spree, almost doubling their headcount from 3400 to over 6,000 in the two years following the pandemic. They enticed Engineers to join by offering stock-based compensation. This let them take advantage of their High share price to conserve cash.

Spiegel has Ambitions far beyond just making a social media app. They created an augmented reality headset called spectacles, which lets you see moving images projected into the real world. They also made a small drone called Pixy, which is equipped with a camera.

While the company has provided little in the way of sales figures for these two products, they are likely years away from generating significant Revenue, let alone profitability. The Pixy’s YouTube channel had 359 subscribers one month after its launch. This is a pretty disappointing number for a consumer product.

Snapchat stock can be considered a long-dated asset. They’re still pursuing growth at the expense of near-term profitability and will likely be many years before they return any significant Capital to shareholders. Because of its long duration nature, Snapchat’s valuation is highly sensitive to increases in interest rates or any negative news about their growth rate.

Bubble pops

In April 2022, Snapchat reported their first quarter earnings results. Revenue increased 38% year over year and their daily active users increased to a new record of 332 million. They provided guidance for the second quarter, saying that they expected Revenue growth of 20 to 25 percent year over year and adjusted EBITDA in the range of 0 to 50 million dollars.

The guidance was a bit worse than expected, but when you consider the macro backdrop, it wasn’t too bad. Uncertainties about inflation, Russia’s invasion of Ukraine, and recession fears have decreased advertising spending as companies look to conserve cash.

Just one month later, on May 23rd, Snapchat issued a regulatory filing saying that the macroeconomic environment had deteriorated further and faster than they anticipated. As a result, they now expect both revenue and adjusted EBITDA for the second quarter to fall below the low end of their guidance. They are also facing monetization headwinds relating to Apple’s recent privacy policy, which makes it harder for companies like Snapchat to Target ads.

As a result, Snapchat says that they will slow down their expense growth. They now expect to hire 500 new employees throughout the remainder of the Year. While this is less than they originally planned, it will still increase their head count by almost 10 percent.

In fact, Snapchat is one of the most aggressive tech companies in this environment, as many of their Silicon Valley peers are either instituting hiring freezes or even laying off existing employees. Twitter has instituted a hiring freeze and has even rescinded job offers that were already accepted.

Robin Hood, Netflix, and many others have laid off employees. In the face of rising interest rates and crashing Equity valuations, hiring 500 new people is a risky proposition, especially when you’re still losing money.

After lowering their second quarter profit guidance, Snapchat’s stock price lost almost half its value in the single worst day in its history as a public company. This is particularly damaging for the company given their heavy Reliance on stock based compensation. When the share price was $80, it could entice a software engineer to come with a relatively small number of shares.

With the stock now in the $15 range, you’ll have to give an equivalent new hire a lot more shares to convince them to join. Over the past four years, Snapchat’s total number of shares outstanding has increased by 18 percent, in a large part thanks to stock based compensation. We could see this growth accelerate over the remainder of the year, which would have a dilutive effect on existing shareholders.

Since fears around the Fed’s interest rate hike started dominating investor sentiments, high growth and especially money losing stocks started massively underperforming the market. Kathy Wood’s ARK Innovation ETF has lost 60% of its value over the past year, while the Vanguard BTV value ETF has increased marginally in the same period.

While Snapchat is not owned by ARK Invest, it has clearly been lumped together with other disruptive technology stocks. This is the last type of company that investors want to own given the upcoming rate hike cycle.

Corporate dictatorship

Given how this company’s share price has been decimated, it might seem odd that Spiegel is going forward with a plan to hire 500 new people. Many investors would probably prefer to lay off employees to accelerate the path to profitability. This highlights another problem with Snapchat, which is their unusual corporate governance structure.

Most publicly traded companies function like democracies. Shareholders vote on important issues such as choosing the board of directors or approving large acquisitions. Senior Executives must act in the best interests of shareholders if they want to keep their jobs. This alignment of incentives has been the Bedrock of shareholder capitalism for hundreds of years.

But Evan Spiegel and Bobby Murphy had a different idea. They structured the IPO in such a way that normal shareholders have zero voting rights. Company Executives and a few early investors get some voting rights, but the super voting Class C shares with 10 votes apiece are held exclusively by co-founders Spiegel and Murphy.

This makes it effectively a dictatorship. No matter how badly they mismanage the company, regular shareholders have little recourse to remove them.

In their IPO prospectus, they also said that they had no plans on declaring any common stock dividends in the foreseeable future. The co-founders probably planned all along to invest in New Growth areas instead of returning Capital to shareholders. They want to reinvest any profits they make into developing new technologies and growing the business, at least for the foreseeable future.

When the FED is pumping trillions of dollars into the economy and real interest rates are negative, this Arrangement works fine. For the current environment, investors want profits and dividends now, and they’re not going to get this with Snapchat.

What’s next for Snapchat?

With all that being said, it’s not all bad news for the company. Their number of daily active users continues to increase at a respectable rate, even after the pandemic-related restrictions have mostly been lifted. Their problems relate to increasing expenses and cyclically weak advertising demand. These are problems which can potentially be fixed over time.

But to believe in any turnaround, you have to have confidence in Evan Spiegel’s leadership, as he could be CEO for life if he wants. With the share price down more than 80% from the highs, regaining investor confidence will not be an easy task.

What do you think about Snapchat? Is the 80% decline in share price Justified? Let us know in the comment section below.