TIVP051: Snap Inc. (SNAP): Why Hasn’t Snapchat Become a Social Media Titan? w/ Shawn O’Malley & Daniel Mahncke

26:06And so they were probably feeling pretty self-confident. But the challenge that Snapchat faced was that by leaning into privacy more than Facebook with the disappearing messages, for example, that sort of erase your footprint, their opportunity at first seemed to be more in brand advertising, where you have large companies simply running ads to try and drive brand awareness rather than catering to small to medium-sized businesses that are run ads that directly drive e-commerce sales for them, for example, and can measurably generate a positive return on ad spend consistently, which is, for the record, what Facebook is very, very good at.

26:43And so the hope was that by creating trust with users around privacy and very high rates of engagement with the app, opening it frequently throughout the day, Snapchat could potentially steal brand awareness-based advertising spending from cable TV, which is the king of brand awareness ad campaigns. And basically, though, the thought was that as that industry has declined and major brand advertisers have begun seeking new outlets to maximize exposure, they might come across Snapchat. So in hindsight, you might have been able to realize that, okay, if Meta can't make a version of Snapchat work and the nature of how people use that app does not line up well with more effective forms of advertising, or at least more profitable and scalable forms of advertising, without directly competing with something that is cable that has dominated brand awareness for many, many decades, then really that could have been, if you put all that together, an early indicator that this company was going to face severe limitations.

27:48And of course, that's not the narrative that most investors clung to when the company first IPO. And so it is, of course, very difficult to become the type of tech titans that Alphabet and Meta have become, but it helps that many different types of advertising can work well on their platforms. But with an app based on chatting, that's almost like really just an alternative to texting. Without the same type of infinitely scrollable feed or even a reason to search information on the app, Snapchat just has much less monetization potential and always has. And so to me, if you look at really the spectrum of most promising advertising businesses, clearly you've got Google and Facebook and then Instagram at one end of the spectrum where you can target specific users and almost mind-numbingly nuanced level of detail or target keyword searches with a very high level of precision going after people that are looking for exact types of search results and information.

28:53as you can on Google. And then in the middle is probably something like Reddit, where you have less precise individual and keyword ad targeting because the platform is synonymous. But you can target effectively by interest based on sort of the various subreddits on the platform, the different communities there. And then all the way on the other end of the spectrum is something like Snapchat, where people are not coming together to shop, search for information or join hobbies or passion-based communities. But they're really just starting to make small talk. And so that just lends itself to a much smaller addressable advertising market.

29:31It would be so interesting to see how the narrative from back then compares to what we kind of see as a problem nowadays. That basically there just hasn't been the real estate to show the ads in the right way that, for example, Instagram can have. So I feel like there's probably a survivorship bias in the other direction that we today now know it didn't work out as they hoped, but I think you could have bought into that story fantastically back then. And just to continue on the storyline and the drama with Matter, I've seen Snap's founder and CEO, Evan Spiegel, take aim at Matter by basically jokingly listing himself as the VP of product on his LinkedIn because of how many of the innovations have been copied by Matter and other competitors too over time.

30:12And that's from disappearing messages to face filters, geotechs, and even stories that were originally coming from Snapchat, even though by now I kind of feel like it's an Instagram feature only. And it's a funny thing, but it's also revealing of just how powerful Matter is. And despite fairly blatantly cloning competitors over the years, Matter has really never paid the price for doing so, while Snapchat very much has been a loser comparatively. And it's great to be innovative and it's fun to point fingers at Matter, but if the company can't legitimately protect and monetize their innovations, then they might as well just sell themselves at whatever price they can get because they certainly won't be creating any shelter value.

30:54Well, as you said, I do think Snapchat has done some genuinely innovative things. Stories were first done by Snapchat and as you said, are probably now more associated with Instagram and Facebook too, ironically. And so the other thing was SnapMap. That was pretty powerful where basically you could see the location of all your friends on Snapchat based on where they had last taken a picture from. And to older generations, I'm sure that sounds like a gross privacy violation and it probably is, but to middle schoolers, high schoolers, and college students, that is the ultimate way to keep tabs on the evolving social scene around you, seeing where people are in real time and really what they're doing.

31:29And there's another question to be had about whether being able to see where everybody is all the time is good from a mental health perspective, but just from a product perspective, you can totally see why it's been popular. And even the augmented reality filters where you hold up your camera and you put puppy ears on yourself or someone else. And stuff is just fun and it's creative and it's at the heart of what made Snapchat so addictive. And yet despite that, the lesson is that innovation alone does not always win. It is possible that incredibly innovative and even incredibly popular companies will not be able to sustainably generate shareholder value.

32:08and maybe that sounds obvious but to me it was sort of a profound realization to look at this and figure out wow you can have all these advantages going for you and still shareholders can fare very poorly because if you had told me in 2013 about how big snapchat would get and how many features they would pioneer that are now essential parts of how people use the internet in 2025 i would have thought that they would go on to generate monster returns on the stock market probably. And of course, if you were a private investor early on, sure, you did great. But for anyone who ever bought the stock publicly, the track record has been abysmal.

32:48Very few people have probably done well on the stock. I'm proud to say that I've been a boomer in my heart ever since because I never had the SnapMap active. But you know, that was only me. I knew it was a fantastic feature for a lot of the people who use it. And just your last point, another thing that would be easy to forget ever happened, but I think perfectly resembles just how flimsy Snapchat's business and popularity have always been, is that a single tweet from Kylie Jenner in 2018 talking about not using Snapchat anymore wiped out more than a billion dollars of market value. And as somebody who, like you, of course, came through the ranks of the investing world by reading about Buffett and Munger, that kind of fragility is almost hard to even understand.

33:30I mean, with businesses like Coca-Cola, Geico, American Express, railroads and energy companies, you're not exactly betting big on the most exciting pockets of the market and technology, but these are exactly the types of bets that have defined Berkshire Hathaway for a long, long time. And that's partly just because of their stability. And these are fundamental businesses to society that for decades now have been relied upon, whereas Snapchat almost perfectly epitomizes the opposite in something that's just incredibly speculative. In 10 years, I would have no idea if Snapchat will still even exist, honestly.

34:08If you were to try and say the same thing about Coca-Cola, Geico, or Amex, you'd probably need to have at least a 100-year timeframe for that to even seem realistic. And they're not going anywhere in the next decade. I think what might help is to just listen to this clip now from Buffett, basically talking about doable businesses and how it helped Berkshire to strive over the last couple of decades. In businesses, we're looking for an entity that has durable competitive advantage, somebody that not only is doing well now, but will do well 10 or 20 years from now. In capitalism, when you have a wonderful business, it's like having an economic castle.

34:48And the nature of capitalism is that people want to come in and take your castle. It's perfectly understandable. I mean, if I'm selling television sets or something, there's going to be 10 other people that can try and sell a better television set. If I have a restaurant here in Omaha, people are going to try and copy my menu and give more parking and take my chef and so on. So capitalism's all about somebody coming and trying to take the castle. Now what you need is you need a castle that has some durable competitive advantage, some castle that has a moat around it. And that moat, one of the best moats in many respects is to be a low-cost producer.

35:20But sometimes the moat is just having more talent. I mean, if you're the heavyweight champion of the world and you keep knocking out people, you've got a competitive advantage as long as you can keep doing it. And it's very profitable. To me, I do really think this all effectively shows the difference between mature companies with wide moats, as Buffett would say, where there's only so much downside to be had, but also maybe limited upside comparatively. And then speculative growth companies where you have this massive range of possible outcomes in the future that includes the stock 100xing or going to zero and really everything in between.

35:54And so there's no moat improving the risk return profile for investors. How about we just zoom in a bit more on how Snapchat works, what makes it unique and what differentiates it for better or worse than something like Facebook or let's say TikTok nowadays? So one of Snapchat's biggest strengths has always been frequent engagement with the app. And by exchanging disappearing photos and short videos, you could easily spend hours on the app daily, just replying to all your friends, keeping your messaging streaks alive and other sort of things like that. And even with Snapchat stories, which are these moments you can post for all of your friends to see rather than messaging specific people, they only exist for 24 hours.

36:35So every day you've got to open the app again to add your story, see other people's stories or to reply to people and keep your Snapchat streaks alive consistently. There's just a sense of urgency to stay on top of it all. And I know folks who even still after using Snapchat for more than a decade and but mostly gave it up after college, they still use it simply just to keep their thousand plus day Snapchat streaks alive. And that's just the number of days in a row that you and someone else have exchanged Snapchats. And so breaking a Snapchat to some people almost feels like breaking a friendship.

37:08It symbolizes something. And Snapchat is trying to monetize that dynamic and loyalty and social perception of how Snapchat streaks are seen as part of people's relationships. And so they've done some other stuff too, more subtly, to pretty effectively drive engagement, such as having designated best friends on the app. And so how this works, or how it used to work at least, was that if you sent the most snaps to one person consistently, and you ranked at the top of their list of people that they send messages to, then you both become best friends with something like a little heart emoji or something symbolizing that relationship.

37:43And yeah, it all sounds very juvenile. But when I tell you that this stuff did and does matter, it's really true. I mean, you can only imagine kind of the playground politics of, let's say, your crush being your best friend on Snapchat, but someone else being theirs. And again, it sounds very silly now to talk about as an adult, but this kind of stuff is how Snapchat came to define the social landscape of now several generations at this point. When you're a teenager, I think you do a lot of stuff that seems ridiculous looking back. I think I have one of the lowest SNAP scores in my friend circle.

38:20I actually just looked it up before the episode, but I was generally never that much into social media. So I might not be the perfect comparison. And still, I had streaks with my best friends that were at least 200 or 300 days back in, gosh, 2013 or 2014. And I'm no expert on Snapchat anymore. Actually, never really have been one, But it seems to me that Snapchat has gone from an innovator to an app that now imitates others as well. And I don't know, maybe that's even a better strategy since being innovative alone only got them so far. And the biggest beneficiaries of those innovations have mostly been other and mostly the big competitors.

38:56And that said, I'm not sure taking more cloning based approach works well when you're not already an established tech giant. I mean, they have a lot of users, but they're not the monopoly power. Like I said, it just emphasizes, in my opinion, how clear it is that they're desperately chasing after companies like, for example, TikTok. And I do think users notice that kind of thing. And, you know, that makes the brand feel less cool, which contributes to the fact that even though we've been talking about the huge reach of Snapchat's user base, much of that has only come from growing in emerging markets where the revenue per user is much, much lower, while usage in its core market, which is mostly North America, has actually started to decline.

39:38and it would be one thing if growth were simply decelerating in the US because, well, nearly the entire indressable market is already on the app, but to see it actually declining while American users are replaced with users in other markets that are, as I said, more fragmented and where the revenue they can generate from those users is maybe a third as much at best and much lower if you look beyond Europe, then to me that's a very troubling sign if you look at what's probably less profitable growth in the future. What I think you're alluding to there in terms of cloning rather than innovating was that they introduced a feature called Spotlight in late 2020, which is a feed of viral user videos that's algorithmically ranked.

40:23So this is basically Snapchat's answer to TikTok and Instagram Reels. And it feels like every app these days has a scrollable short video feed from Reddit to ESPN and even LinkedIn. But yeah, Snapchat was quick to embrace it to their credit, even though it was something of a phase shift for them. They went from primarily facilitating synchronous communication via chatting and snapping, sort of like texting an iMessage or WhatsApp, as opposed to asynchronous content discovery, like browsing video reels on an infinitely scrollable feed. But now Snapchat is a hybrid of those two things. And that actually probably was a smart move, because as we talked about, just because you could open an app and to send a lot of chats doesn't necessarily make the app very monetizable with synchronous communication.

41:10There's just really no way to embed ads without annoying people. And can you imagine getting ads baked into iMessage on your phone? Nobody wants that. And so it's just intruding on personal conversations. Whereas with this asynchronous content that has infinite scrolling, the format is much less personal. And the time that you're spending mindlessly staring at the app is much longer. So there's much more room for advertising opportunities. And at its core, the difference between Snapchat as a synchronous communication app versus more scrollable apps, I think explains a lot of the gap in business performance.

41:47And unfortunately for them, the solution isn't as simple as just adding spotlight to enable more scrolling. If that's an inherently different type of behavior from how people have been conditioned to use the app over the years. And another wrinkle here is that Snapchat's ad products require sponsors to adapt to immersive visual formats like full screen vertical ad videos that appear between friend stories or in the Discover content feed. And that raises the bar for being able to even do effective advertising on Snapchat, requiring more expensive creative inputs to run ads as opposed to the more straightforward text-based ads that could be run on Meta or Reddit.

42:29if marketers have got to create unique ads for snapchat's platform in particular and it's not even the place where you get the best returns on your spending that's just another obstacle weighing on the company's competitiveness and i would say a few years ago i went down deep on the rabbit hole of learning about facebook ads and digital marketing and running ad campaigns to promote different types of products and stuff and i can't say i ever remember anyone talking about advertising on Snapchat. You heard about TikTok a lot. Definitely heard about Facebook a lot. Heard a lot about Google ads and YouTube and Instagram and to a lesser extent, Reddit and Twitter.

43:11I don't think once when I was studying all these marketing gurus and e-commerce gurus did a single one of them recommend Snapchat. And to me, that is very telling because like I said, It's just, there's a higher bar to entry to even be able to run ads there. And then, like I said, it's just not even clear that you can get attractive returns on that ad spending by putting in the extra effort to advertise on that platform. Yeah, it sounds that just by design, Snapchat does not retain most user-generated content, which means Snap cannot data mine private messages, content over time, the way that, say, Gmail might scan emails for ad keywords.

43:53And instead, Snap relies on metadata and usage patterns. And so it knows who your friends are, how often you interact with them, your location, if you turn on the map, the lenses you play with, and also what discovery or spotlight content you watch. But then they use the data to personalize content feeds and to target ads in a more privacy conscious way. At least that's kind of a more charitable way of putting things for them. But if you were to make a bullish case for Snapchat, what do you think that could be? Because at the end of the day, they have so many users that you would just think there has to be a business case that's bullish for the company.

44:30One of the stats that really caught my attention early on was that in North America, Snapchat has penetrated about 22 % of smartphone users, whereas they've reached 17 % in Europe and 9 % for the rest of the world. So again, that amount of penetration in the US is just unbelievable. When you consider that about 30 % of the entire population is even aged 13 to 34. So to reach 22 % of all smartphone users then, I mean, that is really the absolute maximum you could imagine them achieving in a given market. And so I don't really see a ton of opportunity further in the US, obviously, or really even in Europe.

45:09But the key is that 9 % rest of the world number. I mean, taking that 9 % of global smartphone users to 12 or 15 % would mean tens of millions, if not hundreds of millions of more users for them. And the other thing in kind of a bull argument is that while the public discourse around AI has mostly swirled around Google, OpenAI, and Anthropic, Snapchat has actually quietly built one of the most widely used AI chatbots in the world. And so since its launch, Snaps My AI had more than 150 million people send over 10 billion messages. And so based on those figures, management has tried to argue that this would make it one of the most used AI chatbots available today.

45:51And so, yeah, those kind of whenever you're throwing around AI buzzwords, that is something that stands out to people. It sounds really good. It doesn't necessarily create any shareholder value, but you can see how that kind of thing gets people excited about a company that is really maybe not all that promising. And we also haven't even mentioned their subscription business called Snapchat Plus that now has 17 million subscribers and$700 million in annual current revenue. And so between the addressable market globally, the implementation of AI chatbots and this ballooning subscription business, I could see how someone could look at this and be excited as I was for a fleeting moment or at least think that it was too cheaply priced.

46:32but the point that Daniel and I are trying to really make today is for as appealing as some of that looks on the surface we really do believe that would be a mistake and as we talked about if you're losing users in the U.S. who you monetize at let's say$10 a person per quarter that's the average revenue you generate from users in the U.S. divided across all American users over a period of time and you're replacing those eyeballs with users in other markets that over that same amount of time only generate$2 per person, well, then you need five users from places like Latin America and India to be equivalent in monetization terms to just one North American user of the product.

47:13With the point being, they would need massive growth in emerging markets to even move the needle. And if you think the US is oversaturated in terms of Snapchat usage and that the user base there is likely to decline significantly in the coming years, and offset other parts of the business, then the international growth, even if it's very, very strong, might literally not move the needle for them at all. And the other thing is, is this is incrementally less profitable growth where they're having to expand their tech infrastructure and bandwidth and other kind of capabilities to support more users without those users being nearly as profitable as their core base of users who are now falling off the platform.

47:53And then the AI thing, well, I don't know. I don't even know what to say about that. I mean, as good as that sounds, in no way could I justify how that would meaningfully change their profitability trajectory just because people are chatting with their AI bot more frequently. It's just a vanity metric. And honestly, it sounds like one of those things that the more people use it, the more cost Snapchat's occurring and probably is making them less profitable, honestly. And so, and then if you look at the subscription business, again, even this was disappointing to me. I mean, at first I was like, okay, that is promising.

48:25I remember you messaged me and you're like, all right, maybe there's something to this Snapchat business. And then you read about what Snapchat Plus actually is. And firstly, the main subscription tier for it is only like$2.25 a month. And all it does is remove some ads. It doesn't even remove all of the ads. And it provides access to pre-release features. But that just doesn't sound very compelling to me. I mean, there's probably a very small percentage of users that would care enough to pay to access certain features on Snapchat early, then if you're only monetizing these most enthusiastic users at something like$2 a month, I just don't even see how that could be something that would materially contribute to Snapchat's profitability or becoming profitable, if ever.

49:08There was sort of a similar dynamic here when we looked at Match Group because they had these top users that they tried to monetize. But the difference was that they might earn hundreds of dollars per user a year rather than$2 a month off of their most active customers. And so if you think of Amazon Prime as being the gold standard in subscriptions, where the subscription is just so valuable that it pays for itself, then Snapchat Plus is just like the opposite. It's a totally arbitrary subscription that barely improves monetization. And honestly, in fact,$2 a month is about what they generate from most U.S.

49:46users from ads. So you can actually say it's even as much as$3 per month. So this is either at best keeping unit economics flat, where they're just substituting the same amount of ad revenues for the same amount of subscription revenues. Or there's actually a case that it's making the business worse because they're reducing how much they monetize North American users in particular. so I just it's it's a terrible look for them really and the more that they add users from emerging markets it just complicates things further it just sounds so terrible I mean when Sean messaged me he was already so desperate about the business case for Snapchat that I was really trying to look for anything that could make this sound more bullish and then he mentioned the subscription business and I felt like well maybe there's something here I mean even if it's just two dollars you know if the value add would be great perhaps they could charge five you know and a year from now but the value add is just so bad that it makes you question if even the snapchat management team even thinks there's any business they could realistically get and i mean just for the sake of journalistic integrity how about we listen to the ceo to ceo evan spiegel and what he thinks about things because if anyone should be bullish on the company it should be him It should be the management team of the company itself.

51:03So I will just quote here something that he said in his recent letter, and that's, Snap operates in one of the most competitive industries in the world. Our largest competitors are worth trillions, invest hundreds of billions in capital each year and are being sued for monopolistic practices. We also face smaller, nimbler competitors growing ad revenues faster of a smaller base with leaner cost structures and higher gross margins. As Snap currently occupies a unique position with significantly more scale and engagement than smaller players, but with less scale and market power than our large competitors.

51:39Squeezed between the tech giants and smaller competitors, on the verge of greatness, we find ourselves in a crucible moment. I suppose it's a bit like being the middle child. We remain on the 1 % share of a global digital ad market that is growing 13 % year over year, which means the opportunity is enormous. And he continues by saying, Snapchat is likely one of the largest AI-based video and image generation and editing services in the world, with people using lenses more than 8 billion times per day. While the underlying technology continues to commoditize and open source proliferates, the customer relationship is becoming far more important.

52:21Our current stock price reflects doubt. At this variation, there's startup style return potential. But unlike a seed stage company, we are a team of 5 ,000 serving almost half a billion people every day. That means extreme accountability, every line of code, every sales call, every minute, every day matters. So I would say that's some inspirational quotes for you here. And I mean, he's having a point, but then again, everything we showed in the last 50 minutes just makes me doubt that, you know, startup style return potential is actually materialized for any shareholder in the coming years. Yeah, I don't think anybody who's been investing in this company for seven years or longer, if they're in during the private fundraising rounds, wants to hear that they're still at a startup stage.

53:10You want to be well past that after seven years of a public company. So it's like it's embarrassing, kind of, if you really think about it that way. You can also hear that Spiegel pretty clearly acknowledges their disadvantages. And also they had a little call out of their AI features, which I see is just a vanity metric, but I'll get off my soapbox. But, you know, they say that they're sandwiched between these massive incumbents and they have a constant stream of upstarts coming against them. And Snap captures only a small share of overall social media advertising spending, making it unlikely for it to catch up with its competitors anytime soon, who just keep compounding at faster and faster rates.

53:50And so in turn, that limits Snap's capacity to invest real cash into its business, both via research and development and sales efforts, which is why they rely so heavily on share-based compensation to fund the business instead. And I think they know, of course, how dilutive that is, but it might feel like the best option for them to stay competitive. Paying people in stock is sort of like another form of currency. But there is a reason that once young companies start to consistently generate positive operating cash flows, they increasingly fund the business's operations with that cash and try to rely less on stock over time.

54:27And meanwhile, you've got these newer competitors like TikTok that are operating profitably at a scale in China, which can then subsidize their international business while Snapchat is blocked from accessing the Chinese market. So that is just yet another sort of subtle disadvantage that Snapchat has against a major competitor. And they would probably tell you, you know, look, our average revenue per user is two thirds out of Twitter and less than a tenth of Facebook. So any meaningful convergence in those gaps would be a huge tailwind to earnings and then reflect more of the true earnings power of the business, perhaps.

55:04But we've talked about that at length now. This monetization gap does not close on its own, and it hasn't. If their platform is structurally less attractive to advertisers and has been for years, and Snapchat Plus does not create enough value to reverse their fortunes and maybe even is destroying value, then the argument is just insincere. I think it's illusory. And one of the bull cases for Reddit was them closing the gap in average revenue per user between them and all these other social media sites. But they've actually been tangibly making progress and consistently improving their ARPUs and then correspondingly reinvesting those earnings into their ad tech over time.

55:44And so just intuitively, I see that progress. And I can also see why Reddit is just a much better place to advertise for most major brands than Snapchat. And that's how you get this differential and results just compounding over time because Reddit, for example, is continuing to improve its business and Snapchat's just treading water. We often talk about the importance of being a consumer, just a user of the apps that we're talking about. And listeners might know that I'm not a huge fan of Reddit either, but if I go through that platform now, I can actually see the ads, I acknowledge them, and I see that they are important for whatever I'm looking for right now.

56:19Whenever I'm on Snapchat, I feel like I don't even see the ads. And that's not because there are none. It's just that they do not seem targeted at all. And actually they're just disturbing the entire user experience. And sometimes that fact alone is just enough to figure out it's not working well. And one other challenge that Snapchat is facing, and we're not used to seeing this with big tech companies, is that their gross margin is only 52%. And gross margin is basically the most, basic measure of profitability, just showing how much more you're able to sell your products or services for relative to their raw costs.

56:54So with a grocery store, for example, if a pound of chicken costs them$2.50 and they sell it for$5, well then they made a$2.50 gross profit. And on$5 of revenue, that's a 50 % gross profit margin before accounting for overhead costs, depreciation, taxes, interest and debt and all of those costs. And the reason I use that specific example is because Snapchat's gross margins look much more like a retail business than a tech company. AutoZone is a company that you've covered here on the show before and its gross margins were exactly 52 % too. But AutoZone's entire business is based on running physical stores, selling thousands of different products, whereas Snapchat's costs of goods sold should probably just be the tech infrastructure costs of supporting their app and maybe compensation incentives for top influences.

57:46But other tech companies like Adobe, I mean, their gross margins are nearly 90%. Reddit, for example, they're actually north of 90%. So you're asking yourself, Snapchat financials, they don't even look like those of a tech company. And what would you say is the reason for that? Why is Snapchat so unprofitable compared to the sector in general? As you said, Snapchat's gross margin last year is a bit above 50%, where a more typical range for most of its peers would at least be in the 65 % to 80 % range. Hoping for them or expecting them to be at 90 % plus is probably not realistic, but still 50 % is just terrible for a tech business like this.

58:26And the underlying issue, though, has been there since day one. And so in 2016, pre-IPO, Snapchat did$400 million of revenue, but had$450 million in an accounting line known as cost of revenue, meaning they actually had a negative gross margin. And then when you layer in other costs, the net margin was negative 127%. And that's just brutal. And Snapchat has always been a very, very expensive platform to run and maintain. I mean, that's the takeaway. That's what that cost of revenue means. And so all that time, Snap committed to spend$2 billion over five years on Google Cloud Compute, which is no small amount of money.

59:07And in their S1 filing for the IPO, they actually explicitly warned that these hosting costs for their servers and platform will increase as the user base and engagement grow. And in their words, may, quote, seriously harm our business if we are unable to grow our revenues faster than the cost of these cloud services. and that is just not an issue that they've really been able to address to this day and if you compare that to meta or google where each incremental dollar of ad revenue has very high drop through after fixed costs because they've reached such massive scale in revenue and in snapchat's case scale actually can backfire since that scaled user base hasn't translated to a proportionally large revenue base to spread costs across.

59:53And instead, the more users there are, the more infrastructure and bandwidth costs there are, capping any of the potential benefits from economies of scale that you would normally expect to see. And so having so many users without better monetizing them is actually ironically losing them more money, in other words. And post-IPO, some quarters showed that Snapchat generated an average revenue per user of just 90 cents while spending about 60 cents per daily user on hosting costs just so those people could continue to use the app. And all that left is 30 cents per user to cover the operating costs of everything else they do.

1:00:32That doesn't work. And running an app like this that's entirely premised around sharing pictures and videos which are costlier to store and distribute. They're more data intensive, more bandwidth intensive versus an app that's more tech space like Facebook or Reddit, even if they also have videos, I mean, it means that it's going to be inherently more expensive to keep things running smoothly for Snapchat. And that is my very, very gross oversimplification of how this works. But in Facebook's S1, on the other hand, the company had already shown strong profitability just a couple of years into existence and high gross margins at its IPO back in 2012.

1:01:11Meanwhile, Snap was asking investors to believe it could build Facebook-like economics, despite starting from these negative gross margins we talked about in a very heavy variable cost structure that was just going to naturally be harder to overcome. And so Snapchat's S1 really tries to spin one of its biggest headwinds as a positive. And so what they describe is how global ad spending is very concentrated in the top 10 markets and how over 60 % of daily users on Snapchat were coming from those markets, which, quote, gives us the opportunity to grow our ARPU and provides high capital efficiency, as they tried to say.

1:01:50But in reality, by 2016, what that really meant was that North America and Western Europe were already seeing decelerating rates of user growth. So the room for growth was clearly in markets like India and these other rest of the world regions that are a lot less profitable for them incrementally when they hadn't even figured out the unit economics for the entire business at this time in their most profitable markets. And so implicitly, they wanted investors to believe that they could continue to grow strongly in developed markets while significantly closing the gap in how much revenue per user somebody, let's say a country like Thailand, might be able to generate for them relative to a Canadian or a German user.

1:02:29And both of those assumptions aged poorly. And the question to me really was whether investors in Snapchat's IPO even realized that these were the bets they were implicitly underwriting. I would think for many, the answer is probably no, because otherwise it would be hard to justify rolling the dice in this way. If it feels like we're being too hard on Snap because you're not used to us going 90 minutes against the company, usually we're pitching companies that we like, even if we do not end up investing in them. So if you think we're being too hard on Snap, you might be right. But I just want to emphasize again, we're using them basically as a case study because we constantly come across companies that are just good at selling themselves and for less experienced investors.

1:03:12And even for us at times, it can be hard to know how to sift through that noise. But we've got to build that skill, recognizing that, okay, this is something that actually matters. And here's why, why some data point or insight for management is more misleading than anything. Basically what you just pointed out. And there's a lot of reading between the lines in what we do. I think that's almost 50 % of investing is reading between the lines, figuring out what something that is said actually means. And that's not to say we're always right, but what matters is practicing thinking for yourself, which is hard.

1:03:45It's not easy to do because a lot of these CEOs and management teams, and I said that earlier, they're really charismatic people. If they're on earnings calls, usually, maybe not in the case of Snapchat, but usually they know what to say and they know how to communicate with investors and to basically sell the story. And they know what the investors want to hear and they can make a fancy presentation to deliver that pitch. And I think it would be easy to get lured into thinking that Snapchat is just a misunderstood business which is a huge user base and huge potential in the future. And maybe it is, but from what we can tell, it's as good an example as any of an instance where the setup looks promising at first and that's why you thought about pitching the company.

1:04:25And it may even look promising the more you dig in unless you have a well-refined BS detector. Another one of those things that looks good on paper is that Snapchat has this$400 million deal with perplexity to roll out their artificial intelligence search engine within the Snapchat app. And so that's kind of the perfect depiction of these things that look good on the surface. You know, it's got the buzzwords mentioning AI and it sounds like a ton of money at first. And I could easily see how you would think, all right, hey, that business is growing, the subscription business is taking off. And now they're finding new ways to monetize via AI partnerships.

1:05:01I mean, I could totally imagine people trying to sell that narrative. And in many ways, it does kind of sound like Reddit, which is a company we do like. But when you peel back the onion, you see why it's more hype than anything. Firstly, this is a one year commitment only. So we have no idea of whether Snapchat can continue to generate revenue in this way down the road. It's a total one off. The other thing that is maybe the worst part of all is that the deal is not even being done in cash entirely. That's right. The$400 million deal includes an undisclosed amount of equity and perplexity that's being given to Snapchat.

1:05:32So, I mean, listen to this. Snapchat can't fund its own business with cash, so they have to issue shares as compensation to keep operating. And now they are not even accepting payment in real cash. They're getting paid in shares of a highly speculative private AI startup. I mean, it's very circular. These are the types of things that you would see in the dot-com bubble of the 90s. And so we don't actually know how much of the deal is cash for stock. But since they didn't disclose the details to reassure people about what the ratio is, it makes me very nervous that it's heavy on this stock-based comp that may not even be worth anything.

1:06:11I mean, imagine a scenario where, I don't know, only$50 million is real cash. And the rest is supposedly$350 million worth of shares. and this AI company that's trailing open AI and Google and correspondingly might be out of business in two years and the best deal they can make is working with Snapchat of all places. I mean, when you look at it that way, does that still sound like a good deal? Probably not. Because as they lean on chatbots and AI more, which come with these very demanding computing power needs, then I don't think that's doing their gross margins any favors. And for all we know, from a cash return perspective, these integrations and features may make Snapchat even less profitable.

1:06:49So yeah, I mean, it would be really easy without any second order thinking to conclude that, hey, this is a great deal. It's going to substantially improve their margins and reduce their dependence on ad revenues. And that sounds great on paper, like phenomenal sounding, but it just does not hold up to scrutiny. That's the reading between the lines that we talked about. So how about we start to just wrap up things for now? I think we're both in agreement that there's really no plausible price where we would be willing to pay to just own Snap. I mean, sure, if it went to, let's say, one cent per share, then we'd buy it, but we don't see that happening anytime soon.

1:07:23And as far as we're concerned, given how unlikely it looks at least for Snapchat to deliver consistent profits on any kind of foreseeable timeline, we're happy, I would say so, to conclude that Snap's shares have very little intrinsic value, even if we cannot give you a precise dollar amount. and they do have value and probably should have some value in the market given that there is still some optionality there. But I just mean in the sense of truly owning a business where as a shareholder, you're entitled to a split of the profits. Shares are effectively worthless to long-term investors from an intrinsic value perspective if a meaningful profit can just never be generated.

1:08:04And I assume, also from your messages before we even started the episode, that's where you landed with Snapchat, Sean. no surprises here i i would say that's right i mean without even needing to do any modeling if you can't seriously underwrite profits for the foreseeable future seven years after ipo alongside all the red and yellow flags we went over today then i don't think that i feel like i need a spreadsheet to tell me the intrinsic value here is is not even worth bothering with it's just not a company that we're personally interested in if people do know more than snap if people do know more about snap than us or see the thesis differently we would love to learn from you honestly because we i mean we could be wrong but with the information that we have seen this is the outcome that just makes the most sense to us i mean how do you do a discounted cash flow on a company that has no positive cash flow so that's just completely unprofitable but i'll say let me turn around and ask you daniel i mean what lessons did you take away most from having done this case study?

1:09:05Well, I got to say, I assume it just ends up being about the basics. I already mentioned how the management team is probably the first red flag and probably that red flag alone would be enough to just never invest in the company at all. And I'm not even talking about questionable product decisions like augmented reality glasses, but mostly just about how they treat shareholders. If I just cannot be sure, or if they would want to pay themselves first, and there's never a profit that they want to give to me. Well, then that's just a very bad place to be in. And I guess another lesson is probably on competitive dynamics and modes, of course.

1:09:41I mean, Snapchat had enough innovative power and customers like the product. But if you just lack a way to protect your product from getting copied by larger competitors that will take advantage of your innovation and then monetize it, that's just a bad place to be in. And Snapchat has never found a way to mostly defend matter in terms of just stealing their innovations. And maybe one more detailed learning for me has been about ad real estate. I can't remember a single ad I've seen on Snapchat. I mentioned that before. And they mostly show up on, I think it's the discovery page. And that page is probably the worst user experience I've ever seen on any social media app.

1:10:20It's all clickbaity and it has more ads than I think content. So I just never visited and I don't know any person who spends a lot of time on there. And if that's where you're trying to monetize your users, that's just a nightmare. And apparently Snapchat has found no way to place ads in a way that users actually notice them without fully disrupting the user experience. And that's totally different from Meta. And by now, I think we can also confidently say it's totally different for Reddit. And it seems to be that this is what social media companies need to make a lot of money and monetize their users.

1:10:55Well, the other thing we didn't even mention today was that one of the things adding to Snapchat's very gross margins is that they do a revenue share with content creators. So they're trying to reward creators for posting content that would end up on the discovery page. And so, yeah, there's just an irony there when you're telling me, hey, this is maybe the worst interface I've ever seen on any social media app. and part of the reason Snapchat is structurally unprofitable is because they're trying to explicitly pay content creators to fill in that scrollable feed that really nobody is using. It just feels like a circle.

1:11:31It's going nowhere. It's a treadmill that has no end destination. You're just spinning in circles. And so with all that said, let's move on to the next. I want to go back to finding names we're both excited about. I mean, it gets depressing to linger on the bad ideas too much and folks might think we did that today. But tell me, Daniel, what are you thinking about pitching to me for next week's episode as an addition to the intrinsic value portfolio? That's funny. You actually wrote a message to me earlier about what do you think listeners will think about this episode? Maybe it's even fun if we just tear apart a company for once.

1:12:05And I think it's actually pretty good, maybe pretty good content. But I think I speak for the both of us that we just like looking at great companies. It's more fun for us to look at companies where we think, I've just learned a lot looking at this business model and also see how this could be way bigger 10 years from now. And that's pretty much exactly the company I hope to bring next week. We're going to switch continents. In fact, we will cover a company that is operating in Germany. Not only, but it's at least having its headquarters here in Germany, actually in Hamburg. And I'm pretty sure it's the smallest company we've yet covered here on the show.

1:12:41It's a sub$1 billion market cap company and it operates a similar model to Constellation Software. And I think one of the most interesting things about it is that it has some highly famous investors involved. And I think it should be interesting to anyone looking for the next big thing. I know that's a big click-baity too, but I think this company has an actual shot at being that company. I'm excited for it. I think you gave the perfect amount of hints for folks who want to dig into it to figure it out. But yeah, it's going to be a bit of a change of pace in a good way, I think. So that's really fun.

1:13:15I'll leave us on a quote to round things out today. So here's a line from another than William Shakespeare who says, good company, good wine, good welcome can make good people. So after today's episode, Daniel and I are going to need some good wine and good company to raise our spirits. But all jokes aside, we hope that you enjoyed this episode and found it to be useful. We'll see you again next week.

1:13:45Thank you.