The internet, combined with the world of apps, has changed the way overall business has been shaping up. The biggest beneficiaries have been the new age tech companies, where they go about building scale with users and pay very scant attention about the traditional financial concepts of net income, Cash flows, and Margins.
Today, most of the things are getting justified based on Amazon’s success story -- TTM revenue of USD 200 billion but it lost money and virtually crawled after the earlier dotcom boom. The valuations of these new age companies getting listed globally are earth shattering, and we strongly think that collectively they are in the overvalued zone, having said that few would go on to become highly successful and generate great returns to shareholders.
We took a look at Snap. This company had an impressive debut on the stock exchange with listing gains of over 60 per cent, the stock has had its brilliant run. But today, the stock is languishing at a little over USD 6. What explains this downturn, as there is no slack in the American economy. In fact, the economy is firing -- unemployment being at its lowest and with tax cuts, all FAANG Stocks (Facebook, Apple, Amazon, Netflix, Google) have done well. Of late there has been some correction, which is much needed, but otherwise it has been stellar run .
Being a tech company, we started out with valuing Snap. Please do note that traditionally it is very difficult to value Snap, as there is no free cash flow, no profits, nothing traditional accounting wants, in fact the balance sheet is in shambles and Snap has a huge accumulated deficit of over 4.5 billion USD as per the 2017 Annual Report, using TTM this deficit would balloon close to over 5 billion USD.
Knowing well that having cash flows and projecting free cash is one of the easiest ways to arrive at the value of the company, but absence of any, we went on the value Snap on the user base method.
Most of these new age companies have no cash, in fact they burn cash and focus on users, just have a look at Netflix, Amazon Prime, Flipkart, so we focused on its user growth, and that’s the key to ad revenue for Snap.
The argument has been build users, which will help us in scale and we will monetise that data through ad revenues, which is perfectly fine, as long as the story plays out the way you assumed it would. For Amazon Prime or Facebook this growth has been stellar, but for Snap what is it going to be? We dug into the annual report of 2017 and the facts are revenues have grown impressively and that’s about it. The rest has been dismal. The given consolidated statement of operations clearly elucidates the issue at a glance.
The ballooning of the R&D and G&A of 2017 is nothing but restricted stock units which were
issued under GAAP it must be expensed out and in the cash flow statement its added back as
non-cash expense. When we went to calculate the user growth we normalised the R&D and
G&A, assuming that Stock units won’t be issued every other year and the firm will focus on
controlling costs and growing revenue, which is nothing but a huge derivative of User Growth.
The above statement is a clear reflection that the company is burning and its net loss has increased so has its EPS in negative way and this puts the quandary, as to what is the best way to value such companies, because more and more you would see these new age companies, which will have significant startup losses but would build scale with users and then drive revenue through advertising.
We went on to look after the User Growth in Snap from the Annual Report of 2017, TTM figures are also identical at 187 Million, so went to value Snap using the User Based Method of generating Revenue through user and we have gone to use part of the Marketing and G&A expense as a Corporate Drag and have arrived at our conclusion of what is the Value of the company.
We took the base of 187 Million Users and have grown the user base for 3 years at 20% and
subsequent years with growth rates as mentioned in the given table below.
Growing Snap’s user base, we arrive at 599 Million Users and with a ARPU 0f 37.4 US$ with the imbedded growth and cost estimates.
The terminal value is 2%, as we needed to close the valuation. The value of Equity is at best turning out to be 6231 US Million, deducting the debt (which is hardly anything) as most of the funding is through equity, and adding cash (334 Million US$) the value of the stock is turning out to be 5.5 USD.
The Value Drag or Corporate Drag is an expense which reduces the value of the Equity, due to the ineffectiveness of the expense ( here it is marketing and G&A). This can be argued that no organisation knowingly creates an ineffective spends, well we never said it does , we only state that with this New Age companies , when they start up and are young the quest for growth makes them do few things which may be necessary but surely doesn’t add any value, the best explanation is the current user growth rate has flattened and has remained same in twelve trailing months (TTM ).
Snap has spent on Marketing or G&A and still the growth has not appeared. So the spends are nothing but drag on the overall valuation, to be fair and use the best practice we have gone on to increase the value drag by only 10% in the first 5 years and then halve the same to incorporate the learning curve effect, and then to close it off, we have grown the Value drag at 1%.
The base rate for using value drag is 50% of G&A and marketing spends which we strongly believe is a value drag on the business, this excludes the stock units pumped into the respective heads.
The stock is trading at close to fair value as per our estimates of growth and cost, but the most vital part of the story is the subscription of 599 Million consumers, which we believe is the toughest to get with significant competition from Instagram, Facebook, and Google for Ad revenues.
The other part of the story for Facebook and Google, they are cash flow positive, they make significant net income and they are operating at a healthy margin, just to speak Facebook has an operating margin of 50% upwards and terrific free cash flows of 18 Billion, all this put together the future of Snap surely looks troubled and the Stock has ingredients of 599 Million consumers factored in, which we think are highly optimistic. In fact, the Annual Report of Snap clearly mentions that Snap may never become profitable in future. Looking at the numbers it seems to be close to reality that it may never generate any profit in its lifetime. Snap really needs to think hard if it wants to stay awake and fight the demon that it has gone on to create.
(Ramaswamy Ranganathan and Sudarshan Rajan are media professionals who also teach at B-Schools)