Quick Thoughts: A Social Media Pair Trade – Long TWTR, Short SNAP

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SEE LAST PAGE OF THIS REPORT Paul Sagawa / Tejas Raut Dessai

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February 20, 2018

Quick Thoughts: A Social Media Pair Trade – Long TWTR, Short SNAP

  • After both SNAP and TWTR eased deep investor concerns with strong 4Q17 results, the two companies sit at similar market caps around $24B.
  • While the two have obvious similarities as ad-driven social media platforms, we see substantial differences in the maturity and sustainability of the two business models
  • Just returned to growth after a year-long stall, TWTR is profitable and FCF positive with a defensible competitive moat around its core business and potential to accelerate
  • SNAP reaccelerated DAU slightly vs. 3Q17 after a app redesign, but it is furiously burning cash and faces fierce ongoing competition from FB’s Instagram.
  • We are much more confident that TWTR can grow its user base and accelerate sales than we are that SNAP can generate cash flow and hold its own vs. FB. We see a clear pair trade with the two.

Amidst all the market excitement, most of the growth-oriented TMT names that we track posted great numbers in 4Q17 vs. consensus expectations. In a quarter of surprises, the biggest may have been SNAP and TWTR. These much-maligned social networks each countered longstanding negative narratives to drive 30%+ appreciation since reporting. For SNAP, a reversal of recent deterioration in its daily average users (DAU) and a jump in ARPU gave evidence that it might hold its own against FB’s Instagram, which had targeted the service with copycat capabilities of its own. For TWTR, revenues returned to growth, earnings turned positive, and MAUs stayed steady despite an aggressive campaign to delete millions of Bot accounts, ending speculation of user disinterest and lost ad mojo. Coincidently, the market capitalizations of both companies are now in proximity at around $24B apiece. This prompts an obvious question – which one is the better investment? We think TWTR is the obvious answer.

The first consideration is the maturity of the two businesses. The first Tweet was in 2006, 9 years before the company’s IPO in 2015. At its IPO, TWTR had a $2B revenue run rate, slightly positive free cash flow and about 300M global MAUs. For 2018 it is projected to deliver EPS of $0.59, sales of $2.7B and FCF of nearly $600M. SNAP was born in 2011 and IPO’d in early 2017 with $600M revenue run rate, a $678M annualized cash burn and 167 global DAUs (MAUs were not released but estimated to be more than 250M)(Exhibit 1). For 2018, SNAP is projected to deliver a loss of $0.56/share, on sales of $1.3B, with a cash burn of nearly $700M. One company has established a stable, profitable operating model and the other has not.

The second consideration is future growth, and the narratives contrast. TWTR hit a roadblock shortly after its IPO, with user growth stalling as the company struggled to articulate its own use case. This hit the stock and, inevitably, weakened advertiser enthusiasm for the platform. Combined with a C-suite revolving door that led to a part-time CEO and the company seemed to be living up to that apocryphal quote attributed to Mark Zuckerberg, that Twitter was “A clown car that drove into a gold mine”. Still, @Jack, TWTR CEO stanched the bleeding with a 4Q17 that held serve on MAUs, despite culling millions of accounts deemed to be bots in a pitched battle against “fake news”. This coincided with strong ad sales, reversing ARPU slide that had taken revenues down YoY in the prior 3 quarters. Naysayers were forced to reconsider their presumption that TWTR’s well publicized struggles were irreversible rot.

Like TWTR, SNAP’s narrative turned dark shortly after IPO (Exhibit 2). In SNAP’s case, it was the Facebook bogeyman rising over its shoulder that scared investors. The SNAP S-1 was plainspoken about competitive threats – SNAP had no competitive moat and would have to innovate to stay ahead of its rivals. FB’s Instagram has copied Snapchat’s new features at a blistering pace and stole its competition’s mantle as the coolest millennial hangout. The much-hyped Snap Spectacles were an embarrassing flop. SNAP user growth – always focused tightly on that young demographic – decelerated and the cash burn accelerated. For the most pessimistic investors, SNAP was walking dead future roadkill for the Zuckerberg express. CEO Spiegel circled the wagons, announcing a major app redesign which the company began rolling out in 4Q17. With less than 40% of users upgraded to the new app, user engagement reaccelerated a little bit and ad sales jumped more than a little bit. Doom and gloomers had to revise their story – maybe Instagram wouldn’t put SNAP out of business quite yet.

Which is more likely? That TWTR has found its mojo and can exploit the attention brought it by the daily political drama played out on the service to continue to drive new engagement and attract advertising? Or that SNAP can fully reclaim its cool-kid status vs. Instagram, invigorate user growth, and douse the raging cash bonfire on its financial statements. Once again, we are inclined to bet on TWTR. Despite years of trying, neither FB or GOOGL has found traction against the primary TWTR use case – providing instantaneous distribution of information by newsmakers and a raucous forum for users to engage with others on those topics. President Trump’s controversial embrace of the platform has solidified its status as the town crier of the internet, and like it or not, many users feel compelled to engage just to feel informed. Twitter seems to be doing better in serving video to its users – it has attributed much of its resurgence in ARPU to its video ad products. Meanwhile, expenses are down and profits (and cash flows) are up.

On the other hand, the app redesign may have won a reprieve for SNAP vs. Instagram but not a commutation. While 4Q17 suggests that SNAP may be progressing a bit beyond its geographic concentration in North America and Western Europe to monetize emerging markets, China and much of Asia is dominated by regional alternatives delivering similar, and in many ways better, services. SNAP’s user base is overwhelmingly concentrated to younger demographics – coveted by advertisers but nearly fully penetrated by the app and notoriously fickle. Herein lies the greatest risk – that lack of competitive moat leaves it ever vulnerable to alternatives. SNAP may have temporarily stymied the threat of Instagram, but it is still there and Facebook has both the intent and the deep pockets to double down. It is a race, and SNAP doesn’t seem to be the favorite to win it. We wrote about this in detail at the time of the IPO (http://www.ssrllc.com/publication/snap-a-high-wire-act-without-a-moat/).

The YoY growth rate for DAUs ticked up QoQ to 18% in 4Q17, pleasing investors, but growth a year ago was 48% vs. 2015, and a year before that, it was 61%. The trend line would suggest that the 200bp upward

Exh 1: Snap Daily Active Users by Region, 1Q15 – 4Q17

Exh 2: Snap Daily Active User Growth (YoY) by Region, 1Q15 – 4Q17

Exh 3: Snap OPEX Costs as % of Sales, FY2016 and FY2017

Exh 4: SNAP vs. TWTR Quarterly Opex as a % of Sales, 1FQ16 – 4FQ17

tick in annual growth vs. 3Q17 is more likely an aberration than an inflection point. The trends on ARPU are a lot more comforting – the booming digital ad market drove robust 53% growth in revenues per DAU, with particular success in driving monetization of users outside of the US and Europe. Of course, the TWTR story shows how quickly ARPU can soften once advertisers buy into a pessimistic user engagement narrative, and it is unwise to presume that ad pricing will expand indefinitely. SNAP needs new users and new platform services to grow and it is not clear what management is really doing to assure that growth. SNAP will need more than $100 free ad credits to buyers shifting from Instagram to hold off Facebook.

Against this backdrop of uncertain revenue growth, SNAP faces even bigger issues. The company lost nearly $3.00 per share in 2017, even more than in 2016, and is not projected to make a profit until the next decade. With its focus on computing intensive image and video processing, SNAP spends heavily to host its content on Google Cloud Platform and AWS, committing to at least $3B in expenses over the next 5 years. Despite this, the company is also a heavy capex spender, with investment at 10.3% of sales in 2017 (Exhibit 3 & 4), 400bp above TWTR, which runs its own datacenter infrastructure. Operating expenses to sales are also considerably higher than industry peers. No wonder that the company is also burning cash at a furious rate. Consensus suggests 2018 FCF at ($682M) (Exhibit 5). In contrast, TWTR was already cash flow

Exh 5: Snap Inc. Financial Snapshot

Exh 6: Twitter Inc. Financial Snapshot

positive in its first-year post IPO (Exhibit 6). Management has given no real indication that it intends to do something about this, and sooner or later, investors will begin to care a lot more than they do now.

So of the two companies, SNAP with $24.1B market cap at 30 times trailing sales and 19 times forward estimated sales on heavy losses and a cash bonfire, or TWTR with a $24.9B market cap at about 10x trailing and 9 times forward with GAAP profits and nearly $600M in projected FCF, which one do you choose? Add in one factor: Facebook will never buy SNAP and Tencent might not be allowed to buy it. We think TWTR would have synergies for any company with an interest in leading the distribution of real time content – GOOGL? FB? T? CMCSA? DIS? Even CRM seems to have kicked the tires. For us, the choice between the two is a no brainer, an obvious pair trade: Long TWTR and short SNAP.

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