This article first appeared in my column on Equities.com.

The Snapchat IPO is currently the talk of the tech town. The obvious reason for this buzz: with a reported valuation between $20 billion and $ 25 billion, Snapchat is one of the biggest social media and technology offerings in recent years. However, there is a more interesting driver of this buzz: opinions are divided on Snapchat’s business model as well as on the comparatively early stage of the company’s lifecycle, or let’s say, profit cycle.

Snapchat is a business that is based mostly on intangible assets and that, while growing strongly, isn’t expected to see profits in the near future. Valuing these types of business is far from easy. However, this will become a crucial exercise for growth investors who want to play in that space. The toolkit of valuing companies that haven’t reached the stage of profitability yet is what sets apart the front runners from the laggards. Snapchat will only be the beginning of a bigger trend. This is why it’s worth having a closer look at where to spot value in Snapchat.

For this article, we will boil it down to two questions:

  • Deciding which metrics can provide us with insights into the company’s future performance?
  • How can we determine the sustainability of this performance?

The Metrics

Snapchat is not selling something based on single transactions. Instead, the business is based on long-term user relationships, along different economics of subscription businesses. Such businesses require significant upfront investment in building an audience. This audience will then be monetized over time, turning highly profitable once break even is reached.

With these types of businesses, there are always pundits ready to point out that the company is losing money, and that any “alternative metrics” that the company focuses on have “gimmick” character.Some go into more detail, putting the numbers in comparison with Facebook (FB), indicating that Snapchat does not have the best metrics around. Yet, knowing whether or not Snapchat loses money today or how it compares to Facebook does not help us much in coming to an investment decision. After all, we want to see where it will stand in the future. To gain that understanding, we need to discuss the unit economics of these particular types of businesses. We will dive into those unit economics to see how we can determine whether Snapchat is on the path towards profitability or not.

To understand this, look at i) the value that Snapchat provides to users, and ii) the value it provides to shareholders, meaning how the value to users can be monetized. The monetization again is determined by the value the company provides to advertisers.

To its users, Snapchat provides entertainment as well as communication through videos. We can measure that value in the time they spend on the app, as well as through the number of timeline views. Snapchat has 158 million daily active users (DAU), who spend 25-30 minutes per day on the platform. Quarterly growth rates have been between 50 and 60% over the past year. So far, there is little concern about whether it provides value to users.

These are the metrics of user engagement. But we also want to gain a qualitative understanding of what drives this engagement. It seems as if until now, the key drivers of engagement were Snapchat’s product launches. Snapchat has been highly successful in continuously launching new features. According to the S-1, changes in the growth rate of DAU could be closely linked to successful or less successful product launches. In the first half 2016, successful product launches pushed the user engagement and also “adoption rates among older demographics”. In the middle of 2016, product launches had technical issues which again reduced growth of DAU, particular among Android users.

Now for us as shareholders, engagement is only of value if it can be monetized. Snapchat monetizes through ads. Most of Snapchat’s ads appear in between “Stories”, series of photos and videos. Users, media companies, as well as Snapchat’s curators can create those stories. In addition, the company sells branded filters and lenses. Snapchat’s users consist of the interesting and hard to reach demographic of 18 to 24 year olds. Three out of every five 18-24 year old internet users now actively use the app. Let that rest for a second.

The simplified revenue equation is average number of users * revenue per user(ARPU). ARPU is the key metric that Snapchat looks at and it is determined by the number of views. The quarterly average revenue per user is $ 1.05. This is still far below Facebook’s, which is around $ 3.9. Yet, while its ad revenue lags behind Facebook, Snapchat’s advertising business has grown impressively. Snapchat’s ARPU has increased by more than 200% over the past year, from $0.31 in QIV 2015. Not surprisingly, the clients of WPP, the world’s largest advertising firm, spent 50% more on Snapchat in 2016 than they had planned to spend.

With these numbers we can safely say that the audience can be monetized. But will Snapchat be able to do so in a profitable way? Snapchat’s key cost items are hosting cost, followed by R&D and customer acquisition costs.

Hosting costs seem huge. Total costs of revenue, which also includes costs for content creation and acquisition, were at $ 452m or $ 2.86 per daily active user. Compare this with the ARPU of $ 1.05. Not all of these $ 2.86 are for hosting though (the S-1 doesn’t provide the exact split). And while this number still is big, it may not be so extraordinary, if we compare it to Facebook’s 97 cents. And Facebook operates its own infrastructure, while Snapchat is strongly depending on Google (GOOG)Cloud for its hosting, and due to video loads. Snapchat has indicated that it may build up its own infrastructure as well.

The key problem here is not so much hosting cost, but that Snapchat is just at the beginning of the learning curve in terms of user monetization. We can see this in the lower ARPU vs Facebook’s and in Snapchat’s rapid increase. We don’t have much details on the drivers for this increase, but understanding those drivers will be key in understanding Snapchat’s long-term profitability.

Sales and Marketing account for $ 0,79 per user. When we compare those with Facebook’s $ 0.89 at the time of the IPO we see that this is not unreasonable. Again, we have put this into context, and considering Snapchat’s rapid growth this number is not a surprise.

Sustainability

If Snapchat manages to continue to grow its ARPU and gets its hosting costs lined up, then its business model may be working. But will it be sustainable?

Snapchat’s key assets are its users. How engaged these are depends partially on the company’s ability to launch new products. Rapid innovation is the name of the game in this field and this is what Snapchat thrives at. So far their track record of launches is impressive. Snapchat seems to have the culture necessary to understand the needs of its users and build engaging products.

Yet, so far Facebook’s track record of copying these products has been equally impressive. Facebook is well on track to win the 2017 counterfeit awards. Let’s agree that the features alone provide only little protection.

The platform is as important as the features. That means if Facebook/Instagram keeps copying all of Snapchat’s features like-for-like it may end up looking like a Volvo with sports tires. While we cannot say this fore sure, Snapchat’s core users are not the type of users that would trust Facebook as much as they trust Snapchat. And the shifting demographics are clearly in Snapchat’s favor. On the other hand, while revenues are increasing, user growth rates of Snapchat have stalled over the past quarters, declining to 46% in QIV 2016 from above 60% in the first two quarters of the year. As we have seen above, management explains convincingly that this is a temporary effect as a result of product launch related performance issues. App store product reviews seem to confirm this. But for us as outsiders it is hard to tell whether this is temporary or whether this is a a trend or a saturation of a user base at this stage. A risk remains that every potential investor should investigate in more detail.

When we speak about the user base, we also need to speak about user data. The value of Facebook lies in the information that the company has amassed on its users. Facebook used the past years to test and refine its algorithms, making sure that it can extent the advertising reach. In other words, it had access to a large base of crash test dummies – it’s users – to refine its marketing machine.

Snapchat on the other hand has much less experience and data. It is just at the beginning the learning curve. We can see this in the lower ARPU of $ 1.05, vs Facebook’s $ 3,82.

However, Here’s the Flip Side…

As with all media companies, social media companies need to find the balance between the quality of content and monetization. When the content feed is too advertising focused, then value of the platform will decline, which in return will decrease engagement. If we look at our formula, this means that DAU and $ ARPU are in a trade off relationship.

Facebook has been a champion in increasing $ ARPU. However, it has also faced criticism due to fake news and an increasing number of trolls on the platform. On the other hand, Snapchat says in the S-1 that it tries to balance advertising and content. FB has a larger scale and it depends on feeding the marketing engine. Balance is not necessarily top of mind there. This could be a differentiator of Snapchat. But then, as we have seen, an increase in ARPU is desperately need to make the business model work. We will have to watch how ARPU and DAU balance and develop over the near future.

Without doubt, Snapchat is a highly interesting business. It may well be on track to develop a profitable business model. Yet it is too early to say whether it will be sustainable. Growth investments are always risky. But there are those things we can control and those we can’t control. And then there are those items on which we have enough information and those on which we are under-informed. At this stage, we are just beginning to understand the unit economics, but for my risk appetite we are still a step away from having enough insights to make an investment decision. (Footnote: discussing the governance structure, which may also include issues is beyond the scope of this article). In particular investors should understand the drivers behind:

  • Ad monetization and Snapchat’s learning curve
  • The decline of user growth. Is it one off as management has indicated?
  • How Snapchat will manage to balance content and the need for monetization
  • The roadmap of future product launches
  • development of hosting costs

And then there is the long-term vision. Let’s quickly remember how Snapchat started. Originally it was a simple selfie app, which then turned into a new way of communication, both as a result of user demand and of a talented founding team. No doubts that there will be more positive surprises ahead that are hard to foresee. There are some interesting dynamics at work with Snapchat’s users and, more importantly, any investment in Snapchat is an investment in a management team with a solid track record of products launches. Snapchat’s long-term focus is on reinventing the camera, having just launched hardware in the form of spectacles. But for these upside opportunities are at early stages prior to proof of concept. After all, it comes back to risk adjusted returns and to your risk appetite. In any case, Snapchat is definitely worth tracking closely.

See the Important Shifts Happening

Not every Tweet is of importance in this noisy world. Stay updated on the most important shifts that are happening at the intersection of Business, Innovation and Culture.