Snap Inc. – Snap in the box.

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Facebook keeps Snap Inc. in its box.

  • Despite launching in August 2016, Instagram Stories has been extremely successful in mitigating the threat from Snap Inc. as it already has 50% more users than Snapchat.
  • In a blog detailing some feature updates, Facebook has disclosed that Instagram Stories now has over 250m daily active users (DaU) all of whom have been added in the last 10 months.
  • By comparison Snap Inc reported 166m DaU at its Q1 results in May and a far more pedestrian level of user growth.
  • This is a strong indication that Facebook has been very successful in preventing its users from going outside its fledgling ecosystem of apps by replicating new services in house.
  • It is also a sign of how critical the network effect is as Facebook’s 2bn users can all be directed to the Instagram app, use the same credentials and get going with a minimum amount of fuss.
  • By contrast, Snapchat is a completely different system to which users have to be separately recruited.
  • It is this ease of transition and the fact that it is quite simple to cross promote Instagram Stories that has allowed Facebook to imitate an innovation and quickly dwarf the original creator.
  • This is extremely concerning because I suspect that Facebook has more than 90% penetration of the smartphone users that matter from a marketing perspective.
  • If this avenue in increasingly closed off to Snap Inc., then very real questions need to be asked about its medium-term growth prospects.
  • Snap’s narrow focus on Instant Messaging begs the comparison to Twitter, but I do not think that this comparison goes far enough.
  • Twitter is stuck in a niche that it has fully monetised and its attempts to branch out into video are faltering (see here).
  • This means that its outlook for growth remains very bleak.
  • However, in the Digital Life Pie segment of microblogging and related messaging, where Twitter is present it is dominant with no opposition.
  • This means that once it stops spending money in trying to grow, it should make good, but static returns from monetising that niche.
  • Snap Inc on the other hand still has some growth ahead of it but Facebook is doing a very good job of keeping it out of its core user base.
  • I still think that the company could conceivably generate revenues of $800m in 2017E and $1.2bn in 2018E as it is quite far from fully monetising the users and traffic that it already has.
  • However, this is not enough to justify the current valuation.
  • Assuming that all goes well for the next 18 months, I can still be comfortable with a valuation of $14.4bn (see here).
  • While the current valuation is now closer to this figure than it was a few months ago, at $17 a share Snap Inc is still 13% above what I would consider to be fair value.
  • Consequently, I still see no reason to get involved especially as Facebook is showing every sign of very successfully keeping Snap in its box.
  • Twitter, for all of its faults, still has better prospects.

Facebook – Soft target

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Facebook chasing broadcast rather than Netflix or YouTube.

  • Facebook’s move into Media Consumption is well underway but it looks to me to be going after broadcast rather than premium or user-generated content.
  • Facebook has closed a deal for a reality TV show called Last State Standing and is close to doing a deal to shoot and air a second season of Loosely Exactly Nicole which originally aired on MTV.
  • It is also commissioning shorter shows from the likes of Vox Media and Buzzfeed.
  • This is in no way a move to compete with the high-end shows on Netflix or the user generated content on YouTube but instead looks like it is aiming at broadcast.
  • Despite the atmosphere of cord cutting, broadcast TV is still an advertising market that is worth $70bn a year and it is the younger end of this market that Facebook is targeting.
  • This looks to be somewhat experimental as Facebook is not really targeting expensive, high quality content as one of the shows it is looking at was cancelled after one season on MTV and has an IMDB rating of just 5.1.
  • These shows will air first on Facebook via a video tab called Spotlight that will be present at the side of the screen and will be funded by advertising.
  • The broadcast market represents a much softer target in my opinion as Facebook can add all sorts of interactive and social functionality on top to make the experience much more engaging than just watching TV.
  • The level of investment being made at the moment is small with a few hundred thousand dollars being spent per episode on its big shows as well as a few tens of thousands being spent for shorter segments from producers like Vox Media.
  • I see this as a sign of Facebook’s media consumption strategy reaching the point where it can be considered to be properly present in this segment of Digital Life.
  • This will bring its coverage of Digital Life to 46% up from 36% where it is today.
  • For me, this represents a 28% increase in its addressable market which should allow revenue growth to re-accelerate after the slowdown I have been long expecting this year.
  • Given that Spotlight is not yet available in the app and that Facebook is just closing the deals to produce this content now, I do not expect these shows to hit Facebook until 2018.
  • Consequently, for 2017, I see Facebook’s growth potential remaining hampered by the fact that it has already fully monetised the segments of Digital Life where it is already present.
  • The result is likely to be a much slower growth profile, which I think is something that the market has still not fully anticipated.
  • Hence, I can see disappointments coming in the Q2 17 and Q3 17 results as the market adjusts to this more sanguine short-term outlook.
  • It is at the point I would be looking to go back into Facebook as 2018 could see an uplift in financial performance driven by monetisation coming from Media Consumption.
  • This should be followed up by Facebook’s expansion into Gaming and Search which would bring its coverage up to 78% and global market leadership, pipping Tencent which is currently on 77%.
  • This is what underpins my long term positive view on Facebook, although I am expecting weakness in the short-term as it will be sometime before the new business lines can pick up the mantle of growth.
  • In the meantime, I prefer Tencent, Microsoft or Baidu.

Snap Inc. – Price of opposition.

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Twitter is in a better position.

  • A poor set of maiden results highlights that Twitter is actually in a better position because although it is stuck in a niche, it remains unopposed in that niche.
  • Management even had the temerity to laugh off the threat from its much larger and far more powerful rival, Facebook, which is successfully replicating Snap’s innovations to great effect.
  • Q1 17A revenues and adj-EBITDA were $149.6m / LOSS$188.2m slightly below consensus at $158m / LOSS$180m.
  • User numbers also disappointed with 166m daily active users (DaU) compared to consensus at $168m.
  • This is not nearly good enough for a company valued at 31x 2017 EV/Sales which triggered a 23% decline in after-hours trading.
  • The company also burned $155m in cash from operations.
  • Commentators are already drawing the comparison to Twitter, but I do not think that this comparison goes far enough.
  • Twitter is stuck in a niche that it has fully monetised and its attempts to branch out into video are faltering (see here).
  • This means that its outlook for growth remains very bleak.
  • However, in the Digital Life Pie segment of microblogging and related messaging, there is no opposition.
  • This means that once it stops spending money in trying to grow, it should make good but static returns from monetising that niche.
  • Snap Inc on the other hand still has plenty of growth ahead of it but its core business competes head to head with Facebook’s dominant properties of Messenger, WhatsApp and Instagram.
  • This is where the problems begin as Facebook can easily afford to outspend Snap in every instance and has 7.8x more DaUs than Snap does.
  • Both of these businesses are network based where there is an exponential relationship between the value that can be created and the number of connections that the network has.
  • Furthermore, to continue its growth, Snap has to monetise outside of USA as its US ARPU already looks full at $1.81.
  • Outside of the US the relative strength between Facebook and Snap Inc. is even more in Facebook’s favour making Snap Inc.’s task all the more difficult.
  • These results were bad because the company has a very high valuation and then missed expectations rather than anything in particular going wrong.
  • However, Facebook’s announcements and the intentions that it made clear at F8 (see here) are a concern.
  • Consequently, I see no reason to change my position on Snap Inc.’s fundamental outlook or my valuation of $15.4bn or $16 per share in a blue-sky scenario (see here).
  • Given the increasing risks involved, I would not consider buying until the shares were meaningfully below this value.
  • Between the two, Twitter is the better long term investment but given the choice, I would not have either.

Facebook Q1 17 – Sleeping policeman

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Facebook’s growth story hits a temporary bump for 2017.

  • Facebook reported good results but once again tried to temper enthusiasm with reality by saying that overall growth this year would slow materially.
  • Q1 17A revenues / EPS were $8.03bn / $1.04 nicely beating consensus at $7.8bn / $0.86.
  • Advertising revenue was $7.9bn of which mobile was $6.7bn making up 85% of total advertising revenues.
  • The user count has now hit 1.9bn MaU (1.3bn visiting every day) with the vast majority coming from mobile.
  • Video and Instagram remain the biggest drivers of growth but Facebook has reached a limit in terms of the amount of advertisements that it can stuff into its apps.
  • Further increases could improve revenues in the short term but would probably lead to a fall in engagement which would negatively impact revenues anyway.
  • Hence, Facebook is turning to other avenues to find growth.
  • With its existing mature apps, Facebook has 36% of the Digital Life Pie and this is now fully monetised.
  • This is why, I have long been of the opinion that to become a $40bn revenue company, Facebook needs to increase its coverage of Digital Life.
  • The good news is that the signs of this continue to strengthen and at its developer conference, Gaming and Media Consumption were in sharp focus.
  • The issue is that I don’t think that Facebook’s Media Consumption offering or its Gaming strategy are mature enough to really start generating revenues which is why revenues will really start to slow down this year.
  • The street is expecting a 40% YoY improvement in revenues this year which I think is unattainable.
  • However, once those new services hit maturity, I think that Facebook will once again, be in a position to beating expectations.
  • Consequently, as the disappointment sets in for lower growth in 2017, I expect the valuation of the stock to moderate.
  • This will be driven by straight-line-loving (of which I am equally guilty) analysts bringing down their long-term forecasts in response to short-term issues.
  • It is at the point that the greatest opportunity exists to invest in Facebook for the next leg of its development.
  • In the meantime, I continue to prefer Microsoft, Baidu and Tencent.

Spotify – Crown jewels

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Spotify keeps the crown jewels to itself.

  • In striking a deal with Universal, Spotify has traded much better than I thought it would giving the label two concessions that I think will end up being pretty worthless.
  • Spotify has signed a licence with Universal that has three main aspects:
    • First: Universal artists will have the option to release their music to premium users only for two weeks before it is available to all users.
    • Second: It looks like Spotify will cut the share that pays to Universal from 55% to 52%.
    • Third: Spotify will provide Universal with the data that its music generates thereby enabling the label and its artists to gain better insights into how its music is being consumed.
  • On the surface, it looks like two of these points benefit the labels but when I take into consideration how the music industry is evolving, I think the winner from this deal is Spotify.
  • This is because Spotify has managed to increase its gross margins on Universal music by 300bp and has cleared one major hurdle towards its road to an IPO.
  • Sony and Warner are the two remaining hurdles which, now that a precedent has been set, may be easier to overcome.
  • That is what Spotify has gained from this deal but what has it given up in return?
  • Not much in my opinion.
    • First: I do not think that delaying releases to the free tier for two weeks will have much, if any, impact on the appeal of the free tier.
    • I have long believed that the free tier is far more valuable to Spotify than anyone thinks that it is (see here) and I think that its desire to protect the user experience of this segment has been a major sticking point in striking a new deal with the labels.
    • Time shifting media releases is how music and films have been released for years but I think that this is changing.
    • Spotify knows what it users listen to and what they like and I think that in the future, users will be increasingly made aware of new music when the streaming services recommend them rather than when the artist or label releases them.
    • Hence, many users might not even notice a two-week delay meaning that Spotify has received something for nothing.
    • Second: Spotify is giving Universal access to its fire hose of data but I have doubts whether it will be able to make much sense of it.
    • This is because it will only have access to the data which is just a raw material.
    • To make something useful out of it, trained algorithms are required to parse that data and draw meaningful conclusions from it.
    • These algorithms are Spotify’s crown jewels and I am pretty sure that they will be staying safely under lock and key.
    • After all, they are the reason why Spotify’s service is better than Apple’s and are the key to its ability to eventually replace the labels entirely (see here).
    • Furthermore, Universal will only have access to its own data which compared to the entire catalog that Spotify has, is a small subset.
    • Hence, even if it could make sense of the data, it wont be able to draw many meaningful conclusions from it as it will be looking at an incomplete picture of user activity.
  • The net result is that I think Spotify has dealt much better than I thought it would as I was concerned that the pressure to make it to IPO in 2017 would force it to give too much away to the labels (see here).
  • In fact, I think that the reverse has happened putting Spotify in a good position to IPO without having to give much, if anything, away.

 

Twitter – End of days

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The loss of the NFL is a disaster.

  • Twitter has lost its deal to stream certain NFL games which I think punches a potentially fatal hole in its strategy to break out of its niche of microblogging.
  • Amazon has reportedly paid $50m for the rights to stream 10 Thursday night NFL games for the coming season.
  • This is 5x what Twitter paid in 2016 but I do not think that this is a case of the little guy being priced out of the market.
  • Instead, I think that Twitter got a very good price from the NFL because of its promises to be able to leverage its social interest graph to generate meaningful advertising revenues as well as insights that could be shared back to the NFL.
  • Clearly, Twitter has not been able to live up those promises which is why the rights have been sold to a more conventional bidder who I think is simply paying a more regular price for the rights.
  • In my opinion this is nothing short of a complete disaster because expanding into media consumption was Twitter’s one hope to break out of its niche and resume subscriber and revenue growth.
  • The loss of the NFL is an indication that this strategy is failing and that despite its efforts, it is nothing more than a broadcaster of short text messages and a second-rate instant messaging platform.
  • Blogging and Instant Messaging make up a total of 16% of the Digital Life pie which I have long believed that Twitter has already fully monetised.
  • I remain convinced that this is the reason for its growth grinding to a halt (see here).
  • If Twitter can entice its 300m users to do more with Twitter beyond these activities, then there is scope for revenues to begin growing again as it will have more traffic to monetise.
  • This is why the video strategy was so important.
  • Media Consumption makes up another 10% of the Digital Life pie and had Twitter been able generate significant traction from it, there would have been significant upside from current revenue levels.
  • Without this growth, I still fear that Twitter’s shares will fall below $10 because even at $14.5, with no growth, the shares are still expensive.
  • This loss makes it even more likely that 2017 is going to be a stagnant year where the realities of the company’s predicament really begin to become apparent.
  • I think that this could drive the shares to $10 or below.
  • I continue to see Twitter as a potential acquisition target but would expect to see the shares touch $10 before real interest is triggered.
  • I see no reason whatsoever to go bargain hunting as there is no bargain to be had.

LeEco – Electric millstone.

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I think, LeEco must exit automotive to survive.

  • It looks very much like LeEco is giving up its grand plans for a 12,000 employee eco-headquarters in return for hard cash in order to give the ecosystem strategy time to succeed.
  • Despite these radical actions, I still think that LeEco’s only chance is to give up its automotive ambitions and focus on its core business: the ecosystem.
  • LeEco has recently raised $2.2bn (see here) which I calculated would leave $622m free to support the fledgling ecosystem of products and services.
  • However, the sale of the 48 acres it purchased from Yahoo to Genzon Group, the Chinese real estate developer this increases my estimate of free cash for investment to $1.132bn.
  • This is because to reach the $622, I took off $250 for purchasing the land but this outflow is now an inflow of $260m, improving cash flow by $510m.
  • This will give the company time to develop its offering but I remain concerned that its automotive ambitions remain a major problem.
  • LeEco’s automotive strategy is centred on an electric vehicle start-up called Faraday Future in which its founder is the major backer.
  • It broke ground on a huge 3m square-foot factory in Nevada in April 2016 but because contractors have not been paid, work has since ground to a halt.
  • Furthermore, Faraday Future has now reduced the size of the planned factory by 80% to 600,000 square-feet, cut the number of models from seven to two and delayed the factory opening by at least 1 year.
  • Faraday Future’s problems do not end there as senior management turnover has been high in the last 9 months and there could be as much as $300m in unpaid bills.
  • As Apple (see here) and even Tesla have found, building cars is a difficult business that requires a lot of time and very deep pockets.
  • I am pretty certain that Faraday Future has none of these things making its chances of long-term solvency very slim.
  • This is why I think that LeEco’s best interests will be served by not having this millstone hanging around its neck.
  • Faraday Future clearly needs hundreds of millions of dollars of new investment which LeEco simply cannot afford if it is to have any chance at delivering on its ecosystem ambitions.
  • These ambitions begin with a media consumption strategy that needs both heavy investment in terms of content and attention to detail when it comes to software and the user experience.
  • Furthermore, management needs to be focused on delivering on these ambitions rather than being distracted by building self-driving cars.
  • RFM research has found that currently, the user experience in the automobile has no effect on the user’s decision on where to live his Digital Life and therefore building a car to deliver one’s ecosystem makes no sense at all.
  • This combined with the difficulties, cost and poor profitability of automobiles, is why I think that Apple backed off (see here).
  • Hence, I think that for LeEco to have the best chance of succeeding, it needs to extract itself from Faraday Future and forget about self-driving cars.
  • Building a thriving ecosystem is difficult enough and throwing in cash constraints and management distractions can only make it next to impossible.

 

Spotify – Patience pays.

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I think shareholders will see more value by being patient.

  • Spotify is closing in on finally doing a deal with the record labels that I think will remove the last obstacle to the company going public.
  • Spotify and three of the largest record labels have been dancing around each other for a significant period of time without coming to any definitive agreement.
  • This is crucial because without the content from these three labels. Spotify would be unable to provide its current service.
  • I have long argued that as Spotify’s user base grows, so does its negotiating power and that the longer it took to arrive at an agreement, the better it is for Spotify (see here)
  • However, the time for Spotify to go public is approaching fast and I suspect that without a deal with Universal, Sony and Warner, any valuation that Spotify would achieve at IPO would be materially impacted.
  • Furthermore, with this hanging over its head, the stock would be very volatile in the public market as, in theory, the labels could wipe Spotify out at any time by pulling their music from its service.
  • In practice, this is never going to happen because with every month that passes, the labels need Spotify more than it needs the labels and I am pretty sure that if they were going to pull their music from Spotify, they would have done so ages ago.
  • This is because streaming is now the only source of growth in the music industry without which the labels would lose what has become their most important route to market.
  • Spotify is unique in that it is the only major platform to have a free-tier and adding in those users takes Spotify’s total user count well north of 100m.
  • This is hugely significant, as although these users do not pay Spotify directly, they generate vast amounts of data which can be used to improve and train its algorithms.
  • This is critical because it is those algorithms that allow Spotify to both understand the music it has on its platform as well as accurately match it to the users that it has.
  • In the long-term, I think that this gives Spotify the opportunity to cut the labels out completely which would have the effect of substantially enriching both artists as well as shareholders of Spotify.
  • I think that this is why Spotify is not keen to do a deal with the labels that limits the provision of music to free users as data collection and algorithm training would most likely be impacted.
  • The other side of the coin is that I suspect that Spotify has guided its investors to a time when it can IPO, giving existing shareholders visibility as to when they will see a return on their investments.
  • I believe that doing an IPO without a signed deal with all three of the biggest labels has difficulty written all over it which is why Spotify is considering caving in to some of the labels’ demands.
  • Although this will bring some short-term benefits to Spotify and its shareholders, I think that a deal in the short-term could delay Spotify’s ability to supplant the labels which I have long believed is where the real upside lies.
  • This is because I see that this is how Spotify goes from earning $0.30 on the subscription dollar to $0.50 or more.
  • Hence, I think that the best outcome for shareholders will be achieved by being patient and letting the IPO exit window slip for as long as required for Spotify to become powerful enough to dictate terms to the labels.
  • I continue to see only a minor threat from Apple Music as Spotify is still adding paid subscribers much more quickly and shows every sign of having better artificial intelligence with which to differentiate its service.
  • Whether Spotify can convince its shareholder of the merits of delaying their exit remains to be seen.

Facebook – Brainless video.

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Focusing on video first makes complete sense.

  • I think that Facebook is making the right choice in targeting video first as it already has traction and video-based services tend to have the lowest requirements for artificial intelligence to make them easy, fun and useful.
  • With the launch of a TV app being just the latest move Facebook has made in video, it is increasingly clear that Media Consumption is Facebook’s number 1 priority for 2017.
  • The TV app that is being launched is very simple in that it makes it easy for a user that does not have time to watch videos on Facebook during the day to easily to so at night on a larger screen.
  • This should enable a better video experience and begin to spread engagement across other devices but it will come with the added complication of multiple resolutions and bit rates.
  • On a mobile device the screen is small which means that lower resolution videos and bit rates are acceptable, but once these are played on a larger screen, their shortcomings quickly become obvious.
  • This move into TV comes hot on the heels of the addition of a tab at the bottom of the Facebook app which links to the top trending videos as well as videos that Facebook thinks that the user might like.
  • The TV app will initially be available on Amazon TV and Apple TV but I expect that it will quickly spread to Xbox, PlayStation and the other streaming TV devices that are available.
  • The one place I don’t expect to find it is Chromecast as Facebook’s video aspirations are clearly a challenge to YouTube.
  • Of the three new areas of Digital Life (Gaming, Media Consumption and Search) that I see Facebook targeting (see here), going for video first makes complete sense.
  • This is because Facebook already has a lot of traction in this space and also because it is the least demanding in terms of requiring intelligent automation.
  • The total number of video items that are present is very low compared to other things like music or searches and knowing who posted the video is a good indicator of its content and who will like it.
  • I continue to see Facebook as the laggard in AI (see here) and targeting video is sensible as it gives it more time to improve its AI before having to apply it to more difficult tasks.
  • Furthermore, the fact that video is a fast growing, but likely soon to mature, medium for digital advertising also means that the time to really address it is now.
  • I see the app on the TV as just the beginning and would not be surprised to see this being followed up with premium content taking it into the realm of Netflix, Hulu, YouTube and Amazon Prime.
  • That being said, I don’t think that Facebook’s offering in Media Consumption is anything like mature and so I think it will be some time yet before it becomes a real destination like YouTube.
  • Consequently, I still see a slow period of revenue expansion while its new strategies mature before revenues take off again.
  • As this reality sinks in, I think the valuation could unwind somewhat providing a better opportunity than now to invest for the long-term.

Twitter Q4 16 – No Trump card

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Trump card fails to win the trick.

  • Despite becoming a major channel for the White House to communicate with voters, the realities of Twitter’s situation have continued to dominate its financial performance.
  • Q4 16A revenues / Adj-EPS was $717m / $0.12 badly missing consensus at $740 / $0.23.
  • Monthly active users (MaU) also remained stagnant coming in at 319m up 4% YoY which reflected the anaemic revenue growth which was just 1% YoY.
  • Daily active users did manage to grow 11% indicating some increase in engagement with the service, but it was not nearly enough to convince advertisers to spend more money on the platform.
  • This reality was reflected in Q1 17 guidance where Adj-EBITDA will be $75m – $85m well below consensus at $188m which I think reflects stagnant revenues as well as higher investments in media consumption.
  • I continue to believe that the lack of growth is caused by the fact that Twitter has already fully monetised its segment and in order to grow revenue further it has to address the other segments of the Digital Life pie.
  • In this regard, Twitter has opted to go for Media Consumption which would add another 10% points to its coverage, bringing it to 28%.
  • This is why its progress with its streaming of NFL games and partnership with Bloomberg, Buzzfeed News and PBS is so important.
  • If Twitter can develop this offering into a fully-fledged Media Consumption service with real engagement, then I could see Twitter increasing its revenues to over $1bn per quarter giving annualised revenues of $4-5bn.
  • However, it is still very far from challenging YouTube or Facebook Video which is why I need to see far more than just NFL streaming and a bit of news in order to become confident that Twitter has a media consumption offering that it can monetise.
  • With $196m in cash flow from operations in Q4 16 and $763m for FY2016, Twitter is very far from any existential danger but I see the fair value of the company with no growth being way below where it is today.
  • Consequently, I see nothing in 2017 that is going to drive Twitter back to growth which will put further pressure on the share price.
  • I continue to see Twitter as a potential acquisition target but would expect to see the shares touch $10 before real interest is triggered.
  • I see no reason whatsoever to go bargain hunting as there is no bargain to be had.