A Glimpse of Reality
By: Robby O'Brien
The Ivey Business Review is a student publication conceived, designed and managed by Honors Business Administration students at the Ivey Business School.
After Snapchat turned down a $3 billion acquisition offer from Facebook, pundits and tech-junkies alike scratched their heads over the news, while trying to piece together their thoughts on whether the offer was rational or ridiculous. A mere week later, as if on cue, the start-up announced that users were now receiving more than 400 million picture messages (snaps) per day.
Furthering the narrative, February 19, 2014 brought news of Facebook’s successful acquisition of WhatsApp, the dominant conventional mobile messaging application (app) boasting more than 450 million active users, for $19 billion. Framed against the backdrop of Facebook’s prior acquisition of Instagram, and its 30 million registered users for $1 billion in April 2012, a trend of ‘ever larger’ splashes in the start-up technology pool begins to form. With mobile establishing itself as an indisputably dominant force in today’s world, the genius of Snapchat’s decision to remain VC-backed gains clarity.
Framing the Picture
Run by two recent products of the Stanford billionaire machine, Evan Spiegel and Bobby Murphy, Snapchat is headquartered in a cozy office on Venice Beach, but they are not in a position to get comfortable. The company competes for smartphone users’ time against countless other apps within the messaging niche. The global stage is dominated by ‘the big five’ mobile messaging apps: Skype, WhatsApp, WeChat, LINE, and KakaoTalk; all of whom, with the exception of KakaoTalk, claim over 250 million active users. With many more apps closely trailing these leaders, the space is undoubtedly crowded. Apps vie for space on smartphone screens by creating fast and simple user interfaces, and seeking a ‘best in class’ user experience. Additionally, messaging apps benefit from network effects, creating a ‘winner takes all’ scenario for the most popular apps within their respective dominant geographies.
Smartphone users are bombarded with options when it comes to messaging apps, resulting in redundancies when using several of them. But Snapchat provides value above and beyond the typical messaging app. It allows users to send pictures with optional overlay of text that are only viewable for a maximum of 10 seconds. The ephemeral (lasting for a short time) messaging space had no incumbents when launched in 2011. Snapchat has incredible potential in this sense seeing as it can exist simultaneously with other apps on a user’s phone. The value offering and use case is inherently different. Perhaps Lightspeed Venture Partners’ (LVP) Jeremy Liew explained Snapchat’s core value offering best when he said, “It allows people to revert back to a time when they never had to worry about self-censorship.”
Adjusting the Lens
The fact that Snapchat has yet to earn a cent in revenue appears to be a concern to many who question how this start-up could be worth three times what Instagram was worth to Facebook. It would seem that the company needs to pull up their socks and start generating some cash. However with global mobile ad spending set to increase significantly from $25 billion this year to almost $50 billion in just two years, revenue generation should be delayed in favour of maintaining the current user base growth. With a larger user base, Snapchat will be poised to capture a meaningful share of the projected mobile ad spending.
Currently, the average user of the app is speculated to be in the range of 13 to 24 years old. With the phenomenon of technologies, demographics tend to ‘hop’ from children to their parents, skipping the late 20 and 30-somethings. The next user base of the app may be Generation X. What’s more, examining the growth trends for other popular messaging apps, it seems that Snapchat is approaching an inflection point at the 100 million user mark.
The dominant mobile messaging apps are proving the viability of revenue generating functionality ranging from dreaded subscription fees and advertising, to in-app purchases and buyable in-message images or ‘stickers’. However, the revenue potential for Snapchat on the horizon is far greater than today. Snapchat is clearly growing its user base quickly, and should continue to make growth and high user engagement as its top priorities. Rushing the pursuit of revenue in the short term would be a serious mistake as it could limit future earning potential by alienating users or slowing the growth trajectory. Snapchat needs to develop its capabilities for engaging with advertisers today, so that when the app reaches a mainstream user base, tomorrow, it can capitalize to the fullest.
The 10 second photo shoot
Forward-thinking companies have already begun to try their hand at Snapchat marketing. McDonalds and Tacobell have invited Twitter followers to add them as friends on Snapchat. New York-based frozen yogurt company 16 Handles offered followers an ‘exploding coupon’ for their next purchase (within a snap), in exchange for sending a snap of them consuming a 16 Handles product. This is incredible for advertisers – a highly captive audience that has chosen to engage with the company for product offerings. When they decide to pursue a monetization strategy, Snapchat should develop app functions that allow marketers to more effectively engage with consumers.
Snapchat should provide functionality for company lookup within the app similar to the ‘Find Friends’ lookup function, but through a database of companies with Snapchat accounts. Also, Snapchat should offer verification and audit services for any marketers wishing to identify themselves as representing a company, including the ability to track, choose, and limit snaps sent by companies to protect the experience. This would create value for both corporate marketers and regular users; marketers would benefit from a protected corporate brand and users would benefit from a controlled and audited advertising process. Snapchat maintains control over user experience and creates an opportunity for future revenue generation by stimulating relationships with other companies. Best of all, since it simply facilitates the connection of advertisers with users instead of forcing it, it’s unlikely to curb the growth rate.
Beta Testing Opportunity
Though barely publicized, Snapchat has taken advantage of the opportunity to test a range of functions available for future revenue generation, from ‘Find Friends’ to ‘Stories,’ with very low risk of user alienation. The company has admitted that new functions are alpha tested with a small fraction of the user base before wider implementation across the app. The captive audience of Snapchat is thus another avenue of incredible potential – the current app user base is available as a team of dedicated beta testers. When functions like ‘Stories’ go app-wide, they can essentially be beta-tested for future use with marketers; if functions don’t measure up with the alpha-testing they can be taken back to the ‘drawing board.’
There is tremendous potential in the opportunity to ensure that new functions fit well with the general user base before ever being offered as a source of revenue generation. Functionality, which proves successful with a limited alpha testing user base can similarly be implemented across the app for further testing before offered to marketers.
For example, the traditional sticker functionality, used by some other messaging apps, could offer a limited number of images to place on top of photos taken with the app. If a variation of the function proves successful with the general user base, in the future marketers could be offered ‘sticker sponsorship’. If a user chooses to receive snaps from a particular company, the company can then pay to have more, different, or branded ‘stickers’ available to the user for use.
Capturing the Value
By focusing on growth to reach mass market adoption, and pursuing new app functionality to attract marketers, Snapchat will position itself to capture the exceptional marketing spend in the future. But how much can Snapchat really earn?
Snapchat would likely be able to charge high-end marketing dollars to reflect high user engagement. This would then mirror higher prices, such as those for Twitter’s cost per user engagement on promoted tweets ($0.75 to $2.50), or Facebook’s cost per click on promoted ads ($0.60 in the US). Therefore, an advertiser might find it reasonable to pay between $0.50 and $1.00 for each user impression (opened) snap on Snapchat. If the 100 million users received 10 to 20 promoted snaps per year this would represent 1 to 2 billion total ad impressions. As a point of reference the average user receives 1460 snaps per year, meaning advertisements would comprise a reasonable, approximate1% of received snaps. To further justify strong user engagement, a recent study found that almost half of college-aged users would open a snap from an unknown brand and 73% would from a brand they knew. This could generate between $500 million and $2 billion in revenues representing between 1 to 4% of the $50 billion in global mobile ad spending expected in 2016.
So what does that mean for the valuation of Snapchat? Most tech IPOs for internet services fall between 2.8x and 50.0x with a mean of 13.2x. Twitter for example IPO’d at 26.0x its 2014 revenue estimates. Considering the hype around Snapchat and its greater engagement capabilities, Snapchat’s valuation could easily land on the higher end of this range. With revenues of $1 billion in a two year timeframe, Snapchat could see a valuation of $20 billion. It seems then that turning down the $3 billion acquisition for Snapchat makes perfect sense. With profits in the future likely to be significant, valuations could even exceed $20 billion in two years. However, Snapchat will need a clear and deliberate focus on maintaining the user experience to have any chance of capturing that value in the future.
