Why You Should Be Cautious About Snapchat's IPO

The Snap IPO is finally official, and every investor should know what a big deal this is. Snap is by some measures the largest tech IPO to ever hit the market, and its success or failure will be a sign for tech companies like Airbnb or Uber, which could go public later this year. Investors as a group have every reason to hope that Snap will be successful, and Snap’s appeal with younger demographics and its willingness to innovate could persuade investors.

But while Snap is trying to be a cool company, this company has fundamental problems which should unnerve prospective investors. Investors should, at minimum, wait until Snap falls in share value as it will at some point after the initial IPO buzz wears off to snap it up, and they may be better off avoiding this stock entirely.

Making a Profit

What is Snap’s biggest problem? As the company admits in its SEC filing,

We have incurred operating losses in the past, expect to incur operating losses in the future, and may never achieve or maintain profitability.

There are operating losses, and then there is what Snap is losing. Snap had a net loss of over $514 million in 2016 along with a further loss of $372 million in 2015. Snap can point to a revenue jump from $58 million to $404 million in those two years, created by its decision to finally permit advertising on the app. And while Facebook showed that it was profitable before it went public, that is by far the exception to the norm for tech companies, which promise high growth rates which will eventually turn into a profit.

Well, most tech companies because as noted above, Snap is not even promising that. In fact, it is highly unclear what Snap’s road to profitability actually looks like.

Part of the problem to finding that road relates to some of Snap’s supposed strengths. Snap is highly popular among teens and millennials, two demographics highly coveted by advertisers. It is also well positioned to take advantage of the growing popularity of mobile, as is shown by the recent announcement that it will be streaming six episodes of BBC’s “Planet Earth” via mobile.

But while Snap is popular with millennials and teens, for now, these are two demographics that are very fickle, tech-savvy, and don't like ads. If Snap ratchets up the advertising in order to improve its bottom line, will it continue to remain popular or will teens flee to another social media website? And if Snap cannot ratchet up it's advertising, how will it manage to become profitable?

The Competition Problem

The concerns about profitability are even more severe because Snap’s user growth is leveling off faster than CEO Evan Spiegel would like. According to CNET, Snapchat “added only 4.5 percent more users from September to December” compared to previous quarters of double digit user growth.

There are multiple reasons for why this user growth has stalled, but the biggest threat is that Snapchat is facing heavy competition from Facebook (NASDAQ:FB) and Instagram. Instagram has not hesitated to rip off Snapchat as much as possible, launching Instagram Stories last August and announcing plans to place ads between stories just like Snapchat.

What’s more, Instagram is popular among celebrities, attracting those with a net worth of $60 million, sometimes more. And since Instagram is connected to Facebook, users can share their pictures through those two social websites easier than one can between Snapchat and Facebook. If that was not bad enough, TechCrunch points out that Instagram could surpass Snapchat as it has shown itself to be more willing to expand internationally.

Snap is trying to ignore these problems by calling itself a “camera company” and emphasizing its new Snapchat Spectacles, which have sold well thanks to a smart marketing campaign. But the Spectacles do not actually earn a profit at the current price and thus do not fix Snap’s fundamental problem.

Snap is a company which is losing a lot of money, is seeing its once gigantic user base level off partly due to competition from bigger companies, and does not seem to have a serious plan for how to fix these issues. Under these circumstances, it is quite clear that the hype is not matching reality.

Caution Heavily Advised

The tech IPO market would certainly benefit if Snap performs well, and Snap has enough hype and a flashy narrative to mean that it will probably perform well out of the gate. But there are legitimate questions about Snap’s long-term viability which it has not answered so far.

While Snap has its share of problems, investors should not ignore Snap completely and assume that it will be a complete bust. Snap clearly hopes that its stock can make it the next Facebook, but it is far more likely that it will be the next Twitter – an unprofitable company with a massive but leveling off user base and a declining stock.