Snap – Reality of fad.

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Snap learns a hard lesson.

• Snap generated plenty of interest around its first hardware product but the fact that more than 50% users wore the spectacles for just 4 weeks indicates that the device was nothing more than a passing fad.
• To add insult to injury a sizeable number of users got fed up with the glasses after just one week.
• Snap sold around 150,000 units of the spectacles which was above its initial 100,000 target but the interest that it managed to generate in the first few days fooled it into thinking that it was something more than a fad.
• When Snap launched the spectacles, it announced that vending machines would pop-up at undisclosed locations a clever strategy that generated long queues to purchase the product.
• Unfortunately, this development led the hardware-inexperienced Snap to think that it had a hit product on its hands which meant that it ramped up manufacturing orders in anticipation of demand which was never real.
• Snap has declined to disclose how large its inventories are, but it did say that as of Q2 17, it had irrevocable hardware purchase commitments of $29m related to the spectacles.
• This will be on top of the inventory that the company already has.
• I suspect that following launch, the company ramped up its orders to around 500,000 units which assuming 150,000 sold and a bill of materials of $110, would give an unsold inventory of 350,000 units with a total cost of $38.5m.
• Snap has plenty of cash on its balance sheet ($2.8bn) and so writing down this inventory to $0 will not hurt financially but it is a real black eye for the company’s credibility.
• Snap has also substantially reduced its resource commitment to hardware which I think spells the end of its efforts to compete in hardware (see here).
• I have long held the opinion that Snap has no business being a hardware company (which would materially damage its valuation) and should instead concentrate on its core strengths.
• These strengths are working out innovative ways for users to engage with each other over an instant messaging platform but unfortunately these innovations are very easy to legally copy.
• Instagram now has a successful habit of copying all of Snap’s best innovations and pushing them out to its much larger user base pretty quickly.
• This makes it extremely hard for Snap to compete as apps that offer communication are all about the network of users.
• Metcalf’s Law of Networking states that the utility or value of a network increases by the square of the number of devices attached to it.
• This would imply that Instagram (4x Snap’s size) should be at least 16x more valuable than Snap meaning that at Snap’s valuation, Instagram makes up more than half of the valuation of Facebook.
• Instagram is an important part of Facebook, but I don’t think it is contributing more than 50% of Facebook’s value.
• Hence, I would be inclined to believe that Snap remains meaningfully over-valued.
• I think that fair value for Snap remains around $12.40 per share which is still 18% below where the shares are today.
• I still think that negative sentiment could push the shares closer to $10 at which point acquirors could start to take interest.
• Until then I still see no reason to get involved and would strongly prefer Twitter to Snap Inc.