Snapchat IPO? Don’t Buy

Snapchat, which prefers to go by the name of its parent company Snap Inc. in the investment context, is preparing for a $25 billion IPO in the second quarter of 2017. You already know my opinion on things like this, but I’ll go ahead and complete the formalities: People that buy into IPOs like Snapchat are engaging in the greater fool theory that was typical in the 1990s because they are speculating when they purchase an ownership share in a business that has no relationship between profits and earnings.

Right now, Snapchat is earning profits of around $50 million. When compared against a valuation of $25 billion, this means that the initial valuation is 500x earnings. I do acknowledge that the figure is not as absurd as it sounds. Because Snapchat is in the early stages of monetizing its app, it can rapidly double its earnings and then double them again so the cursory conclusion sounds more extreme than what the future reality may bear.

But still, Snapchat is only expecting $400 million in profits by 2023. Even if that proves accurate, and IPOs are notorious for overstating future prospects in promotional materials while hiding behind “no guarantees” in the registration and prospectus documents, we are still talking about a valuation of 63x expected 2023 earnings.

This is a classic, real-time example of people gravitating to the latest shiny object. I’m not even confident that Snapchat will be a cultural force a decade from now because of the nearly all-or-nothing nature of its business model (i.e. if something becomes more fashionable, teens and young adults will flock away from it and Snapchat will be added to the list of citations that are used by curmudgeons to make a point about the dangers of exuberance.)

I view many social media companies as analogous to the teen/young adult retailers of the late 1990s. You have this period of intense fashionability that is then followed by a sustained collapse in wealth.

Go check out some articles that people were writing about Abercrombie and Fitch in the late 1990s. People were gushing about its 40% profit margins and declaring it superior to Coca-Cola. The problem is that the demand proved short lived. Between 2007 and now, Abercrombie has seen its earnings crumble from $275 million to $50 million. The stock price has collapsed from $80 to $15 per share. Those operating margins fell from 40% to 9%. No one predicted the rise of sportswear/athletic wear as an alternative, nor did they foresee the decentralization of popular clothes where no single retailer maintained “it” status in the 18-34 year old market.

At a minimum, you should heed the Benjamin Graham advice of waiting a year because that permits passions to cool and other investors to move on to the next big thing. Yelp went from $24 to $15. Twitter went from $69 to $15. LinkedIn fell from $93 to $77. Even Facebook fell from $42 to $17 within its first year of trading. Categorically, an IPO stock has a very high probability of trading at a lower price than the IPO price because it is natural for anticipatory excitement to wear off over time.

It’s not fun having to be negative about these social media concepts because they are exciting if you vary your viewpoint. If you analyze this from the perspective of the founder, you can tell the story about a guy making $5 billion out of nothing and picking up a supermodel wife along the way. If you analyze this from the perspective of the initial private investors, you can tell a story about the power of networking capital and intelligent risk paying off handsomely. If you analyze this from the perspective of users, you can talk about the attractiveness of having moments that disappear in a few seconds as an antidote to a tech world that seemingly remembers everything. If you analyze this from an advertiser’s perspective, you get a new way to reach an even more targeted audience.

All of those perspectives are positive, feel-good viewpoints. But my blog focuses on the last-in-line common shareholder. These are the only losers in the story. Paying over 60x future profits (which are themselves inherently speculative) almost a decade down on the road is not how you build wealth in any kind of sustainable manner.

I’m not convinced that Snapchat will be relevant a decade from now. In which case, you could imagine a scenario like Abercrombie where 70% to 85% of wealth gets destroyed over a generation. At best, from an earnings perspective, you might have a company worth the $25 billion IPO valuation sometime in the late 2020s. The only avenue a Snapchat shareholder will beat the market is if there is some type of merger in its future (which would really just be a continuation of the greater fool theory.)

Market average returns over the long term will only be possible if Snapchat grows profits at 25% annually for a generation. Stay away from investments where you can’t even make the numbers work under the most optimistic of scenarios. The Snapchat IPO investors might earn a speculative profit over a short examination period, but as time marches on, the prospect of a 20x earnings valuation becomes increasingly likely, and that day of reckoning will be no friend to the Snapchat investor that buys at the IPO.