Snapchat Could Be Worth Billions and Other Reasons Why Social Media Is Crazy

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Social media is all about engagement. A platform like Facebook (NASDAQ:FB) or Twitter (NYSE:TWTR) can’t just have users — in order to maintain critical mass they need to have active users. Users need to read content, share content, and upload content so that other people will feel compelled to read, share, and upload more content. If fostered correctly, the cycle is virtuous: the user base grows and engagement feeds on itself as users connect and interact with each other.

Social networks evolve into real businesses when they figure out how to effectively tax users for their use of the service. In most cases, this means sneaking advertisements into the News Feed, like for Facebook, or Promoted Tweets, like for Twitter. Whatever the case, though, social networks usually achieve a critical mass of users and engagement before they figure out how to monetize. This makes early investment in social media companies necessarily speculative: active users by themselves aren’t going to bring in any cash.

Right now, Twitter is a great example of this. Even though it has begun the monetization process it is still losing money, and Twitter’s enormous valuation is largely a product of speculation. Twitter is sitting on $300 million in losses over the past three years, with a $65 million loss in the most recent quarter alone.

As of September 30, Twitter claimed 232 million monthly active users, up 39 percent on the year, but only about a fifth of Facebook’s monthly active user base. Timeline views, a measure of engagement, increased about 53 percent on the year to 158,758 for the quarter ended September 30.

Revenue has grown enormously alongside user base and engagement metrics. Revenue for the nine months ended September 30 were up 106 percent on the year to $422.2 million. “Although we do not generate revenue directly from users or platform partners,” Twitter said in its S-1 filing, “we benefit from network effects where more activity on Twitter results in the creation and distribution of more content, which attracts more users, platform partners and advertisers, resulting in a virtuous cycle of value creation.”

Twitter’s net loss in the same period, though, widened from $70.7 million to $133.9 million. This loss, coupled with the enormous valuation, may be what is most troubling about Twitter as an investment right now. Twitter’s growth prospects look good, but the path forward is by no means set in stone. As with any social media company, Twitter faces very real risks.

“We generate a substantial majority of our revenue based upon engagement by our users with the ads that we display,” Twitter said in its S-1 filing. “If people do not perceive our products and services to be useful, reliable, and trustworthy, we may not be able to attract users or increase the frequency of their engagement with our platform and the ads that we display. A number of consumer-oriented websites that achieved early popularity have since seen their user bases or levels of engagement decline, in some cases precipitously. There is no guarantee that we will not experience a similar erosion of our user base or engagement levels.”

With this risk so clearly spelled out, it becomes paramount for any would-be investor in Twitter to believe that the company will not fall victim to user atrophy, and that it will be able to fully execute its monetization strategy. All this is fairly well understood by most investors by this point (although Twitter’s enormous opening-day pop may provide evidence to the contrary). Also, with this in mind and the dust from Twitter’s IPO settling, the conversation has shifted toward what could be the next big social media player on the block: Snapchat.

Word on the street is that Facebook tried to buy the company for $3 billion, and was turned down. Google (NASDAQ:GOOG) reportedly offered $4 billion and was shown the door. Even Chinese tech company, Tencent Holdings (TCEHY.PK), is rumored to have put in an offer — but to no avail.

First, how could Snapchat conceivably be worth so much money? The quick answer to the question is that it has enormous engagement. The service reportedly shares 400 million photos every day, more than the 350 million uploaded by Facebook’s 1 billion users and far more than 50 million photos uploaded by Instagram’s 150 million users. Market watchers may recall that Facebook bought Instagram in 2012 for $1 billion.

All this traction could, possibly, be converted into cash flows, which is where the valuation comes from. To some observers, though, Snapchat’s decision to reportedly walk away from the deal is ridiculous. The concern is that Snapchat’s valuation is as ephemeral is its content, and that the company is passing up a golden opportunity. The risks that Twitter outlined for itself in its filings with the SEC magnify when applied to Snapchat. The monetization model for the service is even less clear.

But that begs the question: what would Google or Facebook do with it? Especially at such an enormous cost? Reports on the rumored offers suggest that both Google and Facebook would keep the service an independent app. It’s unclear how exactly the service would justify the cost of acquisition. Whatever the answer, it will mean finding a way to cash in on all that engagement — all that engagement that could, as Twitter outlined, just vanish as the whims of users change. There is really no other industry like it.

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