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In this article, I would try to perform the valuation of SNAP based on my narrative and try to rationalize my stand. Overview of SNAPSNAP redefines smartphone camera as a part of social communication tool by allowing users to add flavor through various captivating features and then monetize these user engagements through advertisements. The company’s user-base has grown from 46 million DAU (Daily Active Users) to 160 million DAUs over the span of last three years. ARPU (average revenue per user) went up by an average of 64% in the last eight quarters, thus driving up the top-line by the average of 80% in the same period. Since the product requires a lot of bandwidth, the company is primarily targeting the potential users in the developed countries. ~97% of the total revenue is from North America and Europe, however, revenue from rest of the world is also increasing primarily due to lower base effect. As the company grows, its total expenses as a percentage of revenue shrink largely due to the dominant portion of fixed expenses in the cost structure.SNAP received net IPO proceeds worth $2.4 billion and plans to invest in working capital, capital expenditures, operating expenses and general corporate expenses.Revenue: Leading driver of my valuation The company would increase its revenue by continuous innovation and acquisitions to expand its portfolio of offerings. This would result in an increase in overall engagements by the users and thus more advertisement inventory. To back up an assumption about engagement through innovative products, SNAP has the track record (even if it is limited) of successful offerings that have gained traction in the social media. Popular features such as stories and picture filters were incorporated by Facebook and Twitter due to their mass acceptance by the users. It is worth noting that SNAP has more user engagement than Twitter or LinkedIn. Further, SNAP is the only platform whose ecosystem is built around a camera, pictures, and social interactions. Latter two characteristics could be found in Facebook, but its value proposition is different from that of SNAP. Moreover, a recent update by WhatsApp has resulted in the concerns of possible dilution in the differentiation of platform provided by Snapchat. My only contention in this regard is that no matter how many features are copied by WhatsApp, WhatsApp would remain a platform centered around text messaging. Other features might add some flavor to the existing value proposition but these features cannot replicate the Snapchat experience.Snap ads and sponsored creative tools are built around increasing user engagement. This is unique when compared to existing social media platforms. The only concern in my view is that the company does not have robust data like Facebook, thus it runs a higher risk of creating products such as “Lens store” that are not well-received by the users. Apart from above-mentioned factors, my revenue assumptions of snap include the following assumptions:33% per year increase in Mobile advertisement till 2020, where SNAP would have at least 2% share.Above 50% growth in revenue for the next five years due to the availability of space for more users.Margins expansions to drive-up the free cash flowsI have calculated margins after accounting for the following points:Higher cost per user on the back of incremental hosting costs. $2 billion and $1 billion would be paid to Google Cloud and Amazon web services respectively.Cost per user ((Cost of Revenue-Equity rewards)/DAU) averages around $0.63.Operating margins (Operating profit + R&D cost) would converge to the average of Facebook and Twitter in the future after adjusting for differences in cost structure. Higher infrastructure costs resulting from capital-intensive projects like spectacles. Lower marginal costs per incremental user due to scalable nature of the product. The company has already reported a positive gross margin (Sales – Cost of revenue) of 0.33% in the last quarter of FY16.The company is expected to incur operating profit in 2019.As SNAP must incur hosting costs for every new user, therefore, its operating margins would be lower than TWTR and FB. On the flip side, its Sales/Capital ratio would be higher and hence lower reinvestment expenditure. Further, it is to be noted that I have included the R&D costs in the calculation of reinvestment expenditure. My concern on the company’s production of spectacles stems from the fact that the management has no prior experience in the hardware manufacturing and the manufacturing requires supply chain management skills in addition to quality and operations management.Cost of capitalI have used higher cost of capital for the first five years to incorporate the higher risk, however, after five years, the cost of capital converges to the average required returns of FB and TWTR. Marginal tax rate to settle at 30%I have assumed following points when determining the tax rates and net operating losses:U.S. federal and state net operating loss carryforwards of $73.7 million and $146.3 million respectively. Federal and state research credit worth $11.2 million and $7.0 million respectivelyTax liability of $195.2 million with respect to IPO proceedsStatutory tax rate of 34% The lower marginal tax rate in future is because of:Research creditsStock-based compensation Income from lower tax jurisdictionsCapitalization of LeasesI have capitalized the lease commitments using the synthetic cost of debt of 5%. Further, after adding an operating lease to EBIT and deducting the depreciation, adjusted EBIT of 2016 went up by $5.2 million. Further, this adjustment has also increased a debt to ~$534 million. The below table illustrates the derivation of adjusted EBIT. Shares outstandingAfter accounting for shares of all classes in addition to RSU (Restricted Share Units), there are 1.2431 billion shares outstanding. Additionally, there were 22.452 million options outstanding. These options were valued using Black-Scholes and then deducted from the value of the firm. ValuationI have use DCF method to value the firm. The target share price with the target date of Dec’17 is $31, offering an upside of 39% to the current closing. My workings are shown below. ................
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