Snap is pricing its IPO — here's the case for and against investing

Snap

Snapchat's parent company, Snap Inc., is set to price its initial public offering on Wednesday, allowing investors to decide how much the social-media company is ultimately worth.

The company is officially seeking to raise as much as $3.2 billion and pricing shares at $14 to $16. That would value it between $19.5 billion and $22 billion. However, as Business Insider on Tuesday reported, there is enough demand to drive the share price to $17 or $18, which would value the company at about $25 billion.

Snap's IPO was already oversubscribed by at least $6.8 billion heading into the weekend, Business Insider reported.

About a quarter of new shares sold in the IPO could go to long-term investors who would be required to hold the stock for a year, the company said in a regulatory filing. In exchange for a guaranteed block, the big investors may agree not to dump the stock — though Snap's filing says it may waive the lockup requirement.

The roadshow in New York last month drew a standing-room-only crowd of nearly 500 people that one attendee said included "the entire hedge fund mafia."

Business Insider spoke to a handful of prospective investors and others close to the deal about the pros and cons. In most cases, these people declined to be identified because they were not permitted to speak to the press.

By now, the books have closed and the IPO investors are locked in. Everyone else will get a chance to make the same call when the stock begins trading on Thursday.

Here are the four key issues prospective investors in Snap are wrestling with, according to investors we spoke with.

• Valuation: Snap's $22 billion valuation at the top end of the IPO price range has been described as "smart" and conservative. However, Snap has no profits, and one venture-capital firm predicts it won't stop the red ink flowing until 2020.
• Slowing user growth: In the fourth quarter of 2016, Snap posted the slowest growth rate for any of the 12 quarters for which it reported numbers. It told prospective investors that the rate was partly due to problems with Android, and that it has focused on quality rather than quantity in terms of users. Still, some are "freaked out" about the slowdown.
• Monetization: Snap has only just started focusing on monetizing its users through advertising, and Goldman Sachs has forecast that Snap will increase revenues fivefold by 2018. However, some are concerned about Snap's niche demographic and the management team's ability to execute. One prospective investor said the success of the sales/advertising part of Snap's business is "TBD."
• The competition: The question of whether Snap should be concerned about Facebook — and Instagram, which Facebook owns — was an important element of the roadshow both in New York and London. On one hand, Snap has a reputation for innovation. On the other, Facebook is a $390 billion giant with deep pockets and a huge user base.

Following are the more in-depth bull and bear cases for buying a piece of Snap.

BULL: Snap's potential $22 billion valuation

Snap's proposed valuation has raised some eyebrows on Wall Street, as people close to the company had for months floated the idea that it would be valued at up to $25 billion.

One person close to the deal, with a vested interested in seeing it succeed, told Business Insider that Snap is playing it safe with the intention of going higher as soon as demand merits. Conversely, asking for the full $25 billion and being forced to roll it back if investor demand isn't high enough would be a worse outcome that would taint the company's trading debut.

Though the company said it was seeking to price shares at $14 to $16, this person said the only acceptable price, in reality, is $16 per share or more. This person expects Snap's order book to be oversubscribed, meaning there will be demand for more shares than it is selling.

A hedge fund manager who attended the New York meeting told Business Insider that "the bankers are being smart about the pricing."

"You could make the point it's too low, but the bankers are being smart enough about not having another Facebook," he said, referring to the plunge that Facebook's stock took in the months after its IPO before shares eventually recovered. "I think they're pricing it at a very reasonable amount. Even if you're a skeptic, the valuation is coming out at a level where you almost have to look at it."

He added:

"If you're bullish, what you want to spin is at the end of day is that Facebook's market cap is $385 billion. Snapchat is coming about $20 billion enterprise value. When you think of enterprise value to opportunity set, it's a fairly palatable valuation. ...

"A similar way to look at it is to look at Twitter as a comparison, with a $12 billion market cap. They have a user-base problem, monetization problem, and they're still worth $12 billion. The premium that Snapchat is coming out as versus Twitter isn't that bad for what I'd argue is a much better program."

BEAR: Snap's potential $22 billion valuation

Still, not everyone is sold on Snap's valuation. GP Bullhound's Manish Madhvani told Business Insider that Snap represents a "very risky" investment.

Addressing Snap's valuation, Madhvani told Business Insider: "Is it worth that? I think you can see a clear path to where they're going to get to monetization of 1.5, 2 billion quite easily from what they are at the moment. But can they go massively beyond that? That's the bet you're really taking."

Snap had revenue of $404 million last year, and Goldman Sachs is forecasting that the company will hit $2 billion in revenue by 2018. Snap's net losses, however, deepened to $515 million in 2016, versus $373 million the year before.

Silicon Valley VC firm Goodwater Capital, which does not have a stake in Snap, estimates the red ink won't stop flowing until 2020.

Atlantic Equities research analyst James Cordwell wrote in a recent note that while the Snapchat app was an "impressive 'made for mobile' service" that was popular among young users, it would be difficult to expand its audience base beyond this demographic.

"With expansion beyond the core audience likely challenging, sustainability of engagement concerns to persist, and margins structurally lower than peers, we do not see upside to the $14-$16 IPO valuation range," Cordwell wrote.

Another investor, who specializes in tech, put it this way: "I'm bullish in the sense that I think Snap can be a multibillion company that generates lots of profits and revenue. ... But the question for me is if you're trying to go public at $22 billion and you have no profits today, if you're an investor, you really need to be compensated for that risk. You need it to be a $50 [billion] or $70 billion company for it to be worth it. I'm bearish on their prospects of getting to that level."

BULL: Snap's slowdown in user growth

In the fourth quarter of 2016, Snap says it had 158 million daily users, an increase of 48% from a year earlier. That's the slowest growth rate for any of the 12 quarters for which it reported numbers.

It's hard to make a bull case for a statistic like declining growth, but one person close to the deal laid out a counterargument. Essentially, this person said, Snap emphasizes the quality of engagement over quantity of users. Spiegel wants existing users to really enjoy the product and is focused on innovating to make it more usable.

Part of that means users must have higher-end smartphones. Snapchat works best on iPhones, and while some problems persist on Android and other phones, Spiegel says he will not dilute the product to make it work on every phone. At the roadshow, Snap attributed the slowdown in growth to persistent problems with accessing the app on Android.

So unlike Facebook, which has nearly 2 billion users around the world, Snap is not focused on non-iPhone-using customers in places like the developing world because those markets are not easily monetized. The logic is that advertisers want to reach North America and develop Europe rather than the rest of world.

Goldman estimates that the company could grow its daily average users to 221 million in 2018, up from 158 million late last year, Business Insider previously reported.