The Cloud Will Stop Snap Inc. From Turning a Profit

A drawing of two clouds.

Snap Inc. (NYSE: SNAP) , the company behind the popular Snapchat app, is not even in the ballpark of being profitable. In 2017, Snap managed a negative free cash flow of $819 million on about $825 million of revenue. The company's costs exploded last year, even after backing out one-time stock awards related to the IPO.

Snap is taking some steps to rein in costs. The company confirmed last week that it was laying off more than 120 engineers, the fourth round of layoffs since September. Those earlier layoffs didn't do much to help the bottom line in the fourth quarter -- total expenses still soared 93% year over year. That should give you an idea of the scope of Snap's spending problem.

Despite the deep hole Snap finds itself in, CEO Evan Spiegel has reportedly set the goal of reaching break-even this year. That almost certainly means more layoffs. But cost-cutting may not be enough to push Snap's bottom line into the black. Because the company runs Snapchat entirely on third-party cloud platforms, instead of on its own infrastructure, Snap's task is made all the more difficult.

Gross margin woes

Prior to its IPO last year, Snap disclosed two massive cloud-computing deals with Alphabet 's Google and Amazon . The company committed to $2 billion of cloud spending with Google over the next five years, and $1 billion with AWS over the same period.

Most of Snap's cost of revenue consists of payments to these third-party infrastructure partners. Snap's total cost of revenue in 2017 was $717.5 million, with hosting costs accounting for about 64% of that total. The remaining cost of revenue is related to revenue share payments to content partners, content creation costs, and inventory costs for Spectacles.

Choosing third-party cloud infrastructure providers over its own infrastructure frees Snap from having to build out and manage its own data centers. But the downside is that the company's gross margin isn't very high. Gross margin was just 13% in 2017, rising to 33% during the fourth quarter. For comparison, Twitter managed a gross margin of nearly 65% in 2017. Twitter started migrating from third-party hosting in 2010, and now it runs its own data centers.

Although cloud computing is convenient, it's not cheap. If a company has sufficient scale, running its own infrastructure is going to be the lowest-cost option. Dropbox, the cloud storage company that recently filed for its IPO, offers a clear-cut example of the possible cost savings. The company completed its migration from third-party infrastructure providers to its own custom-built infrastructure in 2016. Its gross margin went from 32.5% in 2015 to 66.7% in 2017 as a result.

A barrier to profitability

Snap's reliance on third-party cloud providers will act as a barrier to the company reaching profitability. Unless the company can manage to vastly improve how it monetizes its user base without also increasing its hosting costs, Snap's gross margin will remain well below that of its peers. And because the company signed long-term deals with minimum spending commitments, building out its own infrastructure isn't really an option until these deals expire in 2022.

This means Snap is going to have to obliterate its operating expenses in order to turn a profit this year. In the fourth quarter of 2017, operating expenses, not including cost of revenue, totaled $455.4 million. Snap would have needed to cut those expenses by nearly 80% in order to turn a positive operating profit for the quarter. Clearly, laying off a few percent of its staff isn't going to get the job done.

It's hard to see a path to profitability for Snap this year. The company may be able to turn a different profit metric positive, like adjusted EBITDA, but that wouldn't be much of an accomplishment . It's more likely that Snap will see more red ink in 2018.

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John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool's board of directors. Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool's board of directors. Timothy Green has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Alphabet (A and C shares), Amazon, and Twitter. The Motley Fool has a disclosure policy .

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