Snap Out of It: GoPro or Go Home

Most software is fungible these days. Snap (NYSE: SNAP) has called itself a "camera company," which is clumsy shorthand for its goal of becoming a premier consumer hardware company. While Snap has successfully created exciting marketing events with its filters and is well-situated to promote blockbuster movies, this expertise alone cannot justify its current valuation. Following Larry Ellison's unrelated comments many years ago about "going back to the future," hardware is becoming sexy again because software features are easily replicated.

My main concerns are 1) Snap's main user base is between 10 and 29 years old; and 2) GoPro (NASDAQ: GPRO) is already the premier camera company.

With respect to 1), this group lacks high levels of disposable income and isn't known for brand loyalty, indicating hardware margins or profit may be stressed. As for 2), if Snap plans on avoiding competition with GoPro by focusing on teenagers and younger adults with cheaper products, Polaroid and vintage cameras have already been done. Spectacles is not revolutionary, unless you count flashing lights as a remarkable innovation over Google Glass. How does Snap plan on differentiating itself long-term?

Unlike Amazon (NASDAQ: AMZN), Snap cannot displace existing software and hardware companies, which have entrenched users and their own "sticky" ecosystems. Furthermore, how many different ecosystems will consumers tolerate before they become frustrated? A quick online search shows several apps capable of adding both filters and special effects to pictures, such as BeFunky.com. In short, Snap lacks a "wide moat" from a technological standpoint and needs to quickly capitalize on its accomplishment of being first to market and capturing younger users.

Being first to market can be a long-lasting advantage in the consumer market. Success begets success as retailers provide more prominent shelf space to faster-selling products, leading to relationships between suppliers, advertisers, and manufacturers that are hard to displace. If a consumer company is first to market, competitors often end up vying for second place, fighting over shelf and virtual space that hasn't already been allocated to the market leader. Older readers might remember that Gameboy was first to market and maintained its leadership position in the videogame industry, even though Sega later produced a much better product. In fact, Nintendo continues to ride the success of the Gameboy today, while Sega sputtered with its Dreamcast console, becoming the Reebok to Nintendo's Nike.

How can Snap ride the wave of its younger user base and its "first to market" unique filters? One interesting scenario would be for Snap to partner with existing hardware companies like Fitbit (NYSE: FIT) and GoPro. More specifically, Snap could leverage the retail relationships smaller hardware companies have already built and offer access to its software and user base--for a fee, of course--as a way for smaller hardware companies to combat Apple and Samsung. Trying to displace Fitbit and GoPro shelf space in existing retail establishments doesn't make much sense--there's only so much shelf space to go around--and Snap doesn't have enough hardware products to open its own stores yet. If Snap tries to go against Apple, Google, and Samsung alone, it risks becoming exactly like Fitbit and GoPro, i.e., hardware companies desperately trying to hang onto to existing customers as larger companies copy their products and force the smaller companies to spend more dollars on each additional user, delaying profitability and making it harder to maintain margins.

One potential scenario involves GoPro CEO Nick Woodman pledging his own net worth as collateral and taking GoPro private, with the understanding that Snap would be a long-term partner and GoPro would design its products to be compatible primarily on Snap's software platforms. With either Snap or a consortium of equity funds buying a 49% stake in GoPro, Woodman could direct GoPro into new areas, diversifying his own user base and continuing to spend dollars on marketing and retail relationships rather than software engineers. (Note: most of GoPro's open technical careers are currently in Romania and the Philippines for software-related positions.)

Once software costs are minimized, GoPro could quickly move into new areas such as 1) food delivery by drone; and 2) tourism/travel.

Right now, Walmart (NYSE: WMT) is attempting to solve the "food desert" problem in inner cities, which tend to have cheap fast food and not enough healthy food. Using drones and online grocery ordering could revolutionize healthy eating in inner cities or isolated areas like First Nation lands. GoPro could offer to work with Walmart, Costco, and Target in delivering fresh food to consumers--a low margin business, but one that could serve as indirect advertising for its drones and other hardware products and a way to gain feel-good content.

Users, especially younger users, are tired of meaningless news and will quickly warm up to a software platform bringing them creative and positive content, such as tourism videos. GoPro CEO Woodman originally wanted to create content through an entertainment channel, but it wasn't profitable to do so, or he would have done it. As a private company in a cooperative setting, and with Snap handling the software, GoPro could focus on content development and capturing more users outside of Snap's existing demographic. Snap would broaden its demographic reach and save money and time leveraging GoPro's existing retail channels, and GoPro would maintain its financial strength by avoiding the costs of building and maintaining a competitive software platform.

Netflix once advertised with Amazon in its early days when it was trying to build its brand, and Jeff Bezos put a stop to it as soon as he found out about it, but GoPro and Snap don't compete directly with each other or larger food retailers, airlines, or travel agencies, making it easier to build relationships.

Once Snap demonstrates it can be a reliable partner, it can branch out to other consumer companies like Fitbit and discuss partnerships or demand a premium to reach its users in more substantive ways. For example, if Snap receives a movie licensing deal, it would normally create filters and receive payment for its marketing. However, in a longer-term partnership where its platform is used as a conduit to attract self-made content--such as mini-movies--it could become the purveyor of cool.

Right now, YouTube and other larger companies focus on all types of users to gain the most advertising dollars possible, but in doing so, fail to differentiate themselves. People sometimes go on YouTube to search for music and random videos, but they don't look forward to opening its app every day because Google relies on algos rather than curated content guaranteed to "wow" users. If Snap and GoPro create a mutually beneficial relationship establishing themselves as content curators and conduits for creativity, they can attract other companies experiencing difficulty breaking through the usual Apple, Google, and Facebook channels.

Snap's 12% drop on March 6, 2017 shortly after its IPO indicates it needs to think outside the box. In the hardware world, Apple and Samsung already dominate. Smaller companies like Snap need to figure out a coordinated way to take on the established behemoths or end up bleeding cash trying to avoid becoming fads. Meanwhile, GoPro CEO Woodman needs to do something soon. In 2015, he ordered a 180-foot yacht, to be delivered in 2017. It won't look good to be in a custom-made yacht while his shareholders suffer. Unless Woodman does something soon, his yacht might end up being called "French Revolution" or "Marie Antoinette." Will GoPro and Snap work together, or will they try to displace Apple and Samsung, two companies with marketing budgets larger than most companies' market capitalizations? Shareholders of Snap and GoPro should hope their CEOs make the right choice.

Bonus: the kind of partnership I envision is similar to the way Disney runs international resorts, i.e., a hybrid licensing and royalty model. Basically, Snap could license its software and platform to GoPro (and other smaller hardware companies like Fitbit) and also negotiate royalties based on revenues to incentivize a true partnership.  In the first few years, the licensing fees would be smaller and the royalty percentages higher, but as both companies learn each other's channels and execute more efficiently, the licensing fees could increase while royalty percentages to Snap decrease. More here on the overall model. 

Update on March 8, 2017: great comment from another website: "I like your Nintendo vs. Sega analogy but you compared apples to oranges. Gameboy was a portable handheld. Dreamcast was a console system. A better comparison would be how Sega's 16GB Genesis was better than Ninendo's 8bit NES system or how their full color GameGear portable was better than Ninendo's black and white, dinky Gameboy. But like VHS and Beta, Nintendo won out." 

Modern Capitalism, or How to Guarantee a Military-Industrial Complex

My uncle once told me, "In the future, there will be five companies, and they'll own everything."  We needn't go into the future to see such a reality--in most important ways, the aforementioned scenario is already here if you add two zeros to the end of the number above.

Where does innovation come from after a company achieves multinational status, starts paying a dividend, but still has to grow by x% annually to please Wall Street? Some people may know that such growth comes from buy-outs and mergers. Indeed, after a certain size, large companies succeed based on how adept they are at incorporating a newly bought company's products and remaining employees into their own pre-configured business and legal systems. In short, scalability, supply chain management, and risk controls drive value in a major corporation if it survives long enough. What about innovation?

Under the current merger-and-acquisition system, major companies will "buy" innovation and pay premiums--sometimes obscene ones--to avoid having large and unpredictable R&D budgets. In such a dynamic, large companies can pay a small percentage of their revenue to attract a smaller company, but without taking the risk of having larger or recurring R&D costs on the books that don't produce consistent ROI. Smart, right?

Yet, it is precisely the large companies, with their established products and revenue streams, that are best able to take the risks necessary to produce great ideas. If only smaller companies are taking bank loans or SBA loans to try new ideas, then the banks become the primary risk-takers and consequently demand greater influence and political power to take on such risk. If the big banks' investment banking, consulting, and M&A groups are the major players backing smaller companies or venture capital firms, then most innovation not linked to academia is supported by the banking sector.

Guess who supports the banking sector? The FDIC and your deposits.  In other words, under America's current capitalist system, taxpayers are back-stopping the risks of innovation under "too big to fail" because many larger corporations aren't investing enough in R&D, which is seen as an unpredictable cost by Wall Street. Today, only Tesla (TSLA) appears to be choosing innovation over steadily increasing share price. Other companies like General Electric have large R&D budgets, but as a percentage of gross revenue, they're actually minuscule--usually no more than 7%.

Seen this way, of course America's banking and insurance sectors will have the most influence in Congress--they're the ones driving innovation by funding R&D that larger companies should be funding but won't. Not only will large banks and insurance companies demand favorable tax policy for their risk-taking (witness Warren Buffett asking for and receiving a "terrorism" exemption post-9/11), they get their funding directly from the Federal Reserve or indirectly by convincing the Federal Reserve to lower interest rates. What are you, the taxpayer, getting in exchange for stricter personal deductions than businesses; receiving low interest rates on your deposits; and being the insurer of last resort?

You probably won't guess the correct answer: a military with a budget not subject to audits that does the R&D for you, but with the higher risk of pursuing war as a testing ground for new weapons and strategies, and with debt that could sink or split the entire country if mismanaged. If the larger companies have external checks and balances that mitigate R&D risk-taking, and the banks are being back-stopped by the government (and therefore taxpayers) when they make loans that support R&D, big banks and the military become the two groups not subject to checks and balances but necessary for innovation. Under such incentives, it's only a matter of time before the military and banking sectors dominate the entire country and become powerful enough to ignore President Eisenhower rolling in his grave.

And so it goes.

Matthew Rafat (copyright 2017) 

Bonus: "In the past 30 years, America has had 13 wars at a cost of $14.2 trillion...what if they [had] spent part of the money on building up infrastructure?" -- Alibaba CEO Jack Ma

Bonus: below are the numbers supporting the arguments above:

People don't understand the difference between budgetary outlays and discretionary spending, or appropriations/expenditures, which is responsible for the inability to see eye-to-eye on fiscal responsibility debates.

Mandatory spending is federal spending based on existing laws. This budgetary spending is mainly entitlement programs, such as Social Security and Medicare, whose spending criteria are determined by who is eligible to apply for benefits and not by Congress, and includes items supposed to be relatively predictable. Discretionary spending, on the other hand, is the portion of the budget that the president requests and Congress appropriates every year through legislation. In the past, such spending was supposed to be for one-off, unusual and unpredictable items but has now become a slush fund for military adventurism, as we'll see.

Furthermore, when discussing military spending, it's debatable whether to include VA spending as part of the national defense budget, which creates further confusion. Let's try to clear up these issues.

Spending on national defense is estimated to be about 15% of all outlays in 2017. This is less than average when compared to budgets from other years. (Average proportion = 22%). That 15% is about $516 billion, not including VA funding.

The President’s 2017 budget includes $182.3 billion for the VA in 2017. This includes $78.7 billion in discretionary resources and $103.6 billion in mandatory funding (for veteran's disability benefits). Including national defense and VA budgetary amounts together, we have a total of $698 billion spent on military-related budget items. Technically, that's less than what we spend on Health and Human Services (e.g., Medicare) and Social Security (almost a trillion projected in 2017). However, the above figures do not include discretionary spending, which causes annual deficits funded partly by issuing debt to foreign countries. Let's look at those numbers.

For 2017, 49% of total discretionary spending is projected to go towards national defense, or about $500 billion. That means we spend about $1.2 trillion every year on the military and military-related items. Thus, the largest spending items in America in 2017 are the military and the VA; Social Security; and Medicare. Why is that a problem?

In 2017, the government is estimated to have a total debt of $17.7 trillion. At 104.4% of GDP, this percentage is extremely high when compared to other years (avg. 59.0%). Spending on SS is fine--that debt is owed to Americans. Spending money borrowed from future generations on unnecessary or inflated medical expenses like pharmaceuticals and on unnecessary wars or wars of choice is unconscionable. It guarantees fewer opportunities for younger generations. It means our intelligence agencies work overtime trying to justify illegal military invasions or are tempted to engage in false flag or psychological operations to justify security spending. It means millennials are called lazy or immature when they're anything but. In short, when you're going in debt for unnecessary items, and you need the jobs related to that unnecessary spending to get votes and stay in political office, you have to resort to fear and outliers to maintain the status quo. Such an approach is inadvisable in any era, but especially so in an era of increasing competition worldwide and against countries to which you owe money.

Bonus: The local level creates no reason for optimism, either.  In most major American cities, 50% to 70% of all local tax revenue is spent on "public safety" aka cops and firefighters. Many of these taxes go to pension obligations, i.e., paying gov employees who no longer work and who haven't paid into the retirement fund in sufficient amounts to sustain it without higher taxes or cutting other local programs.  Consequently, America's military budget is not subject to any real audits due to the federal gov's ability to borrow almost unlimited debt, while even local entities are forced to divert their taxes into strengthening a police state because by law, pension interests are vested and therefore untouchable. What could possibly go wrong?

Well, this is the kind of activity required in such a regime: http://www.post-gazette.com/news/nation/2015/11/06/Department-of-Defense-paid-53-million-to-pro-sports-for-military-tributes-report-says/stories/201511060140

Basically, the gov spends taxpayer monies to normalize the abnormal, then demands the entities continue its show at their own cost or be called unpatriotic.

Both parties are complicit, and both parties are locked into unsustainable programs that require more debt because neither party wants to impose any fiscal discipline. Why should they, when they can rely on more debt to maintain the status quo and their jobs? In the case of California Democrats, their allegiance is to an unsustainable K-12 system, teachers' unions, and the teachers' pension plan, which guarantees a return of 7.5%--even though the economy is growing about 2% to 3% a year.

Rather than take a common sense approach and reduce benefits for existing retirees--who negotiated an 8% ROI under much different economic conditions--it appears govs will reduce benefits for incoming, younger employees and wait a generation to try to balance their books without relying so much on debt.  It remains to be seen whether any system that depends on achieving consistent 7.5% ROI can be sustained in the "new normal."