Due to an editing error, some (but not all instances) of Warner Bros. Discovery CEO David Zaslav’s name were misspelled in yesterday’s Article. I deeply regret the error. In addition, I do plan to follow-up on the topic, but not today.
On to the update:
Snap Revenue Warning
From the Wall Street Journal:
Mr. Spiegel in a memo to staff reviewed by The Wall Street Journal said “while our revenue continues to grow year-over-year, it is growing more slowly than we expected at this time.” The Santa Monica, Calif., company said revenue and adjusted earnings before interest, taxes, depreciation and amortization would likely come in below the projection it issued only about a month ago.
There are two parts to this Snap news: the first is about Snap specifically, and the second is about the ad ecosystem broadly. Figuring out the first gives insight to the second — and there is a lot to figure out! After all, Snap has been all over the place in its pronouncements about its business:
- One year ago, Snap CEO Evan Spiegel, in the middle of Apple’s Epic trial, and in clear contrast to Facebook, pronounced himself happy with Apple’s App Store policies.
- Last summer the company was very blasé about Apple’s App Tracking Transparency (ATT) changes, suggesting it didn’t expect much of an impact on its business.
- Last fall the company took Wall Street by surprise by announcing that it was in fact heavily impacted by ATT.
- In January, shortly after Facebook’s disastrous earnings, Snap beat on the upside and said it was making solid progress in working through ATT.
- Last month Snap backtracked, admitting it was still working through ATT challenges, and noted that brand advertisement had slowed down in the wake of the Ukraine invasion, and had further slowed due to macroeconomic challenges.
All of this back-and-forth was before yesterday’s warning; from the 8-K:
Since we issued guidance on April 21, 2022, the macroeconomic environment has deteriorated further and faster than anticipated. As a result, we believe it is likely that we will report revenue and adjusted EBITDA below the low end of our Q2 2022 guidance range. We remain excited about the long-term opportunity to grow our business. Our community continues to grow, and we continue to see strong engagement across Snapchat, and continue to see significant opportunities to grow our average revenue per user over the long term.
It seems pretty clear at this point that Snap doesn’t really have a good handle on its business; I think I’ve identified the root issue, which both explain the results above and is also a warning for other ad-based businesses.
Snap’s Direct Response Bifurcation
Go back to Snap’s Q4 2021 results; CFO Derek Anderson said on the earnings call:
Total revenue for Q4 was 1.298 billion, an increase of 42% year-over-year, down from 57% in the prior quarter, but exceeding our expectations entering the quarter. At a high level, the macro headwinds we anticipated entering the quarter materialized largely as we expected, but our direct response advertising business began to recover from the impact of the iOS platform changes quicker than we anticipated.
The macro headwinds included supply chain disruptions and labor-related factors, which impacted our brand advertising business most directly with the consumer packaged goods and restaurant sectors of the brand business being impacted most significantly. These headwinds and their impact on growth rates for upper funnel objectives commonly utilized as part of brand campaigns such as impressions and views were the largest contributors to the sequential decline in year-over-year growth in Q4. Excluding the restaurant and CPG sectors, revenue from our brand advertising business grew at approximately 49% year-over-year, indicating what we believe to be continued strong underlying momentum in areas not impacted by the supply chain and labor issues noted earlier.
In Q4, we experienced better-than-anticipated demand from direct response advertising partners, and our direct response advertising business was once again the largest driver of our growth. We observed that advertisers began to recover from the initial disruption caused by the iOS platform changes and the resulting impact on the ability of our advertising partners to measure the results of their advertising investments…We experienced strong growth across a variety of mid- and lower funnel goal-based bidding objectives, such as app install, pixel purchase, pixel sign-up, and swipes, with revenue from each growing at 50% or better year-over-year in Q4. Our app install objective had been among the most negatively impacted GBBs in the prior quarter, and it’s return to 50% year-over-year growth was a key driver of our results exceeding our expectations entering the quarter.
A smaller subset of lower funnel app-based GBBs, such as in-app purchase, which have historically comprised a smaller portion of the Direct Response business, continue to be the most impacted by the limitations of SKAdNetwork, such as relatively high volume thresholds to return any result for a campaign. With the rapid enablement of our first-party measurement solutions, we are cautiously optimistic that the partners who utilize these lower funnel GBBs will begin to benefit from the more complete and timely measurement of results that these solutions afford.
Snap, appropriately enough, differentiates between brand advertising (without any immediate call-to-action) and direct response advertising (where you do something in response to an ad). Note, though, that there should be a further sub-division of direct response ads: those that lead to revenue, and those that don’t. It’s notable in retrospect that the former were still impaired, while the latter came back. One possible explanation is that it’s easier to measure an app install than a dollar spent; another is that you pay a lot more for a dollar than you do an install, which means that advertisers targeting revenue may have been a lot more careful.
I suspect, however, that another explanation came last month in the Q1 2022 earnings; here is Anderson again on the earnings call:
Total revenue for Q1 was $1.63 billion, an increase of 38% year-over-year. Revenue growth in Q1 initially exceeded our expectations entering the quarter, with year-over-year growth of approximately 44% through February 23. In the days immediately following Russia’s invasion of Ukraine on February 24, we observed that a large number of advertisers initially paused their campaigns. The vast majority of clients resumed their campaigns within 10 days following the invasion. And daily average revenue in March exceeded pre-invasion levels, but the rate of year-over-year growth remained below pre-invasion levels at approximately 32% from February 24 through the end of Q1.
The slowdown in the rate of year-over-year growth observed post the invasion of Ukraine was broad-based, with the deceleration evident in both our direct response and brand advertising businesses, and to many industry verticals…Despite the challenging operating environment, we were encouraged by the progress in our direct response advertising business with a year-over-year growth rate of 43% for the full quarter and nearly 50% prior to the invasion of Ukraine. A small subset of lower funnel app-based GBBs such as in-app purchase continued to be the most impacted by the platform policy changes.
First off, notice that the revenue-driving parts of the direct response business were still killed by ATT.
Secondly, notice that the non-revenue parts of the direct response business moved in concert with the brand business. This shouldn’t happen.
Back at the beginning of COVID, I used the occasion of Facebook’s relatively strong Q1 2020 earnings to explain auction dynamics and the interplay between brand and direct response advertising; from the April 30, 2020 Daily Update:
Suppose a mobile gaming company calculates that it earns $1 in net profit from every app that is installed from a Facebook ad; that gaming company can run an app installation campaign for $20,000 that spends up to, say, $0.99 per app install (obviously this is a simplification: the mobile gaming company also has a very good understanding of what its customers are like, and can target similar ones). At worst the gaming company expects to achieve 20,202 app installations, resulting in a profit of $202.
This capability is obviously very powerful and valuable, while the amount of inventory on Facebook is ultimately capped by the number of users and the amount of time they spend on the service. That means that the amount the gaming company has to spend creeps up towards that upper bound on a per-install basis, which is another way to say that Facebook ends up extracting most of the value out of the mobile gaming company…
Notice, though, what happens in a situation like the coronavirus crisis, where a segment of advertisers [like brand advertisers] competing for limited inventory stop buying ads: the mobile gaming company doesn’t reduce their budget — to do so would be to kill the company! — but in fact ends up getting more efficient spend. Suddenly the clearing price for the auction to show those app install ads is $0.75 per app install; now the mobile gaming company is getting 26,667 app installs for its $20,000 spend, which results in an expected profit of $6,667.
This does, obviously, entail downside for Facebook — that extra ~$6,000 in profit is out of Facebook’s pocket — but at the same time the loss is capped because not only is the mobile gaming company not reducing its spend, it is in fact incentivized to increase its spend given the reduced competition and thus increased profitability for its ads. And, of course, as that opportunity is seized on by more and more companies, Facebook’s profits, which in the end are gated by the amount of inventory it has, not only return to normal but arguably have more upside, given that usage of the platform is increasing.
In short, a slowdown in brand advertising should lead to an acceleration in direct response advertising; at Snap, though, they moved in concert not just last quarter, but the holiday quarter as well. In other words, it sure seems like Snap’s non-revenue-driving direct response ads are really brand ads with an auction attached: they go up in a holiday quarter, and they slow down after a crisis, or when the economy gets in trouble. It gets worse, though: the fact that revenue-driving direct response ads didn’t fill in the gap shows that ATT has actually had a far greater impact on Snap than anyone has yet realized.
This explains why Snap’s forecasting and results have been all over the place: the company is actually much more driven by brand advertising dynamics than anyone — including Snap — realized; by the same token, ATT really hurt the “true” direct response business. To put it another way, the good news is that Snap’s true performance-based direct response business is a lot smaller than 50%, which means the ATT impact on the overall business is less than it might have first seemed; the bad news is that Snap is commensurately more exposed to macroeconomic conditions, which explain this revenue warning.
There are several broader takeaways from this analysis.
First, any company dependent on brand advertising is likely in trouble, including Twitter, which is almost completely brand advertising (bad news for Elon Musk!). This also makes this a rather inopportune time for all of the streaming companies to be launching new ad-based tiers that will be mostly filled by brand advertisers to start.
Secondly, the timing of ATT could not be worse: at the very moment when performance-based direct response advertisers should be naturally filling the void left by brand advertisers, thanks to their ability to track return-on-advertising-spend (ROAS) to the penny, that ability was taken away; there will likely be some response by direct response advertisers to the brand pullback, but it will be much more muted than it would have been otherwise.
Third, while the above point is the most important one with regards to Meta, it’s also important to note that Meta (1) is the least exposed to brand advertising and (2) is almost certainly the most advanced in figuring out some sort of solution for performance-based direct response advertising. Moreover, the company could benefit from a sort of flight to safety as it becomes clear that it is the most dependable option for companies that need to advertise to survive.
It’s difficult to step back much further than that: this downturn isn’t really comparable to the Great Financial Crisis, which happened at the same time as the iPhone and AWS, which drove massive amounts of growth for the industry broadly and advertising in particular. I also don’t buy the comparisons to the dot-com bubble: we are dealing with real companies with real business models that are having their future growth significantly discounted; that’s a lot different than companies that don’t actually work going out of business.
Of course tech wasn’t even around the last time the U.S. faced persistent inflation; for what it’s worth advertising’s share of GDP, which usually hovers around 2% — although that number has crept up over the last decade thanks to digital advertising creating new businesses — was lower during the 1970s when inflation was high:
That noted, it’s not clear that we are repeating the 1970s: the fact remains that global supply chains — which also didn’t exist to nearly the same extent back then — are still snarled, and thanks to China’s zero-COVID policy, aren’t getting any better anytime soon; at some point, though, the disruption will work its way through the system, and tech will remain the deflationary force it has always been. The path from here to there, though, is as murky as can be.
This Update will be available as a podcast later today. To receive it in your podcast player, visit Stratechery.
The Stratechery Update is intended for a single recipient, but occasional forwarding is totally fine! If you would like to order multiple subscriptions for your team with a group discount (minimum 5), please contact me directly.
Thanks for being a subscriber, and have a great day!