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Snap Wants to Be Profitable, Zuckerberg Wants to Stay Chairman

We've missed some major market news while we've covered some new tech issuances. Today we catch up, talking about:
- Snap (NYSE: SNAP) CEO Evan Spiegel is pushing the company to be profitable in the face of concerns over its cash burn.
- Institutional investors waging a war against Facebook (NASDAQ: FB) founder and CEO Mark Zuckerberg.
- Alphabet's (NASDAQ: GOOGL) (NASDAQ: GOOG) extended dance with the European Commission over Google's Android.

A full transcript follows the video.

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This video was recorded on Oct. 19, 2018.

Dylan Lewis: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It's Friday, October 19, and we're catching up on some big tech news. I'm your host, Dylan Lewis, and I'm joined on Skype by senior tech specialist Evan Niu. Evan, we've been paying attention to some of these big new issuances lately. We've been leaving some market news alone for a little while.

Evan Niu: Yeah. There's been a lot of companies going public. You've got SurveyMonkey, Tencent Music. There's a lot going on on the IPO front.

Lewis: Much as we love doing those S-1 and F-1 shows that do the breakdown of these prospectuses, we have to pay a little bit of love to the big tech companies that are making headlines. I think we're going to do that on today's show, talking a little bit about Snap, Facebook, and Alphabet, and some of the big news coming out of them. How do you feel about that?

Niu: Sounds good!

Lewis: Why don't we kick things off with Snap? A couple of big news items coming out over the past few weeks. I thought it might make sense to recap on those before the company reports next week. We had a research note earlier this month from a MoffettNathanson analyst expressing some concerns about the company's cash burn. This came as CEO Evan Spiegel is reportedly targeting full-year profitability in 2019, and a stretch goal of breaking even in Q4 of 2018. I have a little bit of skepticism around that, Evan. [laughs]

Niu: Yeah, I don't think they deserve a lot of trust when it comes to their outlook and their forecasts. They've shown time and again that they're just not executing well in growing the ad business. MoffettNathanson is not the only analyst to express concerns. BTIG a month prior had a similar note. They downgraded Snap to sell and also pointed to this cash burn that's really troubling. They've burned through $0.5 billion dollars in the first half of the year. As of the end of the second quarter, they had about $1.5 billion in cash. Their cash flow is just horrendous. Free cash flow is typically in this negative $200 million range almost every quarter. They're just on this really unsustainable path.

Lewis: I think the narrative that the company is spinning is, "We have this new CFO. He's a little bit more financially minded, more of a traditional Wall Street exec." And we're starting to see them become a little bit more shipshape. We're getting some guidance from them. But I don't know that you can immediately reverse a company's path in one or two quarters. To your point earlier about cash flow, they're also posting operating losses of over $300 million every quarter for the past year. That's an operational issue. That's not necessarily a financial issue.

Niu: Right. On top of that, they announced that they're expanding their Snap Originals, which are these original content shows. Now they're getting into scripted shows and docuseries. They've done these kinds of things in the past, a little bit of original content here and there, but this sounds like a pretty big expansion. These are basically short little series that you can watch on your phone, they're vertical format. Each episode is only maybe five minutes. Then, of course, advertisers can purchase these ad spots, six seconds, you can't skip them.

I don't know about that strategy, either, monetizing original content with ads. Original content typically is very expensive. Monetizing it with advertising is a really tough way to make money. Of course, these are short shows, so maybe the production costs aren't too big. But it seems like kind of a weird thing for Snapchat to be trying to pull. Is that really going to bolster engagement? Their user numbers are already heading in in the wrong direction. I doubt that this is going to work.

Lewis: In some ways, it's surprising for a company like this to get into originals. You think of original content as being something that platform companies need in order to draw people in and have their model scale. You own and operate this content, so you enjoy the leverage that comes from it. You look at a Spotify or Netflix, it's a little bit different when you're licensing other people's work or paying royalties on other people's work for usage. So, in some ways, you have all this user-generated stuff on Snapchat. They don't need to necessarily pay for content. But then, you could also make the argument, these original series give them something that Facebook can't just copy. They can't just port that immediately over to Instagram because it is a Snapchat Original, they own it.

Niu: Right. Then again, also keep in mind that Facebook is also seeding some original content for its Watch platform, as well. Everyone is trying to do original content in their own kind of way. But certainly, Facebook has quite a bit more money than Snapchat does. [laughs]

Lewis: The reason why this works into this financial conversation we're having about profitability is, you look at the books for Snap. Infrastructure costs eat up about half of revenue. As we've talked about before, that's a variable cost, because they do not own all their IT infrastructure. That's going to scale pretty much with usage on the platform. The other big expenses for them, are payroll and R&D. If you see them laying off a bunch of people, there'll be some cost savings there. Or, if you see them stop investing in AR, VR, maybe Originals, then the cost structure might change a little bit. But clearly, they're still investing in new stuff and they're investing in new content. I see all of this as being kind of at odds against long-term profitability.

Niu: Right. I think that's the real crux of it here. They just do all this weird stuff that's arguably a distraction. Spectacles is a good example, too. They're spending all this money developing Spectacles. No one uses them, no one buys them. Now they're putting money into these Originals. Of course, everyone's doing it, so it kind of makes some sense at face value. But again, it's unclear if it's actually going to bolster engagement, strengthen the platform at all. It comes back to the money. Is it going to help them grow ad revenue? We'll see.

Lewis: [laughs] We'll see. Yeah, because that's where it's going to have to come from. For them to reach profitability, they're going to need really strong top line growth that outstrips all of the variable costs that move with increased usage. That basically means they need to increase ad impressions or increase the price that people are paying for ads. I don't really know that that's going to happen. All the revenue growth that they've been posting has been because they've increased impressions. Prices have fallen precipitously since they moved over to the automated ad-serving platform, and I don't really see that ending anytime soon.

Niu: Meanwhile, they're running out of cash.

Lewis: And meanwhile, they're running out of cash. So, something to keep in mind as you look at Snap's financials next week when the company reports.

As an interesting little anecdotal thing, one of the things that we've had a struggle with Snap is, they don't have the same targeting that a Facebook does, that a Google does, with intent and with social activity and demographics. I was on Snap this morning, Evan, and I was kicking the tires of the platform, as I often do before we talk about the company. I was checking out some stuff in the discovery channel, and I was served four variants of the same ad while consuming content. They were all from Merck, and they were all for birth control.

Niu: [laughs] Are you not in the market for birth control? Are you saying their targeting is not working?

Lewis: [laughs] I am not presently in the market for birth control, and I view that as a targeting problem on this platform, and one of the issues that ultimately traces back to ad prices. If that's what I'm getting served up, there's clearly some issue there, and that's going to bear out in whatever the advertisers see in terms of ROI. For reasons like that, I don't really see the ad prices turning around anytime soon. I don't see this company becoming profitable anytime soon, either.

Niu: I just regret getting out of my short too early. [laughs]

Lewis: [laughs] Alright, why don't we switch gears and talk Android in Europe? We got a recent ruling from the European Commission, basically looking at Google's Android practices and deciding that they are anti-competitive. Evan, do you want to give us the rundown?

Niu: The European Commission slapped Google with a pretty massive $5 billion fine, which, of course, they're appealing. That'll make its way through the courts. Maybe they settle, who knows. The issue is, some of the things that Google does with Android are anti-competitive, particularly how it has long paid device manufacturers to pre-install Google Apps and Google Play Store. That gives them this huge advantage within the Android platform. It really undermines the competitive nature of other companies that might want to compete in search.

There's a lot going on here. When the decision was announced, Google CEO Sundar Pichai also suggested that this model is going to have to change. The speculation was that they're going to start charging a licensing fee. Now, that's actually kind of what's happening. Google has now said that they will start charging manufacturers a licensing fee -- not for Android, the platform itself, but specifically related to its suite of apps and services, which includes the Play Store. The Play Store is a pretty huge piece there, because that's where you get all your apps and stuff.

It's a pretty big reversal, in terms of the economics of where the money goes. Instead of them paying manufacturers, manufacturers now have to pay them. And, of course, those companies will probably pass along those costs to consumers in the form of higher prices. We've seen this in other computing form factors. When you have one company that makes the operating system licenses it out, that generally leads to higher prices, because those companies need to make that money back, and they typically throw their own margin on top. I think that has some pretty important implications with the Android ecosystem and the business model, in Europe at least.

Lewis: The upshot for all of this is, short term, it could mean that prices go up on Android devices simply because manufacturers have to pay to access this stuff in a way that they haven't in the past. Longer term, theoretically, this leads to more competition. The barriers to competition are a little bit lower for people providing apps in the space.

Niu: Right. It also depends on, are manufacturers going to really try to sell Android devices that don't have Google Apps and services? Maybe some will try, test the market, see if those devices can sell well. If those devices can sell well, then certainly, consumers might prefer lower prices, manufacturers prefer lower costs.

Actually, news broke today that the licensing fee is actually going to be pretty high. Google had initially said that this fee would be pretty small and not too much to worry about. I think that what they're doing is trying to put in the high fee as a way to incentivize manufacturers to make other concessions. This fee is reportedly as high as $40, which is massive. That's more than what Window's phones used to charge for its platforms, back when Windows phones were a thing. That fee will vary based on country and device type. It's as low as $3, but can go as high as $40. Google will offer breaks if the manufacturer pre-installs Chrome and Google Search. Pre-installing Chrome will also become a requirement for some of these revenue sharing agreements they have around Search. It's basically saying, "We're going to charge a ton of money, but we'll give you a break if you basically keep pre-installing it." It's a roundabout way to more or less keep the status quo. It presents a really strong financial incentive for them to still pre-install Chrome and Search, which have always been Android's primary monetization strategy for Google.

Lewis: The reality is, the reason that the European Commission is so narrowly focused in on Google is, it dominates this market. It's dominant here in the United States, but I think within the top five largest European countries, it has over 80% market share, something crazy like that.

Niu: Right. That's according to Kantar estimates. The big five European markets, Android is huge, it's like 80% of the market. Globally, of course, Android is huge, too. But, yeah, this decision does specifically relate to Europe. They're such a huge player there and they dominate this market, and they have this massive market power position where they can really undermine all competing search providers, particularly on the mobile front.

Lewis: Right. Also, the core of it is, they make good products. That's why people continue to use them. Yes, they are the default for so many of these Android devices. They're packaged in in a way that makes it very easy for consumers to use. The less friction you have there, the more likely they are to use those apps. But a lot of people go out of their way -- on iPhones, even -- to use Google Apps because they're pretty much top of the line for the industry.

Niu: Right. They also have those agreements with Apple, too, where they pay Apple for the default search spot. To your point about removing friction, pre-installing this stuff is a huge advantage because a lot of people, even if they really like Google apps and services, may not go out and install it themselves. If you buy a new phone and it already has the stuff on there, it's a seamless thing, it feeds straight into their search products and other services. That's such a huge strategic benefit of having these things pre-installed.

Lewis: The big picture takeaway for this news is basically, Google is going to do everything that it can to maintain the status quo, although they'll have to jump through a couple of hoops to make that happen.

Niu: Right. That seems like how they're trying to approach it. They don't want to give up any of these advantages they have, but at the same time, they have to navigate this new, precarious legal position that they're in because of this antitrust decision. If they restructure the way the model works, then they can maybe get away with it. They did have to get rid of some of these other restrictions around what devices other people can sell. Overall, on paper, it's a positive thing for consumers, because theoretically it will create more choice, ultimately. But if that turns out to result in higher prices, that's not a great thing. To the extent that Google can keep things the way they are, maybe there's not that much change.

Lewis: Evan, it has been a rough 2018 for Mark Zuckerberg and Facebook, and recent headlines from some investors that own a pretty hefty number of shares of Facebook are only going to make things a little bit tougher for him.

Niu: Everyone is upset that Facebook has really botched so many things. They have this nonstop string of scandals and controversies all around privacy and data. People have been asking for a better corporate governance for a long time. It seems like all of these mistakes and controversies are really riling up the investor base, particularly when it comes to institutional investors, to try to push for change. Trillium Asset Management has put forth this proposal that will be up for a vote next year that'll basically split the CEO and the chairman roles. They actually put up a similar proposal in 2017 that failed. But now, they're getting more backing from other public funds. Numerous state funds are starting to support this measure. It's going to boil down to whether or not Zuckerberg agrees to it or not.

Lewis: These are institutional investors that primarily work in public workers and pension funds. That's why they have these very large allocations of Facebook shares. The reality, though, is that it depends on whether Mark Zuckerberg wants this to happen, because of the way that Facebook is set up from a voting power perspective.

Niu: Right. He has about 60% voting power. He can single-handedly vote any proposal in or out. He can vote any director in or out. He's chairman of the board, so he answers to himself, which is kind of the whole reason why, in general, splitting the CEO and chairman roles is good for corporate governance. Of course, the board of directors is supposed to oversee management. Its oversight responsibilities are fundamentally undermined if the CEO is also chairman, because you're your own boss and there's not really any accountability. That lack of accountability, I think, has really contributed to these controversies and these really big scandals that Facebook has had, because Zuckerberg is not accountable to anyone.

Lewis: To use Elon Musk as a parallel here, this is something that's going on with Tesla right now. We're seeing the SEC push for this type of separation to increase accountability.

Niu: The Tesla situation is bizarre because Elon is kind of erratic, and he made some really outlandish statements about taking the company private that the SEC felt were misleading. They essentially argued that he committed securities fraud. Then, as part of the settlement, he agreed to step down as chairman. The net result is that, for Tesla, the CEO and chairman are going to be split up. Elon has been both for a long time. That's actually good news, in terms of corporate governance. In practice, who they pick and whether or not the board actually tries to do its job better, that remains to be seen.

If we come back to Facebook, Zuckerberg doesn't do crazy things like Elon does that are going to get the SEC's attention. You're not going to have that kind of outside force to make him step down. And because he has so much voting power, you really can't do it unless he agrees to it. He has to voluntarily agree to it.

Lewis: Normally, these huge institutional investors want these voting shares of companies that split out their voting shares or have non-voting shares at some point. That is why you see that slight delta between Google voting shares and non-voting shares, or Under Armour voting shares and non-voting shares. If you have enough of them as an institutional investor, and you have people on the inside that do not have a critical mass of voting power, then you might actually be able to wield some change. The reality here, though, is that the stakes that are owned by all these groups combined -- Trillium and these institutional investors on the public side -- combine to about five million shares, which is effectively a rounding error on Facebook's overall shares outstanding. It's nothing on the 60% that Mark Zuckerberg holds in terms of voting power.

Niu: Right. He has these super voting Class B shares, they get 10 votes per share. He basically has all of the Class B shares. He has like something like 95% of all Class B shares. It's kind of a grim outlook for investors. It's pretty obvious that all the while these investors have been making these arguments, very conventional arguments, saying, "This is better for corporate governance. This will be good for investors." Facebook just doesn't care. They just don't listen to the reasons. I don't know what's going to get through to Zuckerberg, but the company has defended this setup for a long time. As I mentioned before, they voted against this in 2017 and basically said that they still think that the best and most effective leadership model is that Zuckerberg is both chairman and CEO, and that's the way they've always done it, and that's what's helped them get here today. But it's pretty clear that in a lot of ways, it's not working well. We're starting to see investor unrest and people getting upset about it, but there's nothing they can do.

Lewis: Yeah, barring Mark Zuckerberg recusing himself from the vote, his votes will be cast in a certain direction, I think we can be pretty sure. All of this really highlights the importance of corporate governance and the importance of understanding the ownership structure of the stocks that you're owning. We spend a lot of time when we're doing those IPO shows looking at inside ownership and how that's held. We spent a ton of time talking about that with Snap in particular. It can sound like a very academic discussion sometimes. This is exactly why it matters, though.

Niu: It's also worth remembering that Facebook even tried, a year or two ago, to give him even more voting power when they wanted to create this third class of non-voting stock. Then they got sued by all these investors and essentially just dropped the plan. But the point is that obviously, wanted to take it even further, give him even more power so he could continue selling off his stock to fund his philanthropic interests but keep all his power. It's pretty clear that they just don't listen to public investors at all.

Lewis: Yeah. I think by and large, Trillium and these public funds know that they are more raising an issue than creating any change. It's obvious that they're not very happy with Facebook's management.

Before we wrap up, Evan, I put out that we were talking about some of these companies on Twitter. I want to take a listener question. This one comes from Austin, who has asked us a couple of questions before. He says, "What product is worse, Snap's glasses or Facebook's Portal, given the company's recent privacy issues?" What's your take on that one, Evan?

Niu: Facebook's portal is definitely worse. [laughs] There are so many privacy concerns for Facebook as a company. Whereas Spectacles, they're kind of a silly product, but as you mentioned before, Snap doesn't have this crazy targeting reach into all these aspects of your life that Facebook has. I'm not as concerned about privacy issues there. It's more of just a way to use the platform. Whereas Facebook's Portal is very specifically yet another way for the company to gather data on you.

There was a really shocking reversal the other day when. Initially, Facebook said the Portal would not be used to gather data for ad targeting purposes. Then, this week, they completely changed their stance, like, "Oh, wait, actually, we will." [laughs] Or, "We can, but we don't want to," which doesn't really reassure people that don't trust Facebook anymore. On top of that, Facebook is reportedly working on this other type of Portal device that goes on top of your TV that has a camera in it that does the same kind of video calling and Watch platform stuff that Portal wants to do. They're clearly going to keep pushing in this hardware direction. But they're going to use this to target you with ads, even after they said that they wouldn't. [laughs]

Lewis: For me, both of these bother me for different reasons. The Facebook Portal and the launch of the Portal comes at a time where you shouldn't be putting cameras in people's houses. They don't trust you. [laughs] But, what bothers me about Snap is the financial diligence that we want them to be having, looking at what's going on with the cash side with them. They are a distracted business that probably needs to rein in its spending if they're going to be hitting the targets that Evan Spiegel wants them to hit and. I look at it, and I'm like, you guys aren't really eating your cooking when it comes to this stuff that you're talking about in your conference calls. So, Snap bothers me from a financial perspective. Facebook Portal bothers me a lot more from a public perception perspective. I guess that's all to say that we won't be giving each other either for this holiday season, Evan.

Niu: [laughs] Yeah, I'm definitely not buying a Facebook camera to put in my home.

Lewis: [laughs] Evan, thanks for hopping on the show!

Niu: Thanks for having me!

Lewis: Listeners, that does it for this episode of Industry Focus. If you have any questions or if you just want to reach out and say hey, you can shoot us an email at industryfocus@fool.com, or you can tweet us @MFIndustryFocus. If you're looking for more of our stuff, subscribe on iTunes or check out The Fool's family of shows over at fool.com/podcasts. As always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against stocks mentioned, so don't buy or sell anything based solely on what you hear. Thanks to Austin Morgan for all his work behind the glass today. For Evan Niu, I'm Dylan Lewis. Thanks for listening and Fool on!

Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool's board of directors. Dylan Lewis owns shares of Alphabet (A shares), Apple, Facebook, Tesla, Under Armour (A Shares), and Under Armour (C Shares). Evan Niu, CFA owns shares of Apple, Facebook, Netflix, Spotify Technology, and Tesla. The Motley Fool owns shares of and recommends Alphabet (A shares), Alphabet (C shares), Apple, Facebook, Netflix, Tesla, Twitter, Under Armour (A Shares), and Under Armour (C Shares). The Motley Fool has the following options: long January 2020 $150 calls on Apple and short January 2020 $155 calls on Apple. The Motley Fool has a disclosure policy.

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