Snap bets on hardware as Facebook threat looms

[February 20, 2017]  By Heather Somerville

SAN FRANCISCO (Reuters) - Snap Inc takes to the road in London on Monday to promote its initial public offering with a daring proposition: that it can build hot-selling hardware gadgets and ad-friendly software features fast enough to stay one step ahead of Facebook.

No longer just a purveyor of a smartphone app for disappearing messages, Snap has hired hundreds of hardware engineers, built a secretive product development lab and scoured the landscape for acquisitions as it pursues its newly stated ambition to be "a camera company."

These efforts, which are aimed at developing hardware and so-called augmented reality technologies, are central to the strategy of a company that is seeking a valuation of up to $22 billion in its early March IPO despite heavy losses and the specter of stiff competition for advertising dollars with a far-larger Facebook. (Graphic:http://tmsnrt.rs/2kXZxA7)

It is a big gamble and the odds against Snap are long.

There is little precedent for a company with its roots in software and social networking succeeding in the notoriously difficult consumer hardware business. Few U.S. firms aside from Apple <AAPL.O> have made big profits on hardware, and camera and wearable gadget makers have much lower valuations than Snap is seeking. Once-hot camera start-up GoPro <GPRO.O> is a cautionary tale: its stock sits 61 percent below its 2014 IPO price.

More broadly, creating new products and features that have mass-market appeal and cannot be readily mimicked is a huge challenge, analysts say.

"It’s worrisome,” said Paul Meeks, chief investment officer at Sloy, Dahl & Holst, which manages more than $1 billion in assets. “Snapchat is going to have to continue to be really innovative and distinctive. It’s going to be very tough to trump Facebook.”

Snap declined to comment for this story.

Snap first signaled its new focus with the September reveal of Spectacles, funky sunglasses with an embedded video camera for posting to the Snapchat app. The company spent $184 million on research and development last year, nearly half its revenue.

Augmented reality, which refers to computer-generated images overlaid on real surroundings and viewed through a smartphone or special glasses, is a big part of the plan. Snap's "lenses" image-overlay feature has been a hit, and gives Snap an advertising format that's unique, at least for now.

"If you're going to make the bet longer-term on Snap, you are betting they are going to come up with innovative products that Facebook can't copy," said Nabil Elsheshai, senior equity analyst at Thrivent Financial, who is considering whether to recommend that his firm buy Snap's IPO.

Facebook-owned Instagram last year rolled out a feature called Stories, modeled after Snapchat's feature by the same name. Snapchat had about 100 million fewer downloads than Instagram in 2016, according to market research firm App Annie.

NEW GADGETS

Snap had 158 million daily active users in the fourth quarter, up just 3 percent from the previous quarter, compared to 14 percent growth during the same period in 2015, according to Snap's IPO filing. New gadgets that offer more ways to interact with Snapchat could help attract new users and get existing users to spend more time on the app.

"Ultimately, that's what advertisers are going to be looking at," said Douglas Melsheimer, managing director at investment bank and consulting firm Bulger Partners. Snap, along with Facebook and host of online rivals ranging from Google to BuzzFeed, is capitalizing on the shift of video advertising dollars from traditional television to the internet.

Snap's IPO filing reads "as if all the hard things in front of them that they have to do are already done," said Rett Wallace, cofounder and chief executive at Triton Research. But, he said, that's not the case. "How will they hold up against all the guys you don't want to be fighting against in the world - Facebook, Google and Apple?"

 The logo of messaging app Snapchat is seen at a booth at TechFair LA, a technology job fair, in Los Angeles, California, U.S., January 26, 2017. REUTERS/Lucy Nicholson/File Photo

Hardware is part of the answer. Snap has recruited hardware experts from Apple, Alphabet Inc's Google, Nest and Motorola, according to an analysis of LinkedIn profiles. One former employee described ample resources and support from management for the hand-picked hardware teams.

Last spring, Snap set out to hire up to 300 hardware, augmented reality and virtual reality specialists in a single month, according to another former employee. It also set up Snap Labs, a group dedicated to working on secretive projects. Its members have reviewed acquisition targets in areas including wearable cameras, facial recognition and 3D scanning technology, according to people close to the discussions.

Spectacles itself came from Snap's acquisition of startup Vergence Labs in 2014. The sunglasses surprised even Snap's earliest investors, who say hardware was not in Snap's initial pitch to them.

"It was a disappearing messaging product, and that's it," said Jeremy Liew, a partner with Lightspeed Venture Partners, who made the initial venture investment into Snap. Like most Snap backers he lauded the Spectacles rollout.

Snap has acquired at least 10 startups since 2014 according to firms tracking such deals, and M&A deal makers say Snap is one of the most active shoppers they have heard from.

"AMAZON PASS"

Snap's R&D investment as a percentage of revenue is far higher than what Facebook or Twitter were spending before they went public. One result of that investment has been a wave of patent filings - about 46 total, according to research firm CB Insights.

They include eye-wear patents for Spectacles, as well as patents for photo and video-capture devices, and object and facial recognition, which is key to developing augmented reality technology.

One former employee said Snap is working to figure out ways to turn the warehouse of data it collects from Memories, a feature for users to save photos on Snap's server, into augmented reality or facial recognition applications.

Spectacles "opens the doors for augmented reality," Elsheshai said. "That's a different direction for the company than just adding more social media capabilities."

The quirky popularity of Spectacles further endears users to Snapchat, he said, but doubted that such niche products can propel the user growth Snap needs in the long term.

The greatest impediment to Snap's innovation efforts, however, may be its hefty losses: the company lost $515 million last year on $404 million in sales. Revenue from Spectacles. was "not material," according to Snap's IPO filing.

Snap, like Amazon.com, is expecting public investors to allow the company to lose money for years on the promise that more investment in innovation will pay off later.

"They are going to have to get the Amazon pass - investors that don't care in the short run," Elsheshai said.

(Reporting by Heather Somerville; Additional reporting by Julia Love; Editing by Jonathan Weber and Tomasz Janowski)

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