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July 15, 2013

Michael Pachter Steve Koenig (213) 688-4474 (415) 274-6801 [email protected] [email protected]

PRISM … Progress Report for Internet and Social Media

In This Issue: Snapchat, Dropbox

Snapchat

 Developer of the popular photo-messaging app, founded in 2011.

 Application allows photos to be sent between users. Photos can only be viewed for a few seconds, then self-delete.

 App has experienced rapid adoption, with 200 million pictures sent per day, up from 150 million in April of this year.  Valuation has risen significantly, from approximately $70 million in February 2013 to $800 million today.

 Founders now in legal battle with a schoolmate claiming to be a third founder.

 Popularity may represent a cultural shift to less-permanent, more anonymous web services.

Dropbox  Announced at developer conference its intention to create a data platform for developers.

 Introduced new tools for deeper application integration.  User count rises to 175 million from 100 million in November of last year.

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Snapchat

Subsequent to Wedbush reporting on Snapchat last December, the comapny has continued its rapid growth, adding features and landing additional funding. The company’s employee count expanded from 10 to 17 (according to an article by Forbes), and the increased headcount (as well as persistent visits from users) has driven the two year old firm into a larger office in Venice, CA. A new round of funding, valuing the company at $800 million was announced on June 22nd of this year (according to TechCrunch); details on funding are found below.

As described in our previous report, Snapchat is a mobile messaging app based on picture sharing. Similar to Instagram, Snapchat users can take a quick picture of something with their phones and send it to other users. The Snapchat’s logo sender can add a caption or draw a doodle on the picture before sending. However once the photo is delivered and viewed, it deletes itself after a period of time specified by the user, up to 10 seconds. Once erased, the picture cannot be retrieved, and is not stored on the company’s servers, ensuring that the interaction is confidential. If the recipient saves the photo with a quick screenshot, the sender is alerted. The experience is meant to be very quick, private and “frictionless.”

To that end, Snapchat included a special feature when it added a video capture capability in December of 2012. Users take photos or video with the same button, rather than taking the time to switch from camera mode to video mode. This seems like a trivial tweak, but the firm asserts that a few seconds delay can mean missing a memorable moment. Management believes the technology is crucial Snapchat Interface enough to attempt to patent it, as reported by Business Insider. Source: Business Insider

Along with the disclosure of the latest funding round, the company announced a new feature called Snapkidz. Previously, the app would operate only if the user enters a birthdate that indicates he or she is over the age of 13. The Snapkidz mode allows the app to be used to take, edit and save pictures, but they cannot be sent to other users. It seems to be a smart idea; individuals that could not previously use the app can now get a sample of it, and be ready to jump in as full users once they are of acceptable age.

Controversy As the popularity of the app has grown, the company has been plagued by accusations that the service is mainly meant for “sexting,” in which the user takes an explicit picture of his or herself, and sends the pic to another user. The self-erasing nature of the application certainly lends itself to that sort of activity, though the founders have repeatedly denied that this is the main intent of the app. The issue was further complicated when a forensic researcher revealed that some photos could in fact be recovered from certain devices, though it takes extensive know-how (according to the Atlantic). A company representative told U.S. News that management was not concerned about the possible glitch in security. Also, Apple’s (AAPL) upcoming iOS 7 appears to bypass the mechanism for alerting a sender when the recipient has taken a screenshot of their picture (according to an article by Gizmodo). The final version of the operating system has not been released, and it is not known whether or not Snapchat will address the issue.

In addition to these concerns, the founders of the company have become engaged in a legal dispute with a former schoolmate claiming that he was a third member of the original team. Reggie Brown IV asserts that he conceived the original idea for a photo messaging app with self-destructing images. According to an article by TechCrunch, after vehemently denying the accusations, CEO Evan Spiegel admitted in court documents that Brown was part of the original group. While the litigation is reminiscent of Winklevoss v. Zuckerberg, and may have an impact on ownership, there seems to be no sign that the case will impede the marketability of the product.

Business Model Snapchat has not yet monetized its growing user base. However, after its recent funding round was announced, CEO Spiegel disclosed that monetization was on the horizon, and offered some likely strategies. In an article by Forbes, Spiegel says the firm will likely seek revenue from a combination of in-app purchases and native advertising. The report stated that monetization efforts would appear “in the coming year,” though it’s not clear as to whether this means 2014 or in the coming 12 months.

Spiegel told TechCrunch that in-app purchases would come first, and that the firm is already experimenting with hidden features in the development of the monetization strategy. The author of the report hypothesizes that the purchased products would take the form of personalized features and customization tools. This concurs with statements made by Spiegel in the Forbes report, in which he points out the merit of Tencent, the Chinese Internet conglomerate that owns the messaging apps QQ and WeChat. These services dominate the online messaging market in China. According to an article by paidContent, Tencent receives the bulk of its profit from the sale of “virtual goods” in its instant messaging apps. More on Snapchat’s monetization and its comparison to Tencent can be found below.

Leadership Chief Executive Officer Evan Spiegel and Chief Technology Officer Bobby Murphy began developing Snapchat during the spring of 2011. The two were fraternity brothers at Stanford University, and released the app to the iOS App Store in September of that year. Daniel Smith and David Kravtiz are the lead software developers under Murphy. Vice President of Monetization Phillippe Browning is a graduate of Harvard, and was formerly Vice President of Advertising and Operations at CBS Mobile, and developed some of the first efforts in mobile advertising at Electronic Arts (according to the Mobile Snapchat Leadership - From left to right: Software Marketing Association). Engineer Daniel Smith, Software Engineer David Kravitz, CTO Bobby Murphy and CEO Evan Spiegel. Source: Snapchat.com

Market

Snapchat is most popular with a young demographic, aged 13 to 25. However, the app is becoming increasingly popular with people over 40, as well as young professionals (according to an article by AllThingsD). A report from New York Magazine claims that it has become particularly trendy among young Wall Street employees, who are especially concerned about evidence of risky behavior finding its way back to a current or prospective employer.

Snapchat has the deletion of a permanent record as its raison d’etre. A generation of youths have been raised within an environment dominated by social networks, where personal information flows freely, and an individual’s identity is tied as closely to his or her online facade as it is to his or her actual persona. As TechCrunch stated in a June article, “this group has been forced to grow up online, living in public.” This generation has become accustomed to representing itself extensively on the web, but is anxious to control its online image. A study by the Pew Research Center found that 59% of Internet-using teens had edited or deleted a post they’d made previously, and 53% had deleted comments from others. Managing a reputation is difficult given the permanent nature of Internet media; regardless of privacy settings and closely controlled relationships, a single compromising picture leaked to the wrong person can spread quickly and can never be eliminated from the web entirely. College-aged youths are coming to understand how quickly an old embarrassing video can threaten a career.

Snapchat allows users to have it both ways: they can maintain a desirable online “brand” to a wider circle of acquaintances, yet still use the Internet and technology to express a more intimate side of themselves. Websites and applications that address this growing desire have become known as the “Ephemeralnet.” They tend to be more anonymous, don’t collect personal information, or make content easy to erase permanently. As TechCrunch writes, “[Snapchat] is often pointed to as the key trend defining this new era, but that’s just wrong. It’s only one example.” If this is true, then it seems Snapchat is a prominent representative of a cultural shift, not just a passing trend, and may exhibit staying power as a product serving this need. Furthermore, we may see more of these applications emerge in the public mainstream.

The barriers to entry for competitors are low. It is not difficult to add a feature to a networking or messaging app that deletes content after a specified period. Such ease of entry poses a significant threat to Snapchat’s hold on the market, although Snapchat’s first move advantage and large user base provide it a cushion. As the popularity of the app has become apparent, other contenders have tried and failed to steal away users. The most prominent example is Facebook (FB), with 1.1 billion active users (via TechCrunch). In

Source: Topsy

December, Facebook introduced Poke, a messaging app available on iOS devices, which duplicated many of the features of Snapchat. Messages, photos and video can be sent to Facebook friends with expiration times up to 10 seconds. By most accounts, Poke has been a disappointment (via Business Insider), and it has been suggested that the publicity provided by Facebook did more good than bad for Snapchat (according to TechCrunch). The chart above shows that Internet mentions of Snapchat grew rapidly with Facebook’s announcement of their competing app, and continued upward even after interest in Poke had waned. Since that time, other competitors have sprouted up, such as Wink! and Clipchat, but none have been able to achieve the success of Snapchat.

The firm’s main competitor in the picture sharing application space is Instagram, which was itself acquired by Facebook in September of 2012 for $1 billion (via Forbes). As the chart below shows, Instagram’s user base is considerably larger than Snapchat’s, though both continue to grow (this chart represents only iPhone users). These figures are based on app downloads, and do not detail the actual number of users that each service has. In April of this year, VentureBeat indicated that Snapchat had about 5 million users. During the recent announcement of its video features, Instagram’s management disclosed that it had 130 million active users as of June 2013 (via TechCrunch). Snapchat regularly reports the number of photos processed daily, and reports indicate that Instagram is trailing its younger rival in this metric. In April 2013, VentureBeat reported that Snapchat was processing 150 million images per day, compared to Instagram’s 40 million. This suggests that Snapchat’s users are much more active in their messaging than Instagram’s customers. Today, Snapchat is processing approximately 200 million photos per day (via Snapchat.com).

Source: Onavo

Snapchat (numbers in millions) 250 5

200 4

150 3

100 2

50 1

0 0 May-12 Aug-12 Nov-12 Feb-13 May-13

Daily Pics Users

Source: Appmtr.com Source: Company data, Wedbush In our previous report on Snapchat, we used Facebook connections as a way to measure the growth in Snapchat’s customers. Because the app gives users the ability to connect to Facebook to find contacts, the monthly-active-users metric (MAU) of this connecting app is a relevant proxy for estimating Snapchat’s user growth. We pointed out that as of December 2012, AppData estimated that MAU through Facebook had grown to 1.7 million from 400,000 in October (this is relative measure of growth, not an estimate of the actual number of users). Appmtr.com estimates a similar number for December 2012: 1.5 million MAU. However, since that time, Appmtr.com shows that Snapchat’s MAU through Facebook has fallen dramatically since peaking in December. MAU in January 2013 was 302,000, while the following month saw just 31,000. This may indicate that user growth is slowing, but we think that the data is inherently unreliable as a measure of usage. The New York Times reported in February of this year that users in December 2012 had more than doubled to 3.4 million. Four months after that time, users had risen by an additional 50% (estimated 5 million in April).

Financial

Funding Snapchat has achieved a total of $73 million in funding. Most came in June from the $60 million Series B round provided by existing investors Benchmark, Lightspeed Venture Partners and SV Angel, as well as new stakeholders Institutional Venture Partners and General Catalyst Partners (according to CrunchBase). The round was preceded by Series A funding of $13.5 million in February 2012 from Benchmark, Lightspeed and SV Angel (via TechCrunch), and seed funding of $485,000 from Lightspeed in May of 2012 (via TechCrunch). The latest round was originally reported as $80 million, however it was later revealed that the figure included $20 million paid to the co-founders ($10 million each) for a portion of their share in the firm (according to Fortune). As mentioned before, the June financing implies a total valuation of $800 million, a significant increase from the valuation implied by the round seven months prior ($60 - $70 million according to TechCrunch).

Monetization As mentioned previously, Snapchat’s plans for monetization will likely be led by in-app purchases. According to a report from Distimo, most of the money made from iPhone apps comes from in-app purchases, as the chart to the right indicates. In-app purchases as a portion of iPhone app revenue has grown from 53% in January of 2012 to 76% in February of 2013, suggesting that users are becoming accustomed to the “freemium” model of payment. Indeed, the same study found that the ten highest grossing iPhone apps since January 2012 all were operated on a feemium basis. Management may look to model Tencent and its popular QQ messaging app. The Chinese company has been able to monetize over 30 million of its 752 million active users (according to paidContent), or about 4%. We conservatively estimate that Snapchat’s user base is at least the 5 million estimated by The New York Times, so at 4% monetization, the company would receive payment from at least 200,000 users. The

Source: Distimo

two services are not identical, and exist in very different markets, so monetization success may vary. While some measurements indicate slowing growth in total users, growth in photo messages remains strong, suggesting some potential for an advertising-based revenue strategy, if ads were attached to messages as interstitials. However, advertisers tend to prefer sites and applications that offer more permanence of imagery, such as Facebook or Pinterest.

Acquisition In various reports (such as an article by Quartz), Snapchat has drawn comparisons to Instagram. Both are picture-sharing apps, both have experienced rapid adoption and neither has produced direct revenue. Snapchat’s valuation is quickly approaching the figure at which Instagram was acquired by Facebook ($1 billion compared to Snapchat’s $800 million valuation). One may assume that Snapchat’s unproven monetization strategy and large valuation would make the company a likely acquisition candidate. CEO Spiegel has indicated that management is not entertaining the idea of an acquisition right now (according to the Quartz article); however Spiegel hasn’t eliminated the option entirely. In the report by Forbes, Spiegel left open the possibility of selling the company, though he said now was not the right time. He states in the article: “It would be interesting to find a place where we felt at home that isn’t our own office.”

Dropbox

On July 9th, consumer cloud storage provider Dropbox held its first developer conference in San Francisco. During the event, the company announced a slew of developments regarding its popular services. The overarching message of the presentation was the intent of management to transform Dropbox into the default method of storage for all computer users and all devices, regardless of form factor or operating system. The company has released new tools for software developers that will enable the programmers to place buttons and links within their applications that allow users to quickly and easily sync files to their Dropbox accounts. The tools (called “plugins”) are named Chooser (which loads files) and Saver (which saves files). The idea is to make the process of loading data to and from Dropbox as seamless as with a hard drive on a PC or with flash memory on a smartphone. Previously users were forced to save a file to their hard drive, then transfer the file to their Dropbox Source: Engadget account; later the person would download the file and resume their work. At best, a desktop application eliminated a couple steps in the process. The new plugins would make the practice quick and painless.

This functionality extends to application data, not just documents and photos. Ideally users can save game progress to Dropbox, allowing them to pick up a game of Angry Birds on their Chromebook that they just saved on their iPhone. Features such as this create a compelling proposition for users. Currently, individuals can become deeply involved in the ecosystems of their respective devices. An iOS user can’t transfer a to-do list to a Windows 8 PC. If a user switched from a Galaxy S to an iPhone, they have to re-start their mobile games from scratch. If adoption of the functionality becomes widespread, users could become truly system-agnostic.

Many apps already integrate with the cloud services, but the company is aiming to make Dropbox a platform; an integral part of the way apps function, instead of something bolted on. By making synchronization one click (or tap) away, people are more likely to use the service. This, of course, is the whole idea. More data stored on Dropbox’s servers – be it photos, movies or application data – means more revenue for the company. The firm has already secured a number of partners that are moving forward with integration: Yahoo Mail, Shutterstock, PicMonkey, Asana, Animoto, CloudOn and FedEx. Dropbox executives assured attendees that the company would not be charging developers for use of their Source: Dropbox.com platform, nor does it plan to.

During the conference, CEO Drew Houston announced that Mailbox, the mobile email app that Dropbox acquired in March of this year, would see updates with full Dropbox integration. Users will now be able to preview Dropbox files that are linked in an email as if they were actual attachments, whereas previously the recipient would have to click through to Dropbox to see what the file was. Afterwards, in an interview with AllThingsD, Houston said that he would like to integrate Dropbox with Google Docs (GOOG), the web-based suite of apps used for editing documents, speadsheets and presentations. Docs has become part of Google Drive, a cloud-storage for Google account holders that poses some competition for Dropbox. Even so, Google management has previously expressed interest in integrating with Houston’s company, according to AllThingsD. Dropbox does not offer any editing or collaboration tools along the lines of Google’s products; such a partnership could add extensive functionality to its services, but may also sacrifice the company’s operating system-neutral stance.

The takeaway from the conference is that Dropbox is moving to a next level of storage for consumers. The firm can now take on the Dropbox Users (millions) volumes of data that individuals produce 200 through casual activities like adding contacts or saving games; data that quickly becomes a burden when a person’s hard drive is 150 suddenly full. The company’s growth rate has remained robust over the last several 100 years: during the conference it announced that it had reached 175 million users, up from 50 100 million in November of 2012. If developers adopt the new tools that Dropbox 0 is providing, one would expect the amount of data generated per user would accelerate, growing revenue steadily, and prolonging strong growth.

Source: Company data, Wedbush

News Briefs Monday

 Hulu announced on June 12th that they would not accept any of the bids placed to acquire the online video website. Owners Fox (FOXA), Disney (DIS) and NBC (CMCSA) will instead invest a total of $750 million into the joint venture. Time Warner Cable is still attempting to purchase a stake in the company. (According to The Verge).

 Jawbone – Business Insider is reporting that Yahoo (YHOO) will distribute 11,000 Jawbone UP fitness bands to its employees in order to improve employee health. The electronic wristbands track movement and sleeping patterns, educating users on their health and activity. The information can also be shared with friends or workout groups. (According to AllThingsD).

 Kabam employees recently sold $38.5 million worth of shares in a private transaction. The sale places a $700 million valuation on the company, which develops massively multiplayer online games, primarily for mobile platforms. Kabam had previously been valued at $525 million when they raised $85 million in venture funding in May of 2011. None of the funds from the recent sale will go toward the company itself. (According to the Wall Street Journal).

Throughout the week

 OpenX – United Online has announced that it has selected OpenX to manage advertising placements on its websites. According to the report by TechCrunch, United went through a thorough vetting process, eventually choosing OpenX based on the value it provided. United represents an online community of about 100 million users through its online properties that include Classmates.com, Juno and Stayfriends. A representative from United Online claimed that OpenX helps to level the online advertising playing field, as new technology has tended to benefit advertisers rather than content producers. OpenX has been in business since 2008, raising $101 million in venture funding during that time. Investors include Accel Partners, SAP Ventures and Samsung Venture Investment.

 SEC – The Securities and Exchange Commission has voted in favor of a portion of the JOBS Act that allows start-ups, venture capitalists and hedge funds to openly solicit investors for funding. This will allow such firms to use public means to advertise their need for capital, moving beyond word of mouth. The previous restrictions made it difficult for investors to learn about opportunities to seed new companies if they were not located near start-up hotbeds like Silicon Valley. This bit of legislation only covers accredited investors with liquid net worth over $1 million. An additional portion of the JOBS Act, which would allow non-accredited investors to participate in crowdfunding programs, must still be decided upon. (According to TechCrunch)

 Shazam – Mobile app developer Shazam has agreed to a $40 million round of funding. The investment was made solely by America Movil, the Latin American mobile service carrier owned by Carlos Slim, the world’s second-richest man. Eleven-year-old Shazam creates apps that allow users to identify songs through audible samples, then discover the songs through online markets or social media. Total venture funding now stands at $104 million. According to AllThingsD, the funding offered some liquidity to employees and early investors. The report also states that America Movil plans on pre-loading Shazam apps onto mobile phones offered through the carrier.

 The Fancy – Social shopping start-up The Fancy has raised $53 million from investors American Express (AXP), Len Blavatnik and actor Will Smith. This round puts the firm’s total funding at $112 million, and gives the New York City-based firm a valuation of $600 million, up from $100 million in November of 2011 (via BetaBeat). According to Bloomberg, the company earns about $3 million in revenue per month, and now counts American Express president Edward Gilligan and Twitter co-founder Jack Dorsey as board members. The Fancy functions as a social image cataloguing website, similar to Pinterest, but also allows users to purchase products directly through the site. Previous investors include the French fashion conglomerate Kering (formerly PPR), which invested in 2011.

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Important Disclosures

Covered Companies Mentioned in this Report (priced at market close July 15, 2013)

COMPANY TICKER RATING PRICE PRICE TARGET Google GOOG Neutral $920.99 $800.00 Facebook FB Outperform $25.77 $35.00

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