On Facebook’s acquisition of WhatsApp  

I have recently started thinking about the merits of Facebook`s recent acquisitions. In 2012, it acquired Instagram for USD 1 bn; in Feb 2014, in acquired WhatsApp for USD 19 bn (15 in shares, 4 in cash); and most recently in March 2014, it acquired Oculus VR for USD 2 bn (0,4 in cash, 1,6 in shares). After thinking and reading a lot about it, I decided to write this to argue that I would be very mad if I were a Facebook shareholder for the following reasons:

i) Facebook’s acquisitions signal bad management outlook for its core app and a big red flag for social media as a whole;
ii) Facebook is going significantly off-track on its acquisitions in terms of its stated strategy;
iii) Facebook’s management is doing a bad job vis-a-vis its shareholders;

First of all, I need to clarify that I am looking at this through the lens of an IPO investor: someone who purchased its shares on the initial public offering, and therefore, assumes some things: that Facebook is accessing public markets because it has significantly de-risked its business model, that it will not make any significant changes in its core business model without stating so to investors, and that it will now have to worry much more about minority shareholders, therefore avoiding big bold moves unless it earns them with great execution on current propositions.

But why has Facebook purchased WhatsApp? We can only speculate, but there is not a lot of room for creativity here. They either:

i) Are purchasing usage growth purely to boost share prices, which, as we see below, is the key metric that is driving social media valuations nowadays and I believe is the actual reason;
ii) Are purchasing usage growth with the eye on WhatsApp users migrating to Facebook’s revenue generating main app;
iii) Are purchasing a new technology that is complementary to Facebook’s, and enhances its monetization prospects;

The technology thesis is easily refutable. Facebook already has a chat application. Actually it already has two: one built into Facebook, and one spun off as a separate application. WhatsApp’s application is pretty simple, any technologist can argue, and could/can be easily be replicated by Facebook’s massive war chest. This also ducktails nicely into my wariness of social media as a business model, about which you will read more ahead. Lastly, WhatsApp if nothing else decreases Facebook’s monetization prospects: the company/app itself is against ads, which are Facebook’s main “market opportunity” according to the company, and the user spill over thesis, based on WhatsApp being a way to acquire customers into the main app’s platform, has a huge hole in it – almost all users already use both.

As Aswath Damodaran argues in his recent blog post about the WhatsApp acquisition:

 Number of users is the dominant driver: The key variable in explaining differences in value across companies is the number of users. While the value side of you may be telling you that you cannot pay dividends or buy back stock with users (you need cash flows), remember that the pricing game is not about what you or I think makes sense but what traders care about. This is reinforced by market reactions to earnings announcements, withZillow seeing its stock price climb 12% when it reported earnings on February 14, 2014, primarily on the news that they added more users than expected and Twitter seeing its stock price drop 25% last week, again primarily on news that the user base grew less than expected.

 User engagement matters: The value per user increases with user engagement. Put different, social media companies that have users who stay on their sites longer are worth more than companies where users don’t spend as much time. While making comparisons across companies is difficult, since each company often has its own “measure” of engagement, there is evidence that markets care about this statistic. For instance, another reason Twitter was punished after its last report was that investors believed that the “timeline views per average user” and the “revenues per 1000 timeline views” reported the company were lower than they had anticipated.

 Predictable revenues are priced higher than more diffuse revenues: Some of the companies on this list derive revenues entirely from advertising, some from a mix of advertising and subscriptions and some from just subscriptions. In fact, some like Zynga make their revenues from retailing (in game purchases). While the sample is too small to draw strong conclusions, the value per user of $577 attached to Netflix’s users suggests that the market values predictable subscription revenues more than uncertain advertising or retail revenue.

 Making money is a secondary concern (at least for the moment): Markets (and investors) are not completely off kilter. There is a correlation between how much a company generates in revenues and its value, and even one between how much money it makes (EBITDA, net income) and value. However, they are less related to value than the number of users.

So basically, Facebook’s huge valuation is based on the number of users it has (both inventory and growth rate) and the engagement it generates: it’s the only metric that makes any sense. So what is the matter, then, with Facebook paying so much to acquire WhatsApp’s 450 million users? First of all, because a mere one year ago it has sold itself to us as THE vehicle to capture user growth. Nobody even thought of Facebook as a growth consolidator entitled to pay to valuation for other players. It just sounds like its core app, Facebook (web and mobile), is not growing as much as expected (by us, for sure; for them, I hope so).

Why does it signal a bad outlook for the Facebook app and a major red flag for social media?

If the technology is not new, and the user conversion thesis is bogus, Facebook is buying growth to pump (or desperately maintain) its market valuation. This is a huge red flag signaling bad outlook for Facebook, Inc and social media as a whole.

Why a red flag? Because for one, if Facebook had been being successful in monetizing its main app, it would not be concerned with buying usage – remember half the worlds internet users are on it – but maybe buying additional technologies to enhance monetization. Not an app that cites The Fight Club’s lines when justifying its choice for no ads.

Furthermore, knowing that Instagram (which had I think 10 employees when it was acquired) and WhatsApp (which had more or less the same ridiculously small number of employees in March 2014) were worth a combined USD 4,4 bio in cash and 8% equity dilution for current shareholders just shows how fickle the social media business is, and leaves me wondering why in the first place would someone want to become a Facebook investor. If Facebook’s massive war chest is not able to sustain user growth and engagement, and less than 50 people can make such a dent on it, what is the sustainability of the business model? None.

See, I personally know a number of people that are just fed up with Facebook. They have moved on, leaving their Facebook’s accounts idle just because of the number of other apps that have log-in APIs based on its accounts. I myself have cancelled my account. People move on, to Instagram, WhatsApp, Google+, or whatever the latest social trend is. We have seen it happen with Orkut, MySpace and even the Blackberry Messenger. The punch line is: users are volatile because social trends are volatile, and so it is not a reliable metric to base the value of a company on. This suspicion of mine was basically confirmed when I opened up Facebook`s Earnings Release Slides (Page on shareholder.com) and saw that it divulges its consolidated metrics of usage: you see Facebook + Instagram + Face + WhatsApp, but not the individual apps’ performance breakdowns.

Why are Facebook’s acquisitions significantly off-track?

In its IPO prospectus, Facebook states two major market opportunities that basically justify its investment case:

Our Advertising Market Opportunity

Advertisers’ objectives range from building long-term brand awareness to stimulating an immediate purchase. We offer advertising solutions that are designed to be more engaging and relevant for users in order to help advertisers better achieve their goals. Facebook’s combination of reach, relevance, social context, and engagement gives advertisers enhanced opportunities to generate brand awareness and affiliation, while also creating new ways to generate near-term demand for their products from consumers likely to have purchase intent. According to an industry source, total worldwide advertising spending in 2010 was $588 billion. Our addressable market opportunity includes portions of many existing advertising markets, including the traditional offline branded advertising, online display advertising, online performance-based advertising, and mobile advertising markets.

Advertising on the social web is a significant market opportunity that is still emerging and evolving. We believe that most advertisers are still learning and experimenting with the best ways to leverage Facebook to create more social and valuable ads.

Our Market Opportunity for Payments

When users purchase virtual and digital goods from our Platform developers using our Payments infrastructure, we receive fees that represent a portion of the transaction value. Currently, substantially all of the Payments transactions between our users and Platform developers are for virtual goods used in social games. According to an industry source, the worldwide revenue generated from the sale of virtual goods increased from $2 billion in 2007 to $7 billion in 2010, and is forecasted to increase to $15 billion by 2014. We currently require Payments integration in games on Facebook, and we may seek to extend the use of Payments to other types of apps in the future.

Great. So two main things: Ads and payments. Are any of its acquisitions aligned with its strategy? Of course not, WhatsApp, the largest one, is declaredly an enemy of advertising, as seen on its home page manifesto:

Also, WhatsApp is a hardly a new technology for Facebook, which has its own, built in chat app. How can Mark Zuckerberg justify that it has not built a chat app better than 10 guys in a humble office? Because that is not the point.

How can Facebook pay so much for an app that – literally – goes against it business model and that is based on a technology that Facebook already has? The real answer, IMHO, is it is buying usage metrics to compensate for slower growth on its core app in mature markets (see above). Because arguing that WhatsApp has a strong footprint in Emerging Markets that will generate “cross selling” to the revenue-generating Facebook? I don’t know of any Facebook users who are not using WhatsApp; and I live in Brazil, a significant emerging market.

Again, Damoradan:

“Returning to the Facebook/Whatsapp deal, it seems to me that Facebook is playing the pricing game, and that recognizing that this is a market that rewards you for having a greater number of more involved users, they have gone after a company (Whatsapp) that delivers on both dimensions.”

Why its management is doing a bad job?

First, if a company is making a strategy change, or pivot, and spending such a large amount of cash on it, it must at least acknowledge that something is wrong with the original strategy, that opinions change when facts change, or whatever. But nonetheless everybody seems to have accepted such pivot without any major criticisms. Facebook is going against what it said it would do, and doing so based on – again, IMHO, and Damodaran’s – stock market sentiment.

I still remember watching Facebook’s IPO video, and am startled to remember how so much of it was spent explaining why the app’s advertising platform was a game changer for small and medium companies, in terms of targeting and segmentation. I even got excited with how good it sounded. Where is all that now?

Facebook has very small earnings relative to its valuation. It has yet to execute on its core advertising/payments strategy to start spending lavishly on crazy acquisitions such as Oculus VR. Will it enhance monetization? Nah. Should we pay top valuation for Facebook to bet on emerging technologies? I don’t think so, specially when it hasn’t delivered on its core promise. I can even overlook Google’s spending on Google X: their flawless execution of Ads has its perks. But Facebook has yet to prove one strike. As Damodaran says:

“The key variable in explaining differences in value across companies is the number of users. While the value side of you may be telling you that you cannot pay dividends or buy back stock with users (you need cash flows), remember that the pricing game is not about what you or I think makes sense but what traders care about.”

 
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