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Was WhatsApp really worth the $19 billion price?

Some see huge monetization possibilies, while others see a tech space that is out of control

Financial trends and news by Steven Loeb
February 23, 2014 | Comments
Short URL: http://vator.tv/n/3536

(Correction: Screener.co was previously identified as Screener.io)

Facebook's purchase of mobile messaging app WhatsApp earlier this week, for a jaw-dropping total of $19 billion, is a big damn deal, to put it mildly. I don't mean that this is important just for Facebook and the messaging space, but for the tech industry as a whole. 

This deal is so big, and so risky, that it will, ultimately be a defining moment for Mark Zuckerberg. When we look back, this will either be the moment when he started to lose it all, or it will be the moment when he became the next Steve Jobs.

Either he will be labeled a fool, or a prescient, almost guru-like, figure in the tech world. It's hard to see it not going to one of those extremes given just how much Facebook has bet on WhatsApp.

So, which way will this go down? At the moment, public market investors have given a collective thumbs up. Shares of Facebook were trading at $67 the day before the deal was announced. It closed the week at just under $69. Still experts and analysts are coming down on both sides.

Since the acquisition was announced on the 19th, Evercore Partners has downgraded its price target from $70 to $60, while Pivotal Research downgraded from $66 to $65, according to Analystratings.net. Janney Montgomery Scott raised its price target to $71, while Noumra and Wedbush reiterated positive ratings. 

Terms of the deal

First thing's first: before we get into the potential outcome of the deal, though, it's probably best to go over the specifics of it.

The total price for WhatsApp was $16 billion paid, which is to be paid out as soon as the deal is done, which should be sometime later this year. The price includes $4 billion in cash, along with approximately $12 billion worth of Facebook shares.

In addition to that figure, the agreement also provides for another $3 billion in restricted stock units, which are to be granted to WhatsApp's founders and employees, and which will vest over four years subsequent to the closing of the deal. That brings the total price to $19 billion.

The positive

Those who are coming down on the positive side of the purchase are looking specifically at two things as justification for the huge price: first there is WhatsApp's extremely fast growing user numbers, and, second, its potential for monetization down the road. 

Right now, the app is now seeing over 450 million people using it each month, with 70% using it daily, and more than one million new people signing up every single day. 

To put that in perspective, as Ryan Perlowin, an entrepreneur and former CEO of FIX, a subscription model candle company, noted to me, if the company had 450 million users when it was purchased, its already up to at least 454 million and counting. 

There is no doubt that WhatsApp really is seeing an astounding growth pace at the moment. 

Moreover, the app is dominant in the majority of the big markets around the world, including Brazil, Indonesia and South Africa; and it is the second most used messaging app in the United States, behind Facebook Messenger. The only major market where it does not have a presence is China. 

Looking at how Facebook Messenger is lagging behind in most markets might also be a key clue as to why the company made this purchase. Basically, it didn't believe it could make a dent with its own product.

"There is no doubt that Facebook's primary objective is to connect the world. The key to that strategy are feature phones in emerging markets, which drive incredibly high user engagement numbers," Arnie Chaudhuri, the co-founder of mobile messaging app Chaatz, told me.

"No one has been able to accomplish that," he said. "WhatsApp gives Facebook a huge opportunity to penetrate new markets, and that makes $19 billion a worthy investment."

In the end, he said, "The price doesn’t matter, because they are only scratching the surface with 450 million users."

Right now, there are two billion people in the world with smartphones today, meaning there's a lot more upside, even though 25% of the market is already substantial. One of out every five people in the world owned a smartphone, according to a BI Intelligence report from December. As of a year ago, six out of the seven billion people on the planet had a mobile phone of some kind, more than the number who own a tiolet. 

With that kind of potential growth, according to Chaudhuri, who was also part of the team that helped develop Facebook's mobile version for feature phones in 2011, comes huge upside for WhatsApp's monetization. 

The app currently works on a subscription model; it is free to new users for the first year, then charges $1 per year after that. With the way it is growing, Zuckerberg has already said that he believes that WhatsApp could reach one billion users within a few years, and Chaudhuri thinks the number could go as high as 2.5 billion users, with growth in countries like Brazil and India. 

In fact, Aswath Damodaran, a professor of finance at NYU, wrote a blog post in which he said that WhatsApp will have to get up to at least 2.5 billion users for Facebook to make a return on its investment in the company.

"If the company continues its current business model of allowing people to try the app for free in the first year and charge them a dollar a year after that (99 cents) and has zero operating costs (completely unrealistic, I know), you would need about 2.5 billion people using the app on a continuing basis," he said.

If every user pays the flat fee, that means the company would be raking in over $2 billion from its subscription plan alone. Combine that with other revenue sources, and the company could really bring in a nice profit for Facebook.

So what are those potential efforts? Almost certainly not advertisements, which Zuckerberg made pretty clear in a conference call following the purchase. Jan Koum, WhatsApp co-founder and CEO, has also made his displeasure over advertising known in the past.

In a 2012 he wrote blog post, railing against the use of ads online, saying, “When we sat down to start our own thing together three years ago we wanted to make something that wasn’t just another ad clearinghouse. We wanted to spend our time building a service people wanted to use because it worked and saved them money and made their lives better in a small way. We knew that we could charge people directly if we could do all those things. We knew we could do what most people aim to do every day: avoid ads."

But while the company will not be putting ads on WhatsApp, that doesn't mean there's no other potential revenue sources.

"They could make money from in-app game sales and stickers," Perlowin said. "Other competitors, like WeChat, which is huge in China, and Kakao are making a huge amount off of emoji, by selling different sets and packs."

Moreover, if you look at Skype, another global communications platform, the revenue streams could be quite diverse. Skype makes money through low-cost features that can be accessed through Skype Credit, as well as a monthly subscription plan. These include allowing users to make calls from mobile to landlines, as well as connecting to the internet from a public WiFi hotspot. 

The negative

Of course, not everyone sees the deal as being so great for Facebook, and its investors.

There is already a big issue with monetization:  Facebook has already explicitly said it will not be focusing on it in the short term, focusing on growing WhatsApp user base instead.

This cannot be news that will sit too well with investors, who want to know that a deal of this size is going to pay off soon, and not in a decade and a half.

"This has to be kind of medium-term project," said Perlowin. "It cant be too long term, because if you spend $19 billion, investors will want to see what you will do to make it worth it."

On top of that, perhaps the company is not making quite as much profit as many people think.

According to David Nelson, Chief Strategist at Belpointe Asset Management, only around 60% of WhatsApp users are currently paying for the service, while the other 40% get it  for free. That means that the company is only taking in money from 200 million of its users, not 450 million.

Taking into account a potential high turnover rate from users who might not like the service or may not want to pay for it, and the deal doesn't look quite so good for Facebook.

"They are assuming that they are going to sign up most of the planet," he said. "But there is a lot of competition out there."

In fact, Nelson is so down on the deal that he told me he actually sold off his Facebook stock when he heard about it, calling it Facebook's "jump the shark moment."

What disturbed Nelson the most about the deal, though, was the lack of questioning by analysts on the conference call, which he called a "love fest," despite a lack of details from Zuckerberg and Koum.

"There was no discussion as to how they arrived at the price, with only vague answers," he said. "When you do these types of deals you have to take into account potential revenue earnings, and count backwards."

No analyst has yet put up a financial valuation, according to Nelson, and the deal seems to be have been struck between Zuckerberg and Koum while "they were sitting around."

Here is how Zuckerberg described how the deal came together in that call:

"Jan and I have known each other for a couple of years, and we've been talking about different things we could do together and how the world will evolve in terms of communications and social networks," Zuckerberg said. "And he's been a valuable thought partner the whole time."

So, two weeks ago, the two started talking and Zuckerberg "proposed that if we joined together that that would help us really connect the rest of the world and could help out with things like Internet.org, by bringing these two communications tools, that are very different, together."

To Nelson, the lack of questioning of Zuckerberg, and how the deal came together, might be a symptom of over-adulation on the part of analysts, as well as their not wanting to rock the boat.

"There is too much faith in Mark Zuckerberg being a visionary," he said. "But not everyone turns into Steve Jobs."

"Everyone wants to be Zuckerberg's friend, maybe because of potential investment banking opportunities down the road."

What he really sees, though, is a company being irresponsible with investor money. 

"When you're a private company, you can do what you want. When you're a public company, the CEO and board of directors answer to the shareholders," he said. "This was a flagrant disregard of the use of capital. I can't justify it."

Lenny Grover, founder and CEO of Screener.co, a service that gives stock trading tools to average people, also said the company far overpaid for what it is going to get. He pointed to other, smarter, deals that Facebook potentially could have made to arrive with a similar product.

For example, he said, they could have bought BlackBerry Messenger, which has 80 million users, is cross platform and is used on a lot of old phones popular in emerging markets, for a third of the price. 

(Correction: Grover informs me that he actually meant that all of BlackBerry could have been had for 1/3 the price, not just Messenger. That includes their cash, patent portfolio, and the QNX business)

Or, he noted, they could have just done it themselves.

"Facebook has the audience, and the technology can be replicated at small cost of acquisition in existing apps," he said.

The deal was a defensive one, made out of fear of falling behind in the messaging space.

"Facebook feels threatened, but it should instead be looking to monetize its existing user base," he said,

Another bubble?

Facebook paid $42 per user. Many companies would like to see their user base valued in the double digits, making the $42 price seem steep. Yet with more than 1.23 billion monthly active users, and a market cap of $174 billion, Facebook is valued at more than $150 per user, making $42 seem high, but not insane. One could argue that there is a network effect with the WhatsApp user, which makes them far more valuable. 

Still, WhatsApp has been around for five years, since February 2009, or roughly 1826 days. That means that Facebook just paid $10.4 million for every single day of WhatsApp's existence. That's a startling amount of money. 

Grover, though, sees more than just Facebook wasting money in this deal; he thinks that the fact that a company would pay so much for a startup without a sound monetization strategy actually suggests that we are currently in a bubble, akin to the dot-com era.

He compared the deal to the disastrous purchase of GeoCities by Yahoo in 1999. Here are the details of that deal, if you do not know them.

In January 1999, Yahoo spent $3.6 billion to buy up Web hosting service GeoCities, which, at the time of its acquisition, was the third most visited site on the Web behind AOL and Yahoo, with 19 million unique visitors.

The deal, however, turned out to be a bust. Yahoo tried to imposed new copyright rules on members, which said that Yahoo would own all rights and content, including media such as pictures. The decision was reversed, but it still lead to overwhelming anger in the GeoCities community.  

This, combined with Yahoo's decision to switch the format from neighborhoods to "vanity" URLs through members' sign-up names to Yahoo, doomed the company.

In 2009, 10 years after being acquired, GeoCities was shut down. "When Geocities was bought by Yahoo, eyeballs were valued as currency," Grover said. "It was not cash flow or profit. You needed visitors and page views." Given that WhatsApp's greatest appeal was its large user base, he sees a parallel in how the two companies were valued.

Nelson agreed with the assessment of there being a bubble somewhat, though he did not say that we were currently in one, only that this was "the first step in that direction."

"We've started letting our imagination run wild," he said, saying that it is reminiscent of the 1999-2000 era.

The only reason that we are not currently in a bubble, he said, is because social media is not dominating the way that tech did in 2000, when it was the biggest part of the index.

So did Facebook overpay?

The true answer is that only time will tell.

But while the price may seem insanely high, remember Facebook shares are now valued at $174 billion, and the bulk of the purchase price was made in stock. If there was a time to make a bold purchase, it's now when the stock market and Facebook shares are at all-time highs, making the stock currency relatively cheap. Facebook could actually be making a statement in the marketplace about where it sees the market heading.

One thing does seem clear, if Facebook were trading at half the price - or at $85 billion - I doubt we'd be talking about a $19 billion price. It's more likely the price would have been closer to $10 billion. 

(Image source: http://www.leaguearena.com)


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