Facebook-Whatsapp $19B Acquisition: Dotcom 2.0?

Facebook is acquiring WhatsApp  for $19B of which $15B is in stock. Reaction rages from skepticism-repeat of the 1990s dotcom bubble-to euphoria as a brilliant move. Here are some facts:

1. WhatsApp is a 4 year old firm with 55 employees. It has 450 mln users. If they pay $1 each it will generate sales of $450 mln in 2014.Thus, Facebook is paying a price to sale multiple of over 40 based on trailing number of users.
2. The $19B price exceeds the market value of such well known names as Xerox ($13B) and Nordstrom ($11B).
3. WhatsApp had an implied venture capital value of $1.5B in July, 2013.
4. Google was allegedly prepared to offer $10B for WhatsApp.
5. Facebook has a market value of $170B. The market reacted favorably to announced transaction.
6. Facebook has a price earnings ratio of 55 compared to 23 and 14 for Google and Microsoft respectively.
7. The previous Internet deals exceeding $10B in market value flopped-the biggest being the Time Warner AOL deal.
8. Internet firms have an average life of around 11 years. Thus, Facebook is middle aged.

I understand the difficulty applying traditional valuation techniques like comparable and discounted cash flow to rapidly growing technology based firms. Nonetheless, I continue to rely on the following bedrock principles:

1. Value is an opinion about what you may receive in the future. Price is a fact you pay for now.
2. At some price even an excellent firm becomes a bad investment.
3. Evaluate companies not industries.
4. Beware of cash flow proxy measures like price per user. Eventually, they must tie back to cash.
5. Access the Real Option Value of high growth investments, but be careful and make sure they are options and not just hopes or beliefs.
6. Estimate the performance need to justify the price and determine whether it can be realistically obtained within a reasonable time period.
7. Using stock as the primary form of consideration can help mitigate the acquirer’s risk.
8. Do not forget about time and present values-how long do we have to wait?

Let’s focus on # 6 for now and assume the following:

1. We can value WhatsApp at Facebook’s current Price earnings ratio of 55 in 5 years
2. This implies breakeven profits of $363 MLN are needed in 2019.
3. Assume a 20% net income margin.
4. Required revenues of $1.8B are needed in 2019.
5. The users required to generate that revenue are around 1.8B compared with current 450 MLN users-about 280 MLN new users p.a. are required.

We have ignored the 5 year time lag, ability to scale up and grow that fast and the impact of competitors and new technology on margins. This is of course just one, and a favorable one at that, of many possible scenarios.

The above indicates that while difficult-it is possible the deal could work financially. Facebook’s use of its potentially overvalued stock for over 75% of the purchase price helps cushion the downside. This is similar to what happened to AOL in the Time Warner transaction. Finally the WhatsApp acquisition could be viewed as a defensive or pre emptive transaction to keep Google, Facebook’s arch competitor, at bay. In M&A there are two different types of errors. The first is a type I error in making an over priced acquisition. There is also, however, a type II error from not making a good purchase and suffering possible adverse competitive consequences. The short average internet firm life span of 11 years suggests the cost of inaction - a type II error- outweighs the risk of a type I error.

I am not trying to justify the transaction. Rather, I am trying to understand it. It is a big bet for high stakes. It will be interesting to see how it plays out.

J