Facebook Inc’s (FB) $19 Billion Mistake

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February 20, 2014 1:34pm NASDAQ:SOCL

facebookIan Wyatt: Ukrainian entrepreneur Jan Koum stopped by Facebook Inc (NYSEARCA:FB) founder Mark Zuckerberg’s house on Valentine’s Day with a box of chocolate-covered strawberries.  Koum left with $19 billion in his pocket after Facebook

agreed to buy his startup called WhatsApp.

Facebook’s acquisition of WhatsApp is the third-largest Internet deal since Time Warner merged with AOL back in 2001.

The deal is by far the largest acquisition by Facebook, which in 2012 bought Instagram for $1 billion. At the time, that was considered a shocking price tag given that the popular photo-sharing app was pre-revenue, with no clear plans to become profitable.

So, What is WhatsApp?

WhatsApp is an Internet messaging service that lets users send messages to each other through a variety of different platforms and devices.  The app lets users try the service absolutely free for one year, and then charges a nominal 99 cents per year for continued access.

WhatsApp isn’t exactly unique, and competes with the likes of WeChat from China’s Tencent (OTC: TCEHY), SnapChat, and Facebook Messenger.

But with 450 million users, WhatsApp has attracted a large and rapidly growing audience. In just three months, the number of users has more than doubled.

Not only is the audience large but it’s also sticky. Seventy percent of those users communicate through WhatsApp every day.

WhatsApp has also become an important platform for photosharing. There are an estimated 400 million daily photo shares on WhatsApp, compared with 350 million on Facebook. Photosharing has been a key aspect of Facebook’s social platform, and the social giant is willing to spend lots of money to protect its core business.

SnapChat is another big player, with an estimated 350 million photo shares per day.  In November, SnapChat turned down Facebook’s offer of a $3 billion buyout. After that befuddling rejection, it didn’t take Zuckerberg and company long to start exploring alternative acquisitions.

In the deal announced yesterday, Facebook will acquire WhatsApp for $19 billion.  The acquisition includes $12 billion in stock, $4 billion in cash, and $3 billion in restricted shares.

The steep price tag is an attention-grabber. The deal gives WhatsApp a valuation equal to 11% of Facebook. Put another way, it values each of the company’s users at $42. That’s a 50% premium to the $28 per user that Facebook paid to acquire Instagram’s 35 million users.

How valuable is WhatsApp?  I’ll use some pretty aggressive assumptions to outline the “best case scenario.”  Mark Zuckerberg went on the record saying, “[WhatsApp] is on a path to reach over 1 billion people worldwide in the next few years.”

Based on Zuckerberg’s comments and the company’s user growth, I’ll estimate that the number of WhatsApp users will grow to 1 billion in the next two years. Meanwhile, I’ll assume that 50% of users are paying $0.99 per year.  That translates to $500 million in annual revenue.

The $19 billion buyout price values WhatsApp at 38-times future sales.  That’s an astounding valuation, especially when you consider that Twitter (Nasdaq: TWTR) is valued at about 10-times sales and LinkedIn (Nasdaq: LNKD) trades at a mere 8-times sales.

Facebook investors don’t seem too excited about the deal so far. In trading this morning, Facebook stock fell by 2% to $66. However, that’s just a few points below the all-time high of $69 for the stock, which was set earlier in the day yesterday.

Back in November, I wrote about The Latest Sign of a Second Internet Stock Bubble. But the frothy market for social media stocks has continued. In the last three months, Facebook shares have soared 35%, Yelp (Nasdaq: YELP) is up 43%, and Twitter stock is up 33%.

I’m worried that Facebook is playing defense, and is willing to pay any price to stomp out the competition. While that may work when Facebook uses its overvalued stock to buy the competition, that’s not a sustainable growth strategy.

What do you think of this Facebook acquisition? Feel free to leave a comment below.

This article is brought to you courtesy of Ian Wyatt from Wyatt Investment Research.

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