“The competition in mobile and the social space intensified. It is imperative that we increase our market space in mobile in order to stay competitive.” Sina Weibo’s CEO this week, echoing Facebook’s dilemma
“Party like it’s 1999…” Prince, who unwittingly wrote the anthem to the last tech bubble
I’ve been consistently overweight tech over the past year as a beneficiary of relatively scarce revenue growth momentum and global excess liquidity, as well as several new innovation driven growth cycles. Back in a note covering the ongoing upside for China’s social media giants last September, I highlighted that ‘…there is no question that we are now seeing similar global investor excitement over the potential of the mobile internet as the original PC based model back in 1999.’ The social media sector is essentially a smartphone screen ‘land grab’ at this stage with relatively low barriers to entry, and in investment terms a global momentum trade until clear winners emerge and/or overall customer acquisition growth rates peak – it’s dangerously late to chase the theme. Many fundamental investors understandably recoil from social media/mobile web valuations, but these companies will eventually be value destructive across huge swathes of a blue chip equity portfolio, as consumers shift their media and retail consumption as well as financial management to the mobile device, and revenues follow them. For the moment, investors in this exponential growth sector think less about fundamentals to focus primarily on numbers of users, their growth rate and engagement with the service as indicators of potential future revenues, as detailed below. In other words, ignore them at your peril as a force for classic technological ‘creative destruction’.
It is very likely that the market is over estimating the value of users at social media companies in aggregate, as many brands will fall by the wayside like fallen web giants (and early movers) MySpace or AOL over the past decade. As social media companies move up the life cycle, the variables to price companies will change from number of users/user intensity to revenues, earnings and cash flows. When that happens, there will be a repricing of social media companies, with those that were most successful in turning users into revenues/earnings being priced higher. The problem for companies (and investors) is that these transitions happen unpredictably and that markets can shift abruptly from focusing on one variable to another. For Facebook, the path to success with this deal is therefore simple, albeit not easy. Start by trying to attract Whatsapp users to the Facebook ecosystem, and hope and pray that the market’s focus stays on the number of users for the near term until you can monetize them in some sustainable way, and the user churn rate in these services is likely to be very high.
Facebook paid 11% of its market value, or approximately 35% of cash on hand and nearly 10x the company’s 2013 free cash flow for WhatsApp, which is worth more to Facebook than it is on it own because the competitive threat from mobile messaging services could cause a significant decline in Facebook’s valuation if the company didn’t act – they’re pretty good at game theory in Silicon Valley. If say WhatsApp gets to a billion users and it continues to charge them only $1 per year, that implies well over $600m in operating income, given that the only material costs are likely to be the 30% app payout to Google and Apple. That incremental EPS largely offsets the deal dilution. If Facebook has significant competition, and its acquisitions of Instagram and WhatsApp and the attempted acquisition of Snapchat signify that it believes it does, it’s hard to justify Facebook’s current valuation on a standalone basis, and using that high priced stock currency to pre-empt competitive threats, even in their start-up infancy, makes sense for the US tech giants (as Google has done recently with the UK’s DeepMind), although it will ultimately strangle innovation and deliver some form of cartelization of the internet.