Monday, February 24, 2014

Facebook, WhatsApp and the Social Bubble Bandwagon

I do not have a crystal ball, but I know the difference between irrational exuberance and levelheaded, sound business analysis. In the wake of the news of Facebook's acquisition of WhatsApp, I have seen a lot of the former and very little of the latter. The flood of articles and blog posts containing weak arguments and wishful thinking has, once again, confirmed my fears that a social and tech bubble continues to grow and prop up social media stock prices and valuations. My concern runs deeper than just stock prices, however; I am deeply concerned about what this all means to the social media industry and those who work within it.

Some folks seem to think the bubble has burst and we have already recovered; in the three months after Facebook's IPO, the stock lost half of its value, but in the roughly 18 months since, Facebook's stock has risen 280%. While some see the rise as evidence the bubble burst and recovered, I look at Facebook's Price Earnings (P/E) Ratio of 100+ and wonder when the piper will show up for his payment. By comparison, Google, Apple and Yahoo have P/Es of 33 or less.

The only real comparison to Facebook's generous P/E is Amazon, which has a P/E ratio north of 500, but in this case investors are paying for a company that has strong growth, multiple revenue streams, a significant share of the cloud computing market, 20 million paying Amazon Prime members and more than 15% of total US ecommerce sales. More to the point, investors continue to buy Amazon at a premium because it will own a significant share of the $5 trillion US retail sector long after the JCPenney and Sears in your neighborhood have been converted into condos or indoor mini-golf courses.

My point is not to convince you that Facebook is in for rough times since 1) I am not a financial advisor, and 2) unfounded optimism may continue to trump financial fundamentals for some time (although it never lasts forever). Instead, I want to encourage a reasonable examination of the WhatsApp acquisition and explore what it means to Facebook and the social media industry.

Remember when charts just like this were being used
to justify claims Google+ was going to swamp Facebook?
How'd that work out again?
Here is what Facebook purchased for $18 billion: 450 million users (which is honestly quite impressive) and an estimated $20 million of revenue.  Wait, hold up there a moment--only $20 million? This is a company that supposedly charges users a 99-cent annual fee after the first year and, according to that widely circulated "hockey stick" chart, had 200 million users one year ago. Why is the revenue of this company not ten times higher? Either WhatsApp has a business model that charges people 99 cents a year starting in their second year or WhatsApp had 200 million users a year ago--both cannot be true. 

So, what else could Facebook have bought for $18 billion? (A lot of articles claim Facebook could have bought the entire global music industry, but this is weak logic from writers who cited not the value of the music industry but the annual sales of records and songs.) For the same amount Facebook paid for WhatsApp, it could have acquired 50% of Yahoo, giving the social network a half stake in Yahoo's billion-dollar annual income and 800 million active users. Or better yet, Facebook could have acquired several sharing economy startups, such as TaskRabbit or Airbnb, allowing Facebook to introduce peer-to-peer business into its network and giving the social network a new revenue stream tied to its core business.

I have a hard time seeing what the $18 billion WhatsApp acquisition has bought Facebook. Even if WhatsApp monetizes every one of its 450 million users at its current annual subscription fee, the company will earn revenue of $446 million; of course, its net income would be much less than this after paying for people and infrastructure expenses. If WhatsApp earns a net margin of 25% (which is greater than Google's, Apple's or eBay's), it would clear $112 million of net income, leaving Facebook with a 160-year break-even time frame.

Even if WhatsApp triples in size and becomes larger than Facebook itself is today (and that is a big "if"), it is likely to contribute less than $350 million to Facebook's bottom line. That means even with remarkable record-setting growth, Facebook will still not break even on its WhatsApp investment until 2065, barring a considerable change in the messaging app's business model. (I do not think many of us would take a bet that Facebook will still be around in 2065, would we?)

Note written by WhatsApp
founder Brian Acton. 
Of course, WhatsApp could try to collect more than 99 cents a year from each user, but considering the service has yet to charge anything to even 5% of its customers, it is fair to ask how much more the service can ask before users flee to one of the other free options. Or WhatsApp could start serving ads, but there is no telling how much ad revenue the service could generate or how many users, who were very clearly promised no advertising, would abandon.

A lot of articles and blog posts have been written about why the WhatsApp acquisition was a good move for Facebook; in fact, too many were written on this topic, which seems very telling. The more people feel a need to defend something, the more it is reasonable for us to question it. A lot of tech, VC and social media professionals with an interest in keeping the social bubble bandwagon rolling have been awfully quick to offer justifications as to why this deal was not another sign of a growing social media and tech bubble.  Their arguments include:

  • "Facebook is buying new users!"  Many suggest that Facebook is getting value by acquiring customers who do not already use the social network, including younger and overseas users. This may be true, but in the long term, companies are not rewarded for having customers but for earning revenue and profit from them. Unless Facebook can find a way to convert these new users into a stream of revenue and income to match the enormous investment (and we just explored its challenge in doing so), then paying this much for those new users makes little sense. Besides, with Viber, WeChat, Snapchat, iLine, BBM and others accumulating their own sizable user bases, there is no evidence that Facebook may not have to chase these same users to other platforms in the future.
  • "There's value in the data!"  Others argue there is value in Facebook collecting data about WhatsApp users. First off, it remains to be seen if WhatsApp users will allow Facebook to harvest data from their personal communications; in Germany, WhatsApp users are already fleeing following the Facebook announcement after a German data protection commissioner urged citizens to seek more secure messaging options. Secondly, we have to ask how Facebook will use this data to drive revenue. For that portion of  the WhatsApp user base that currently uses Facebook, the social network already possesses huge amounts of data and is not likely to secure any additional and meaningful insights. As for those WhatsApp users who are not on Facebook, how can the social network convert this data into revenue if WhatsApp does not serve ads? Where is the potential to monetize this data sufficient to justify an $18 billion investment?
  • "Facebook will own the address book." Analysis by The Register claims Facebook paid so much for WhatsApp in order to get access to our "phone book." I'm not sure I understand of what value it is to access consumers' digital phone books. How did Outlook generate revenue for Microsoft by being the application people used to store their contact list? How have Google and Apple profited by furnishing Gmail Contacts or the iPhone address book? "Owning" the address book has not historically been a means to generate revenue, and this is not likely to change in the future.
  • "Google wanted it."  Just seven months ago, WhatsApp was valued at a mere $1.5 billion. What suddenly made the company worth 1200% more? Google wanted it, and many argue that the price Facebook paid was worthwhile in order to prevent Google from snatching WhatsApp. Overpaying for an asset just because a competitor wants it may work in an art auction, but it is hardly an appropriate business justification for a multi-billion-dollar business deal. The fact Google was willing to pay so much does not mean WhatsApp was necessarily worth it; although Google has made a lot of smart acquisitions (such as YouTube), the company has a far from perfect record. In 2006, Google paid $102 million for radio ad platform dMarc but shuttered it 2009 after it failed to take flight. And Google purchase Motorola Mobility for $12.5 billion only to unload it two years later for less than $3 billion.
  • "It's a strike against the telcos." No doubt about it, mobile service providers (particularly overseas) are seeing a decrease in text messaging fees as a result of free and low-cost messaging apps such as WhatsApp. Of course, users of Facebook and WhatsApp still need to rely on the telcos to furnish the data services those apps require, so while WhatsApp may force telcos to shift fee structures, it hardly threatens the relationship between the mobile companies and their subscribers. Moreover, Facebook and WhatsApp do not win by interrupting the revenue stream of telcos but by replacing it, and given WhatsApp's buck-a-year model, there is little indication they can do so.
  • "Facebook is buying the competition." Some bloggers and armchair analysts argue that buying the competition is a great idea. Sometimes it is, but most acquisitions fail. (Estimates for what percentage of M&As fail run from 50% to as high as 90%.) Merely eliminating the competition is not enough--the acquisition still has to furnish value appropriate to the cost. Facebook cannot afford to continue chasing every messaging application that arises. First it was Instagram, then it failed to capture SnapChat, and now it's snagged WhatsApp, but with each acquisition, the costs rise--Facebook got Instagram for $28 per user, but less than two years later, the price for WhatsApp was 50% greater per user. With other messaging platforms growing and given the way users adopt and abandon communication platforms, Facebook cannot keep chasing users; at some point, Facebook has to build a better mousetrap rather than overpaying to acquire the mice.
  • "It's just funny money." Or, "It's about users and network effect, not money." With every discussion I have had about this acquisition, the dialog tends to devolve to this: The supporters accuse those asking how Facebook will earn a return of being small minded and failing to understand the new economics at work. If you want evidence of the existence of a bubble, look for people claiming that profits and returns do not matter and that billions of dollars of cash and stock of publicly traded companies is "funny money." There is no better sign that an industry has lost its business sense than this. For a while, investors may reward innovative companies for something other than income such as growth and potential, but eventually it becomes about profit and value. It always becomes about profit and value in the end. Today, I'm hearing the same arguments about social acquisitions and valuations that I heard during the dot-com bubble. I have seen this movie before and I know how it ends. 
To be clear, I think Mark Zuckerberg, Sheryl Sandberg and crew are very bright, but even the brightest get caught up in market euphoria and make mistakes. It was not dumb people at NewsCorp who made the $580 million deal for Myspace (which was sold six years later for $35 million.) Idiots were not responsible for the disastrous AOL/Time Warner merger. Nor were ignorant executives responsible for Yahoo's $3.6 billion acquisition of Geocities. Smart people make mistakes all the time--and never more often than in the midst of a market bubble. 

I'll be happy to eat crow years from now if the value of WhatsApp becomes apparent, but given its user base, potential growth and business model, it seems much easier to ask troubling questions than it does to justify the $18 billion price tag. So why aren't more people asking the easy troubling questions? Why do so many people feel the need to offer so much justification with so much passion so quickly after each ever-larger acquisition?

Social media has become more religion than business--something to be felt and believed rather than analyzed and questioned. This sort of (il)logic is not limited to M&A activity but is also present in the dialog about social media marketing strategies. People praise every expensive social marketing program, Vine video or viral post that accumulates useless fans, followers, likes and views without regard for the impact on consumer attitudes or business results.

The lack of simple, critical, business-oriented thinking in the social media space should be a blinking red light for anyone whose job and career depends on the continued success of social media. Now is the time for drinking water, not Kool-Aid. We have been to this picnic before, and we have no one to blame but ourselves if we again discover that the Kool-Aid leaves us with a bad taste in our mouths.  


Dennis jenders said...

I'm with you Augie. I struggle to understand the value and impact of the acquisition beyond further inflating the bubble around technology and social media.

These valuations continue to climb without any sound understanding of the value of the companies... especially those without significant (or any) revenue.

Augie Ray said...

Thanks Dennis, I'm glad you concur. I'm struck with how many smart people are so willing to just jump on the bandwagon. And when someone shows up to ask a few simple questions about return and business value, they just get dismissed as old-fashioned thinkers. Well, this old-fashioned thinker is pretty sure that traditional business economics still matter, and as a social media professional, I am very worried what this all means to our industry.

Unknown said...

Augie, at this point in time it matters not whether we agree or disagree with the purchase and its price. I do agree it will be interesting to see what becomes of this. I love business and business history and have been a subscriber of Forbes and Fortune for over 30 years. I am really only commenting to compliment you. This piece is worthy of publication in either. I hope I didn’t offend you. I sincerely appreciate the investment you made in the past few hours to put this out. Well done. Cheers!

Unknown said...
This comment has been removed by a blog administrator.
Bryan Person said...

Thoughtful post, Augie. You even attracted a spammer!

Augie Ray said...

John, I appreciate every comment (other than from spammers.) I'd suggest it does matter, because at the time the acquisitions got the craziest in the dot-com era was the beginning of the end. I believe a social media reassessment is coming, and this is something everyone in marketing and social media should care about.

Bryan, Thanks for the comment and pointing out the spam. I try to keep up on it, but it gets tough to fight spam in my inbox, on Twitter and on my blog. Hope you're well!

Judy Gombita said...

I keep being struck by how the media went on and on about the Sochi Olympics costing $51billion. If you think about it, compared to the value and (past, present and likely future) outcomes of that investment by Putin and Russia, it's a steal compared to this Facebook acquisition (at just under 40 per cent the Russian Olympics price)!

Augie Ray said...

Judy, Zuck could've brought the Olympics to Menlo Park! (Problem is, the Olympic vendors probably don't except Facebook stock as payment.) :)


Yeah, folks truly want to take their minds off the inevitable.