Most of the articles / news on Whatsapp acquisition are portraying the deal as irrational exuberance and as a general hype in Social Media sector, or as a desperate and expensive act of Facebook (FB) to stay relevant.
However, I do not believe that Facebook management likes to waste huge sums of money just to make headlines. Keep in mind that Zuckerberg has majority of his worth invested in this company and therefore he probably thought very hard before spending $4bn in cash and diluting his stake in the company by another $15bn. So it is quite likely that Whatsapp acquisition will be value creating for Facebook and in this article I will show how.
Two completely different business models
Facebook is running a free to use business model and generates revenues from advertising (90% of revenue) and payment systems (10% of revenue, mainly payments for game apps). Whatsapp on the other hand has no ads and is charging to use software for $1 per user per year (starting with the second year) That is the only revenue stream for Whatsapp so far, however based on its globally spread user base, especially within emerging markets, it could introduce such lucrative ideas as mobile transfers and remittances, VoIP calls and etc. Further most Facebook users are in developed countries, whereas Whatsapp is focusing on emerging markets. As Facebook is struggling to invent new revenue streams, the business model of Whatsapp might provide the opportunity. Now let's to turn to the deal.
Structure of the deal
Most headlines quote the $19bn as the purchase price for Whatsapp, however what Facebook actually agreed to pay was not $19bn but 'only' $4bn, the rest will be in newly issued Facebook shares. Now I will look as this deal slightly differently, but this kind of perspective allows to assess the rationale better. Let's assume we can break this deal into two separate parts:
1. Current Whatsapp revenue stream for which Facebook paid $4bn in cash.
2. Any further growth in Whatsapp revenues, any synergies or new revenue streams from the joining of two business models for which Facebook paid $15bn in shares.
I will analyze each of these parts separately.
Purchase of current Whatsapp revenue stream
Whatsapp has 450m users, with each paying $1 annually. As it has zero advertising spend and only 55 employees, I would think it is reasonable to assume 80% profit margins (the biggest expense is probably getting those millions of payments of $1 into account of the holding company, with any systems that are being used taking a cut). Thus Whatsapp could be generating c. 360m of annual net profit, which indicates that Facebook bought this part of business for P/E=11, which is a good price for stable (all growth is included in the second part of the deal) cashflows.
Purchase of any growth and synergies between the two companies
As per my assumptions above, Facebook does not pay any cash for this part of the deal, all will be done in stock exchange (230m of Facebook shares to be issued). To assess whether this kind of stock exchange makes sense we have to compare what Facebook gets for each additional issued share versus what it already had. Thus only relative value assessment really counts.
Before the deal was announced, Facebook had c. 2,700m shares (including unvested RSUs) and will issue another 230m for Whatsapp, this translates into $176bn market cap for Facebook and $15bn for growth/synergy part of Whatsapp business.
If we look at these numbers on per user basis - each Facebook user is valued at $143 whereas the company paid only $33 for each Whatsapp user. Thus for anyone who believed that Facebook was fairly valued pre-acquisition, the Whatsapp should seem like a great deal - users are 4 times cheaper and thus Facebook only has to convince 1/4 of the Whatsapp user base to start using Facebook (and generate add revenue) to break even on this acquisition.
Thus, even if we include only the above mentioned parts (existing revenues of Whatsapp + relative value of each Whatsapp user when transferred to Facebook) the deal already seems reasonable. However, there are further potential synergies / growth opportunities, which Facebook kind of gets for free.
1) Existing Facebook users start using Whatsapp paying 1$ annually. Assuming 50% of Facebook users start using, the company could generate additional $500m in net profit (applying the same 80% profit margin). That's another $5bn in value.
2) Growth in Whatsapp user base / revenue (in addition to users that came from Facebook). If number of users growth 10% for the next 10 years and 2% afterwards, if creates an additional NPV of $4bn (compared to no growth situation, which I valued above).
3) Any banking /remittance / mobile payment solutions that Whatsapp could potentially introduce for emerging markets customer base. Hard to assign any value on this possibility, but I believe it could be a significant number.
Conclusion
Acquisition of Facebook appears to be value creating:
1) Facebook pays $4bn for existing revenue stream of Whatsapp, which equates to purchase at PE=11.
2) By issuing $15bn in new shares, Whatsapp users are acquired 4 times cheaper than current value of existing Facebook users.
3) Further potential synergies / new business opportunities of $9bn+ are likely.
However, keep in mind that this analysis is done on a relative basis, so acquisition makes sense within perspective of currently prevailing prices is social media sector (or more specifically Facebook valuation). Nevertheless, even if one would believe that Facebook is significantly overvalued, from capital allocation perspective issuing shares when they are overvalued is considered a value creating transaction.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. (More...)
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