If Facebook Overpaid For WhatsApp, It Did So With 'Cheap Stock'

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It's easy enough to conclude that Facebook overpaid for WhatsApp --the Internet texting service with a subscription fee of $1 per year (after an initial free year). The $19 billion purchase price paid by Facebook seems extravagant for a company with no profits, modest revenues and only 55 employees.

But Facebook paid this price mainly in its own "cheap" stock, and the price per user for WhatsApp is lower than the implied valuation of users in other social media companies. In the final analysis, whether this acquisition makes economic sense for Facebook will depend on how effectively it can monetize the rapidly growing user base of WhatsApp.

Of the $19 billion purchase price for WhatsApp, Facebook paid only $4 billion in cash. Facebook paid most of the purchase price in its own shares -- $12 billion in shares upfront and 3 billion in restricted shares that will be granted to key employees of WhatsApp and vested over the next four years.

Facebook shares are cheap by the most important investment standard -- the ratio of its price per share to its earnings per share (the PE ratio). The average U.S. stock has a PE ratio in the range of 15 to 18; even the PE ratio for Google and Yahoo is around 30. By contrast, the stock of Facebook has a PE ratio over 114 times its actual earnings in 2013, and over 68 times its estimated earnings for 2014.

On the date the acquisition was announced, WhatsApp had approximately 450,000 users -- meaning that Facebook paid approximately $42 per user. In 2012 when Facebook bought Instagram -- the Internet photo sharing site -- the price per user was $42.

On the other hand, the market capitalization of LinkedIn translates to over $150 per user. Twitter's market capitalization suggests a price per user of over $120. Based on its current $2 billion market valuation, Snapchat is worth $50 per user, but that company has reportedly turned down a purchase offer from Facebook at $3 billion.

While Facebook's overall use is down, WhatsApp is gaining new users at the startling rate of one million per day -- mainly from the emerging markets. As WhatsApp adds voice to its texting service, it could plausibly reach one billion users in a few years.

If WhatsApp can actually collect an annual subscription fee of $1 from every user (after a free initial year), it could generate gross revenue of $1 billion per year. And if WhatsApp can continue to hold down its operating costs, it could potentially throw off net income of $700 or $800 million per year for Facebook.

However, there are many competitors that offer a broad range of communication services through the Internet without an annual subscription fee. Here is a sampling of strong competitors to WhatsApp across the world:

-- Skype (text, voice and video)
-- WeChat (text, voice and video)
-- Kakao Talk (calls and texting)
-- Line (calls and texting)

Because of these existing competitors as well as new entrants, the ability of WhatsApp to produce large amounts of net income from subscriptions is unclear. Given this uncertainty, Facebook management would logically want to try other avenues to monetize WhatsApp's user base.

One avenue for profit making would be to run advertisements on WhatsApp. This is how Google monetized its $1.65 billion purchase of You Tube in 2006. But Jan Koum, the co-founder and CEO of WhatsApp, was put off by Internet ads when working at Yahoo. His desk now has a hand-written note saying: "No Ads! No Games! No Gimmicks."

His note seems to cut off games -- a second lucrative side line for some Internet chat services. For example, Kakao Talk has become profitable primarily by selling games over to its mobile user base in Asia.

A third avenue would be to mine data from WhatsApp's users for commercial purposes. But Jan Koum,
reacting to his childhood experiences in Ukraine, staunchly protects user privacy: "We don't save any messages on our servers, we don't store your chat history."

For now, Facebook CEO Mark Zuckerberg is allowing Jan Koum to run WhatsApp as an autonomous unit with a subscription only service. In the future, don't be surprised if Zuckerberg decides to assert more control over WhatsApp in order to pursue multiple approaches to monetizing its user base.

 

Pozen is the former chairman of MFS Investment Management, a senior lecturer at the MIT Sloan School of Management, and a Non-Resident Senior Fellow at the Brookings Institution.  

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