GRAND BLANC, Mich. (MarketWatch) - The news last month that Facebook bought a messaging service for $19 billion drew immediate attention and renewed analysis of the Facebook business model. Most American investors had never even heard of WhatsApp, nor do they understand why it is worth more than the market capitalization of Xerox Corporation or Southwest Airlines.
So, let's take a closer look at Facebook's acquisition of WhatsApp, why it may actually be fairly valued, and what metrics Facebook investors should be keying in on.
With new companies in emerging industries, it's worth looking closely at what is driving revenue growth. For the new social-media sector, analysts focus on 'Number of Monthly Users.' Below are the top four social media stocks ranked by market capitalization.
From this table we can see that a higher number of users tends to correlate with higher market cap and revenue. So, the question now is how well is Facebook doing in generating new users?
In 2012, Facebook monthly users increased by more than 17%. In 2013, growth of monthly users slowed to 11%. Even more troubling is that the more profitable U.S. and Canadian demographic only had a 3% increase in users in 2013, compared with 5.5% increase in 2012.
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In October 2013, for the first time, Facebook acknowledged many investors' concerns - that Facebook is experiencing slowing growth in daily users, especially in the key teen demographic. At this point, Facebook is starting to look like a mature blue-chip company that has mostly saturated its potential market share.
As we have seen, Facebook is having trouble generating new users organically, which helps explain the recent purchase of WhatsApp for $19 billion. WhatsApp is a messaging-service app, much like a text message, that allows users to send text, video, and pictures to each other without having to actually pay for a text messaging service. WhatsApp has also recently announced that it is adding a voice service as well, putting more pressure on telecom companies.
For those who have never heard of WhatsApp, keep in mind that it is not a huge player in the United States. It does, however, enjoy a large global presence outside the U.S., especially in emerging markets. WhatsApp is the most popular mobile-messaging app in emerging-market countries such as India, Brazil and Mexico. Even more impressive, WhatsApp dominates the market in Germany and Spain with 84% and 97% share, respectively.
The $19 billion purchase price is the number on which everyone is focusing. Granted, it is a shockingly high number. However, in light of the above, the reasoning behind the purchase might make sense. WhatsApp currently has 465 million monthly active users - a number higher than LinkedIn, Twitter or Pandora. Even more remarkable, WhatsApp is gaining one million new users every day. At that breakneck pace, it would increase monthly users by more than 80% in 2014 alone.
The valuation seems to make sense when looking at its monthly users compared with Twitter and LinkedIn. Facebook is paying less for WhatsApp than the current market cap of LinkedIn and Pandora, yet it has more monthly users than either of them.
Does that mean Facebook is a buy? Typically, we would prefer to see growth generated organically vs. growth generated by acquisitions. However, at this stage in Facebook's evolution, it may be just the right strategy.
The biggest concern that we have for Facebook is the slowing growth of new users in the more profitable U.S. and Canadian markets. The company will need to grow revenue by increasing its users or increasing advertisements. The increase in advertisements may, ironically, be part of the reason for the slowdown in new users, as well as the reason teens are finding other social-media sites to connect with friends.
Facebook has enough cash on hand to 'purchase' users and generate growth. It has recognized that organic growth is slowing and they need other means to grow revenue. The WhatsApp purchase allows Facebook to acquire a company that already has an impressive number of monthly users, and more importantly, a company that is growing their user base.
Remember that 'ridiculous' $1 billion purchase of Instagram by Facebook two years ago - a company with no revenue and almost no name recognition at the time? Today, Instagram and its 150 million active users may be valued well above $10 billion.
At this point, we are not going to become Zucker-bears.
Disclosure: Clients and employees of Mainstay Capital Management may hold the securities mentioned in this article in their investment portfolios. The securities mentioned may not be suitable for some investors, based on their tolerance for risk or their investment time horizon.
David Kudla is Founder, CEO, and Chief Investment Strategist of Mainstay Capital Management, a fee-only, independent, Registered Investment Advisor. More information about his firm can be found at http://ift.tt/1jLsmqV .
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