The Billion Tech Bubble

Edited by Vani Rao

A closer look at acquisitions and whether a bubble is building in the tech space

As the news of the “bold” move from Facebook (NASDAQ:FB) rumbles on, we have tried to make sense of the staggering amount that Facebook paid for WhatsApp. We have used both the conservative fundamental approach as well as the stock market view to decipher the acquisition cost.

Profit

Fundamental View

To justify a $19-billion value for a company in equity market today, WhatsApp would need to generate about $1.5 billion in after-tax income.

Deal Price = $19 billion

Return on Equity = 8.75% (taking in consideration a 5% equity risk premium on top of a 3.75% risk free rate as of January 2014).

Revenue stream to justify the deal price = $19 billion *.0875 = $1.66 billion

Using an effective tax rate of 30%, pre-tax revenue stream to be = $1.66 billion/(1-.30) = $2.25 billion.

That would translate into pre-tax income of about $2.2 billion, which is a fairly conservative estimate for a breakeven analysis. These numbers will increase with the passage of time considering the time value of money.

The following assumptions are being made if WhatsApp has to be profitable:

  • If WhatsApp continues using its current business model, where it gives the app for free for a year and then charge users 99 cents after that, then it would have zero operating costs (unrealistic). However, it would require around 2.5 billion people using the app.
  • To increase the charges per year, WhatsApp would have to increase the charges to about $5/year per user for the existing user base of 450 million, assuming the customers would still be loyal to the company.
  • To introduce advertising on the platform, which would be again tricky and against the company’s philosophy.

The fact that a significant portion of WhatsApp’s customers are teenagers makes it an undependable business proposition. If we look at the takeover from the fundamental point of view, the acquisition looks doomed. Let’s look at it from the trader or stock market perspective.

Stock Market View

Looking at the market prices of social media companies, we measure it in terms of its success and activity. The social media companies follow different business models and have different core businesses; the pricing however reflects the market assumption about the companies.

The key variable in explaining differences in value across companies is the number of users. This is reinforced by market reactions to earnings announcements. For instance, Twitter (NYSE:TWTR) saw its price drop 25% last week, primarily on the news that the user base grew lesser than expected while the price of Zillow Inc. (NASDAQ:Z) climbed 12% on the news that it added more users than expected.

There are few factors that the markets currently believe as important in terms of the valuation of the tech companies.

  • User engagement: Social media companies where the users stay longer are worth more than companies where users don’t spend as much time. The markets view this as a primary measure of their growth. For example, Twitter stock tumbled after it reported “timeline views per average user” and the “revenues per 1,000 timeline views” were lower than estimated.
  • Steady revenue stream are priced higher: Majority of the social media companies derive revenues entirely from advertising, some from a mix of advertising and subscriptions and some from just subscriptions. For example, Netflix’s (NASDAQ:NFLX) revenue of $577 per user suggests that the market values predictable subscription revenues more than uncertain advertising or retail revenue.
  • Making money is secondary: Though there is a correlation between the companies’ revenues and its value, and the profit it makes on it, this is however, less valued than the number of users.

Facebook is currently valued at $170 billion, at about $130/user, given its existing user base of 1.25 billion. If the WhatsApp acquisition increases Facebook’s user base by 160 million (conservative estimate of 35% conversion as there is bound to be an overlap) and the market continues to price each user at $130, Facebook’s market value will increase by $20.8 billion, more than the deal price. There are lots of caveats in it, but it becomes another way to put things into perspective.

The deal is fraught with risks; it is likely that the market might be overestimating the value of users in social media companies. Facebook though has a hedge against this problem by paying for the bulk of the deal with its own shares. Thus, in two years’ time if there are massive corrections in the lofty valuations, Facebook would have surely overpaid for WhatsApp. However, the shares that it used for the overpayment will also overpriced.

The way that the markets price social media companies will inevitably change with the passage of time from number of users/user intensity to revenues, earnings, and cash flow.

This will result in the correction in the perceived value of companies in the Technology sector with those that were most successful in turning users into revenues/earnings being priced higher. The problem for the companies and investors is that these transitions can happen unpredictably, resulting in a change of focus from one variable to another without giving them time.

The Growing Tech Bubble

Facebook’s $19-billion takeover of WhatsApp is going to be the fourth-biggest technology acquisition so far. Moreover, a staggering $43.2 billion worth of M&A transactions have been entered into in the first month-and-a-half of 2014, the highest in the last 14 years.

Merger and Acquisitions in 2014
Source Bloomberg / WSA

The exaggerated valuations of technology companies have turned dozens of founders into millionaires overnight. However, it has also raised concerns that the crash of 2000 will be repeated. In this regard, the WhatsApp deal is the latest example of the sector getting overheated.

A host of companies are looking to ride on the growing demand for technology stocks. Twitter (NYSE:TWTR) went ahead with its IPO in November 2013, with the social network currently being valued at $30billion despite reporting losses in the last quarter. British games producer, King who has developed the hugely successful game Candy Crush Saga, has filed for a New York listing, and not long ago Snapchat, the photo-sharing app, is believed to have rejected billion dollar bids from Google and Facebook.

The NASDAQ the tech-heavy index rose more than 25% in 2013 and is currently trading at highest level since the dotcom bubble crashed.

There is a fear of what happened in 2000, wherein within a span of few months, hundreds of internet companies went bankrupt or saw their values plummet as the dot com bubble burst.

However, although technology values are rising rapidly, the $42-billion worth of deals so far this year is still some way off the $79.6-billion at the same point in 2000. Hence, rising valuations may just be a reflection of the increased size of the industry.

The price that Facebook is paying for a company that charges users less than a dollar a year is just the latest indication that the bubble is inflating again.

There is a saying that history repeats itself, watch this space for more action…

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