Bone-headed valuations marking the end of the cycle

The big headline is the deal Facebook made to acquire WhatsApp for an absurdly large piece of change – $4 billion cash and $12 billion in stock. There was also $3 billion in extra restricted stock that vests over four years, but really, $3 billion is a rounding error.

The owners of WhatsApp should be given a massively huge congratulations for extracting a huge pound of flesh and hopefully they will have the foresight to start hedging their stock so they’ll be able to live in luxury forever.

I highly suspect in five years or so that the guys at Snapchat and Instagram are going to be kicking themselves for not dumping their businesses at equally absurd valuations. They’ll probably end up being like Friendster when they are superseded by some other up-and-coming application service.

I am not a user of either technology, either Facebook or WhatsApp (or Snapchat and Instagram for that matter!). Today was the first time I ever heard of WhatsApp, and just looking at the Wikipedia summary, it looks like a well-used and functional version of BBM crossed with Skype.

This also explains why Blackberry is up today – if WhatsApp can fetch $16 billion, why can’t BBM?

Media is already panning the deal and I seriously have no idea whether this makes any sense for Facebook strategically – eventually they will want to fold the WhatsApp’s not insubstantial user base into Facebook in some seamless transition, but one can just ask Google how things went with Google+ and you’ll easily see it is a lot easier to do that on paper than it is in practice.

Financially, of course $16 billion is a huge price to pay. Even if you assume the stock component of the deal is worth zero, the $4 billion in cash is a huge investment. Putting that $16 billion in a 30-year treasury bond will reliably spin off $600 million a year in pre-tax income for 30 years and does anybody seriously think that WhatsApp will contribute that incremental income to Facebook’s bottom line?

This acquisition reminds me of what happened when Yahoo acquired (from Mark Cuban), or the mergers that occurred in the optical networking space in the last couple years of the dot-com boom where you had massive equity-for-equity transactions (in particular, JDS, Uniphase, and SDLI come to mind).

Acquisitions like these highly suggest the 20-times-sales valuation hype is going to end sooner than later. I don’t know when, but I’m staying far, far away from this territory and letting the insiders and lucky day trader-types make their killing to the detriment of those that will be holding the bag when the party ends.

Facebook IPO and social media

All of the financial journalism out there is directed toward Facebook’s IPO and the fact that the price dropped after offering. Here’s a cool chart after the $38 IPO:

There is no requirement for IPOs to rise in price after they go public. In fact, the huge price spikes seen in IPOs (especially during the internet stock era) simply represents a mispricing in the IPO price – in the usual case where a hot IPO spikes up on the first day of trading, the difference between the market price and the IPO price is cash that went into IPO purchasers’ wallets instead of the underlying company.

In Facebook’s case, however, the offering was for new equity and also selling stockholders – Facebook itself sold 180 million shares of stock (raising $6.76 billion net), and insiders sold 241 million shares (liquidating $9.07 billion net for themselves).

Notably, a week ago, the insiders were slated to sell 157 million shares. This was bloated up by another 84 million shares and raised a cool $3.157 billion net for those insiders. They had a vested interest in the IPO price being high and not low, so in classic form, Wall Street of course fleeced investors once again. I don’t sympathize whatsoever with the investors of the IPO simply because they were trying to make exactly the same dollar that the selling shareholders made off of them.

I’m not going to offer any critique on valuation, but an investor in Facebook shares is investing mostly for the ride and not for control – insiders control most of the Class B shares, which has 10 votes, while the offering is for Class A shares, which has 1 vote per share. Thus, CEO and founder Mark Zuckerberg will have 58% voting rights and 44% economic rights after the offering. This will shift over time as insiders cash out their Class B shares (they will convert into Class A and then be liquidated into the market).

The top of the tech IPO market in the last decade was the IPO of Palm, which went for nearly a hundred dollars per share when it went public in March 2000 before crashing to earth during the tech wreck. Is this broken IPO a sign of what’s about to happen in the social media space? Companies like LinkedIn (Nasdaq: LNKD) and Yelp (Nasdaq: YELP) and Groupon (Nasdaq: GRPN) come to mind. I will make a concession that Groupon is not exactly a “social media” company but I will lump them in that space.

Fundamentally, Facebook reminds me of what AOL or Compuserve was back in the 90’s. After acquiring Compuserve, AOL managed to sport a huge market capitalization before crumbling into obsolescence and I suspect that Facebook will follow the same trajectory. The question is whether there is still any growth left in Facebook, or whether the business at this point is strictly about monetization and nothing else – before it manages to get rid of all of its customers with relentless spamming and other useless features which will degrade the product.

Perhaps I am biased since I do not have a Facebook account.