Facebook Investors, Contact Mark Cuban's Options Advisor Before Inking a Deal

Sep.22.06 | About: Yahoo! Inc. (YHOO)

The Wall Street Journal reported Thursday that Facebook, the social networking online service used by millions of US college students, may be engaged in advanced acquisitions talks with Yahoo (NASDAQ:YHOO) for $1 billion. It remains unclear whether Yahoo will use cash, stock, or a combination to make the purchase, but with the recent decline in its share price because of slower growth in automotive and financial advertising, the terms of a potential deal should be interesting.

Facebook supposedly generates $100 million in revenue, and by applying an (optimistic) operating margin of 35%, the firm may thus book $35 million prior to taxes. So, right now, YHOO will make 3.5% on their $1B investment and will need to bolster Facebook ad sales substantially in order to prevent diluting both their return on capital invested and equity. I will post another article concerning YHOO's deteriorated cash flow, but the company has an extremely poor record in generating meaningful revenue growth from their acquisitions.

I also disagree with some Wall Street analysis stating that $1B would be a fair price based upon Facebook's assumed earnings prior to taxes, interest, and depreciation/amortization. I believe that EBITDA remains a poor measure of YHOO's stock value and of a firm's real free cash flow because investors should include the significant capital used for acquisitions and other expenditures in their calculations. In then determining the firm's return on invested capital, one receives a very different view of YHOO's worth.

All said, the purchase may be an aggressive attempt to augment YHOO's registered user base to prevent continued audience erosion because of competition from Google (NASDAQ:GOOG) for search. However, additional advertising on Facebook's site may be unwelcome by current users. Copyright violations aside, YouTube, another popular and relatively young online service, has likely experienced similar concerns over the placement of ads on user generated content to cover its rising bandwidth costs and has delayed ad usage for now.

As this story circulates widely through the financial press, you may see comparisons of the possible deal with YHOO's terrible purchase of Mark Cuban's and Todd Wagner's Broadcast.com for over $5 billion. YHOO used stock to complete that transaction, which minimized any impact on its debt and cash levels, but hardly a trace of Broadcast.com remains in YHOO's business.

The acquisition also made Mark Cuban a billionaire, and his judicious use of options (I believe it was puts on S&P index futures, which gave him the right to sell the S&P index prior to its 2001 fall) adequately hedged his gains without suffering from YHOO's stock decline. So, several Silicon Valley VC's and Facebook founder Mark Zuckerberg may want to contact their local derivatives trader or just ask for cash.

Although current Facebook members may continue to use the site following their college years, I think that many will just email or call each other instead and choose to more closely guard their privacy rather than posting so much detail online. Ultimately, I do not believe that the level of Facebook usage into adulthood and the assumption that students define their product loyalty at such a young age substantiates significantly higher ad rates/revenue and the purchase price.