Facebook Paid Too Much For Instagram

| About: Facebook (FB)

On April 9, 2012, Facebook (NASDAQ:FB) announced that it was set to close a then $1 billion cash and stock deal to acquire photograph-sharing company Instagram. Instagram had just secured another round of financing out of a consortium of investors led by Sequoia Capital that valued the application at $500 million one week prior to the Facebook acquisition. At that time, Instagram was a 13-employee operation that counted 30 million active users upon its rolls. According to Web 2.0 metrics, Instagram was rife with potential, although the company had yet to close one sale. Facebook bull Bruce Upbin of Forbes then played up the Instagram acquisition as a "defensive move" and "smart arbitrage." In retrospect, however, Upbin may need to reconsider his own personal definition of the word arbitrage.

Today, the Instagram photo-sharing application has expanded to claim 150 million active users amongst its ranks. Still, this Instagram addition to the Facebook social network has yet to generate one penny in revenue. As such, Facebook executives may be acknowledging the idea that Instagram cannot be monetized against a plethora of social media photo sharing and messaging applications that include Tumblr, Pinterest, and Snapchat. Fundamentally, the Facebook buyout of Instagram was yet another manic signal of a Web 2.0 bubble and refutation of modern portfolio theory. Going forward, wide-eyed speculators who own Facebook stock may be at risk of enduring severe losses amid a market correction.

The Web 2.0 - Social Media Bubble

The Federal Reserve Board first established a zero percent federal funds rate target during the fourth calendar quarter of 2008. The Fed was to follow up this monetary easing with newfangled stimulus packages and terminology including the Troubled Asset Relief Program (TARP), Maturity Extension Program (Operation Twist), and Tapering. On December 18, 2013, Ben Bernanke and the Federal Reserve Board first announced that it would taper, or trim, its bond buying program by $10 billion to $75 billion in purchases. In a series of prepared remarks, Bernanke worked to differentiate between tapering and monetary tightening. Going forward, the Federal Reserve may curtail the bond-buying program, but officials have already signaled their intent to keep fed funds at zero, even if the unemployment rate were to drop beneath 6.5%. Speculative capital, however, has emerged to trigger yet another round of irrational exuberance. The Road to Hell is often paved with good intentions.

Web 2.0, in a grand touch of irony, has been cited as a prime beneficiary for speculative capital. Web 2.0 may be used as a catchall term to define the second installment of the Internet movement. Former high flyers Geo Cities, Lycos, Pets.com, and Webvan were to all crash and burn amid the 2000-2002 dot-com bust. In retrospect, the financial wreckage was largely the result of several billion dollars being thrown at websites that lacked sustained revenue growth and any semblance of real earnings power. Today's Web 2.0 has added a social element to the basic website set-up. As such, the Web 2.0 business model functions as a literal broker-dealer that matches an established user base against a lineup of advertisers pitching their own goods and services. Facebook, for better or for worse, has established itself as the Web 2.0 Social Media King, for now. Facebook stock closed out the December 30, 2013 trading session at $53.71 per share, which did calculate out to roughly $135 billion in market capitalization. Facebook claimed 1.19 billion monthly active users (MAUs), as of September 30, 2013.

Original terms of the merger called for Facebook to put up $300 million in cash alongside 22,999,412 shares of stock to buy out Instagram, which did value Instagram at $1 billion, on April 9, 2012. The Instagram acquisition, however, actually closed on September 6, 2012, after Facebook stock had fallen from its May IPO price at $38.00 down to $18.96. Facebook stock, again, has nearly tripled to $53.71 per share, within the fifteen short months following the Instagram takeover.

Still, Facebook bulls are mistaking cause for effect, in terms of grading the success of the Instagram deal. Facebook - Instagram is far from an Exxon Mobil (NYSE:XOM) consolidation of two titans and hundreds of billions of dollars in long-term shareholder wealth creation. If anything, Facebook is taking a page out of the Yahoo (NASDAQ:YHOO) playbook, where it exploits an irrational stock market bubble simply to overpay for competitive threats that may be ultimately shut down. Facebook lacks what Warren Buffett would refer to as a moat. If anything, only one literal thin piece of 100-meter dash finishing tape shields the Facebook business model away from competitive threats sprinting at a furious pace. The demise of MySpace, of course, may serve as a case study in boom and bust social media economics. Social media empires never recover after users migrate over to the latest flash in the pan. It may therefore be inevitable for the Facebook bubble to burst.

Instagram Integration and The Competition

To date, Facebook has largely kept its word and refused to meddle with Instagram operations. A virtual firewall still seems to separate the two companies, more than one year after the merger. The Instagram website lacks advertisements and makes no mention of Facebook. Meanwhile, the Facebook interface features one inconspicuous link within the personal photograph albums that automatically posts Instagram images to linked Facebook user accounts. Instagram has appeared free to tinker with applications that add professional touches to pictures taken with cheap smartphones and digital cameras. The exponential growth of the Instagram user base may confirm that amateurs prefer the photo-sharing company to be left alone. Wall Street merger and acquisition specialists, however, may be left scratching their heads. At this rate, Facebook and Instagram may have simply partnered up and exchanged links, instead of Mark Zuckerberg and Co. opening up the checkbook for an original pledge of $1 billion.

Said Zuckerberg, at the time of the Instagram deal, "We don't plan on doing many more [acquisitions], if any at all." On November 13, 2013, Zuckerberg backtracked upon his guidance and sent Silicon Valley into a tizzy with a $3 billion offer out of Facebook for Snapchat. Shortly thereafter, Google (NASDAQ:GOOG) was to escalate the bidding war with a $4 billion bid of its very own for Snapchat. Shockingly, Evan Spiegel, 23-year old Snapchat Founder and CEO promptly rejected both offers out of Facebook and Google at the negotiating table. Snapchat was a 30-person shop that had yet to close one sale, as recently as last month. Still, Business Insider speculated that users had averaged 400 million daily snaps, or video and picture messages, via Snapchat through the month of November. For the sake of comparison, Business Insider also claimed that Facebook and Instagram were averaging 350 million and 55 million daily uploads of photographs, respectively, during the same time frame.

The Snapchat photo sharing application is most notable for automatically deleting images off company servers and recipient devices within 10 seconds of transmission. As such, the Snapchat application has come to be somewhat associated with an underground Internet subculture of "selfies" and sexting, where individuals share provocative pictures of themselves with other users. The rapid emergence of Snapchat to the fore has uncovered the Web 2.0 poison pill, where users rightfully associate all-inclusive websites with a lack of privacy. Twitter, Facebook, and Instagram photographs and rants in poor taste may be used as documented evidence in support of termination, academic suspension, and imprisonment.

On October 10, 2013, Minneapolis investment bank Piper Jaffray released its 26th semi-annual "Taking Stock with Teens" report. As part of this report, Piper Jaffray had teenagers identify their most important social media websites. For Fall 2012, a respective 42% and 12% of teenagers listed Facebook and Instagram as premier destinations. One year later, Facebook and Instagram were both separately identified by 23% of respondents as the most important social media website. The "Other" category response was to expand from 2% to 17% of participants through this same one-year time frame. "Other," of course, likely included message applications Vine and Snapchat that compete directly against Facebook and Instagram. The data squared with a recent warning out of Facebook that teenagers were migrating away from this platform. Daniel Miller, Professor of Material Culture at University College London, has already dismissed Facebook as "dead and buried" and "embarrassing." Miller was part of a team that recently surveyed the social media trends of 16-18 year olds living in the United Kingdom.

The Bottom Line

Be advised that Facebook fiscal years coincide with calendar time. Facebook, again, closed out its December 30, 2013 trading session at $53.71, which did also calculate out to $135 billion worth of market capitalization. Facebook has banked a mere $977 million in net income off $5.3 billion in revenue through the first three quarters of 2013. Facebook may close out the 2013 year with $1.5 billion in net income, at best. The Instagram purchase, again, has yet to generate any revenue, let alone profits for Facebook. Any attempt to monetize Instagram may actually self-destruct and drive traffic into the hands of the competition. To date, the Instagram allure has largely arrived due to a clean interface that serves as an ideal backdrop for vintage still shots.

Facebook, as a whole, now trades for 90 times current estimated earnings. Legendary investor Peter Lynch once performed back-of-the-envelope calculations to argue that a stock was fairly valued, if it featured a price to earnings to growth ratio of one or less. According to Lynch's metric, Facebook investors may be expecting the social media company to double annual earnings well into the near future. Facebook has been priced to perfection, and any misstep will trigger extreme volatility in shares at the trading desk.

Facebook, however, has been unable to double annual revenue, let alone profitability, through its short existence as a publicly traded corporation. Facebook research and development and marketing and sales costs have remained relatively flat between 2012 and 2013, while the cost of sales increased by more than 40%. For the sake of comparison, Facebook did bank 50.9% in year-over-year revenue growth to post $5.3 billion in sales through the first three quarters of 2013. Still, Facebook, like many of the dot-coms before it, seems to lack a clear path towards efficiently monetizing its user base. As such, Facebook shares are now trading off hope and may be primed for a major correction into reality. Conservative investors should avoid Facebook stock.

Disclosure: I am long XOM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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