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There is an old saying in business - "If you can't beat them, buy them".

Of course, as an analyst covering $173 bn (now 173 +19 bn) company one need to ask why Facebook (NASDAQ:FB) wasn't able to compete with this startup and had to pay such a huge valuation to acquire it. Is it a one-time thing or does it indicates the secular changes posed by changing landscape of social media usage.

Background

Back in January, I wrote an article about the imminent existential risk Facebook is facing from messaging apps; and how management, despite of its desperate attempts to fight that risk (e.g. taking mobile numbers without permission), is not disclosing this to investors. Analyst community finally woke up and Goldman's Heather Bellini asked Zuckerberg about the competitive threats from messaging apps on the company's last earnings call. While Zuckerberg did answer that question on the call and ended up praising Facebook messenger traction; his real assessment of the risk from messaging apps became public only after Facebook acquired WhatsApp for a whopping $19 billion yesterday.

Near term existential threat removed, but secular threat remain

Facebook's acquisition of WhatsApp is a good move from the business perspective. The WhatsApp user base is likely to grow to a comparable size as Facebook's mobile user base by the end of this year. Without this acquisition, "uncool" Facebook would have been in a very difficult competitive position against its cooler messaging apps rivals. With mobile users increasingly shifting their social communications to messaging apps from Facebook, it would have posed an existential threat for Facebook. By acquiring the leader in messaging apps, Facebook has removed this threat.

However, the bigger concern remain around the decline in value proposition of Facebook as an integrated utility and the fact that Facebook is now just another app on the smartphone instead of the center of the social media universe on PC. Smartphone has decimated Facebook's competitive advantage of a strong network. Your network of friend is already there on a smartphone. Once you install an app, your mobile number becomes your unique id and you can see which of your friends are using that app. This is a secular threat for Facebook as new competitors won't find it difficult to reach the critical mass if their products offer compelling value. And if we see the latest trend, users are preferring individual apps for specific usage - Wechat, WhatsApp, LINE Messenger, Facebook Messenger for messaging/sharing with close friends; Instagram, SnapChat for photo sharing; Twitter (NYSE:TWTR) for sharing outside their network; LinkedIn (NYSE:LNKD) for professional networking.

The New Dilemma

So, Facebook has acquired WhatsApp - does that mean its near term concerns are over? The answer is no. Facebook now has three mobile offerings which are at high risk of cannibalizing each other - WhatsApp messaging app, Facebook Messenger app, Facebook's core app. While Zuckerberg has maintained that he intends to keep Facebook messenger, it is unlikely as WhatsApp and messenger serve almost the same purpose. One has to go in favor of other. Since WhatsApp is the leader, it is likely to stay.

The biggest threat WhatsApp posed to Facebook was user migrating away from its core app. This still remains. Some may say that now users will be migrating to an app which is under Facebook's umbrella. However, the problem with this argument is that the monetization of WhatsApp is nowhere close to Facebook's core app. WhatsApp charges just $0.99 per annum to its users. Facebook earns more than that in ARPU from its mobile advertising in a quarter.

As users continue to migrate to WhatsApp, Facebook's ARPU will come under pressure and so will the sell side estimates. Now, you might ask can't the company just treat WhatsApp as a stepchild to favor its core app. Facebook won't have that liberty as there are other players in the messaging arena like Wechat [controlled by Tencent (OTCPK:TCEHY)], LINE messenger etc. which will benefit and still pose threat to Facebook's core app.

Bottomline

There are two things type of acquisitions - one done to grow your business and other to hide weakness of your core product. This acquisition belongs to the latter category. The secular threat Facebook faces with the rise in smartphone usage is secular in nature. While Facebook is using its financial power to avoid these threats by buying apps like Instagram and WhatsApp; it is not a sustainable strategy as the competition will only increase from the current levels in the future.

Facebook's investors are suffering from "fool poisoning". Once, they recover and understand risk in the company's business model, Facebook's stock will go much lower meaning it will lose muscle power to make more such billion dollars plus acquisition. This will lead to a vicious downward cycle with competition increasing and the company's low valuation making it increasingly difficult to tackle it through acquisition strategy. Hence, I recommend avoiding the stock.

Source: Facebook's WhatsApp Acquisition Exposes Grave Risks To The Business Model