Facebook Buyout Of WhatsApp Offers Asymmetrical Risk To Reward

| About: Facebook (FB)

Facebook (NASDAQ:FB) closed a deal to buyout WhatsApp, for $19 billion. To put this in perspective, T-Mobile US (NASDAQ:TMUS) trades at a $25 billion market capitalization. Facebook has high hopes for one of the fastest growing mobile apps on planet earth.

Many have criticized Facebook for its over-dependence on advertising revenue, and with Facebook buying out this messaging app, it further diversifies from being just a social network.

Value of communication

WhatsApp doesn't offer a whole lot of excitement based on present metrics. In fact, analysts on the conference call were wondering whether or not the buyout was based on fighting off competition, or if there was something about the business that merited the high valuation. Facebook's CFO, David Ebersman mentioned that WhatsApp's total addressable market was $100 billion. So the deal wasn't based on competition, but rather "future potential."

WhatsApp generates approximately $1 per year from each subscriber, with the first year free. Translate this into a billion users, and Facebook's purchase of WhatsApp was valued at 20x forward price-to-sales. Granted, there aren't a billion users right now. WhatsApp has 450 million monthly active users, 70% of users access the application each day, and it's the leader in its market.

Current figures on what WhatsApp generates in revenue aren't available. We'll get consolidated financial data once the deal is completed later in 2014. At the present moment, Facebook is awaiting regulatory approval. I'm assuming that once the deal is finalized, the impact from WhatsApp will be included in Facebook's financial statement. I'm pretty sure Facebook won't be able to add a whole lot to financial guidance as a result of buying out WhatsApp in the foreseeable future.

Why it's right to monetize later

Remember, when the first fax machine was released? Me neither, in fact, I wasn't even born. In the beginning stages, the fax machine didn't offer a whole lot of utility, and it was an expensive device. But as more and more consumers adopted the fax machine, the value of the device grew exponentially as the device could communicate with a bigger network of other devices. Finally, the cost of buying a fax machine declined as unit volumes were able to lower the marginal cost of production. Soon, fax machines were cheap and abundant. The companies selling the fax machine did okay, however, service providers like AT&T (NYSE:T) earned additional profit from selling two service lines rather than just the single one.

At the present moment, WhatsApp is priced the way it is, because the network isn't as valuable until it scales. But once it scales, WhatsApp will be able to price itself substantially higher without losing subscribers. Telecom services are considered inelastic, because consumers are less sensitive to pricing. According to an academic paper, the price elasticity of demand for telecoms varies from 0.36 to 0.51. From the context of a shareholder, lower is better.

At least according to the metric, for every percentage increase in pricing, the demand would decline by 36 basis percentage points to 51 basis percentage points. In English, this means that if I increase the price by 100%, the demand would decline by 36%. The end result is better monetization. Selling less and earning more comes with the benefit of lower variable costs, and if fixed costs aren't too high, sometimes it makes sense to sell substantially less.

At the present moment, WhatsApp offers the most superior messenger experience, and comes in handy when people want to collaborate together on projects. The application works with every web capable device, so it's a better communication service than SMS. With WhatsApp priced at a dollar per year, I'm fairly certain that WhatsApp will be able to increase prices without impacting demand as much.

Financial projection

WhatsApp generates extraordinary growth.

Source: Facebook

WhatsApp has a four year compound growth factor of 1,330%. This is certainly impressive growth, and there's no inflection point expected in the immediate future. High user growth with moderate increases in pricing could translate into serious revenue on an annualized basis. Also, WhatsApp has 50 employees so overhead costs, will remain low so as long as we exclude the impact from restricted shares, and stock options.

That being the case, what's WhatsApps growth potential? I offer a very different stance on the topic than other analysts. At least according to Pivotal Research, analyst Brian Wieser:

On our own (crude) estimates, if we assumed the product had an average of 1bn users next year and added 100mm per year, with 25% of the user base at that time paying $2/year (we would assume many users will simply never pay, shifting devices and/or services as needed, while those who will pay might be willing to pay more than the current $1/year level), we could arrive at $650mm in revenue. $1bn is possible, but given the optimism already incorporated in a $650mm figure, it might seem a stretch.

I think this figure is way too low for total user growth. And while Brian Wieser makes solid points, I think the average revenue per user figure at $2 is far too low. To put this in context, telecom companies charge $80 per month or $960 per year for mobile plans. Communication services can generate more profit from price increases than many of the other sectors or subsectors in the global economy.

Based on current growth rates, it's likely that WhatsApp will be able to saturate a very high percentage of the global addressable market for phones. By 2020, Microsoft (NASDAQ:MSFT) estimates that the number of people who are connected to the internet will increase to approximately 4 billion. I assume that WhatsApp will reach global saturation; therefore I expect monthly average users to grow from 450 million to 4 billion from 2014 to 2020. This translated into a 43.93% annual growth rate for users. This sounds like a very attainable figure for WhatsApp, as it has been able to grow at a compound rate that was higher than a thousand percent in the past four years.

Finally, demand elasticity isn't exactly known for a service that's priced at a $1 per year belonging under the telecom services category. But when compared to broader elasticity figures, maximizing profit becomes easier as the network scales. The assumed benefit from the service is much higher when compared to other consumer non-durables. Therefore, it's likely that the average revenue per user figure should be able to scale to something significantly higher than $2 per year. I think that the average revenue per user figure could grow to $12 per year, and pricing could reach $1 per month without having a negative impact on user retention. This is still substantially cheaper than a Netflix (NASDAQ:NFLX) subscription, and even cheaper than a SMS subscription on a per month basis.

So if annual pricing were to grow from $1 to $12 between 2014 and 2020, the pricing will increase by approximately 51.31% per year. I'm going to combine the impact of rising user figures paired with incremental price increases to come up with a projected sales figure for the service.

Granted, not everyone may want a communication service like WhatsApp. Assuming 70% of users stay based on daily average usage data, WhatsApp may need to factor in an annual churn rate of 30%. A 30% churn rate can be offset with higher pricing.

I expect high user retention despite gradual increases in pricing. Netflix (NFLX) sustains high growth rates with a freemium business model, and they charge substantially more than WhatsApp at the end of the free trial.

Assuming WhatsApp sustain user growth and incrementally increases pricing, I'm willing to estimate that WhatsApp will be able to generate $48 billion in annual revenue, which translates into $14.4 billion in annual net income assuming a 30% net profit margin. Assuming a 20% net profit margin, I expect annual net income of $9.6 billion.

To put this in comparison Google (NASDAQ:GOOG) has a net profit margin of 20.42%, Yahoo (NASDAQ:YHOO) has a 15% net profit margin, Facebook has a 19% net profit margin, and eBay (NASDAQ:EBAY) has a 17.8% net profit margin. So my 30% net profit margin figure is generous. However, I expect web infrastructure costs to fall as a result of third-party providers like Amazon (NASDAQ:AMZN). I also expect labor costs to remain low, as the company is able to scale its operation with 55 employees currently. Assuming those two factors remain constant, profit margin should be significantly higher than peers in the space.


I expect significant accretion of value for Facebook in the foreseeable future following the buyout of WhatsApp. I think internet services haven't reached their saturation point, and won't reach that saturation point for quite a while. Also, based on current growth rates, I believe I have given WhatsApp a fairly reasonable growth trajectory.

Assuming something similar to my projections occur, WhatsApp will add significantly more value to the market cap of Facebook than the $19 billion it cost Facebook to buy out the company. In this specific instance, I believe the risk to reward asymmetrically favors Facebook shareholders.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.