I wasn't totally impressed with Facebook (NASDAQ:FB) stock after the latest earnings report. User growth was slowing at a rate I thought was a bit alarming, and the valuation was a concern. At that time, given the current business, I thought Facebook could be grouped in the "short ideas" category. Well, Facebook's recent deal has put a bit more faith in my thoughts of Facebook, the company. I do think the WhatsApp purchase was a great long-term idea, even if the price seems ridiculous at first glance. I am changing my tune on Facebook a bit today, but I wouldn't go long until the next pullback. Today, I'll provide my thoughts on the WhatsApp deal, and explain who the many other winners are.
The Facebook deal:
By now, you probably already know that Facebook announced plans to acquire WhatsApp. These are the details of WhatsApp, taken directly from the press release:
- Over 450 million people using the service each month;
- 70% of those people active on a given day;
- Messaging volume approaching the entire global telecom SMS volume; and
- Continued strong growth, currently adding more than 1 million new registered users per day.
There has been a flurry of analyst activity since the deal was announced, and the general consensus is that the purchase was good for Facebook. Here are just a couple of brief analyst comments on why this deal makes sense:
Raymond James' analyst Aaron Kessler notes the strategic importance of adding a global leader in mobile messaging.
SunTrust believes this deal helps Facebook move closer to its goal of connecting the world.
Analyzing the financials of the deal:
The one potential negative that many analysts and observers have pointed out is the deal's price. Facebook could be paying more than $20 billion to acquire WhatsApp, as evident by the following details from the above linked press release:
Upon closing of the deal, all outstanding shares of WhatsApp capital stock and options to purchase WhatsApp capital stock will be cancelled in exchange for $4 billion in cash and 183,865,778 shares of Facebook Class A common stock (worth $12 billion based on the average closing price of the six trading days preceding February 18, 2014 of $65.2650 per share). In addition, upon closing, Facebook will grant 45,966,444 restricted stock units to WhatsApp employees (worth $3 billion based on the average closing price of the six trading days preceding February 18, 2014 of $65.2650 per share). As of February 17, 2014, Facebook had 2,551,654,996 Class A and B shares outstanding plus approximately 139 million dilutive securities primarily consisting of unvested RSUs. The Class A common stock and RSUs issued to WhatsApp shareholders and employees upon closing will represent 7.9% of Facebook shares based on current shares and RSUs outstanding.
In the event of termination of the Merger Agreement under certain circumstances principally related to a failure to obtain required regulatory approvals, the Merger Agreement provides for Facebook to pay WhatsApp a fee of $1 billion in cash and to issue to WhatsApp a number of shares of Facebook's Class A common stock equal to $1 billion based on the average closing price of the ten trading days preceding such termination date.
If the deal doesn't go through, a $2 billion break-up fee is required. If the deal is completed, Facebook said it would be paying about $19 billion, and that was based on a lower share price. With Facebook shares continuing higher, the true cost of the deal could be higher.
So how does this deal affect the balance sheet and the stock? First, the cash component is $4 billion. Facebook, as per the Q4 earnings release, ended 2013 with $11.45 billion in cash and short-term investments. At the end of 2012, Facebook had $9.63 billion in cash and short-term investments, against $1.5 billion in debt. The debt has been eliminated, and the cash position's rise was partially due to the company's stock offering in late 2013. The $4 billion cash part of this deal will take a chunk of the company's cash position, but the company will still have plenty of financial flexibility to work with.
The larger part of the deal was the stock-based part. Facebook said it will dilute shareholders by about 8%. When companies believe their stock is overvalued, it usually is a good chance for them to sell shares and raise cash. Facebook is essentially doing that here in a different form. The company is selling shares to acquire another business. Initially, many took that as a sign Facebook was saying its shares were overvalued. Facebook shares dipped about 6% initially when the deal was announced, but shares have rocketed higher to new highs since. The stock part of this deal will dilute shareholders and pressure earnings per share (for a given level of net income) a little going forward.
A deal price that could exceed $20 billion seemed excessive to many. WhatsApp doesn't have a ton of revenues right now, and it is unclear how that picture will change going forward. An RBC analyst did some quick math on the numbers, but right now it's all guesswork. Facebook made this deal to strengthen its business model and core strategy. This wasn't a deal necessarily made to immediately increase revenues or earnings. From that aspect, it's hard to say whether or not Facebook overpaid.
Who are the winners?
Outside of those invested in WhatsApp, and Facebook shareholders that have seen Facebook rise since the deal was announced, there's a couple of other winners in this deal.
The first winner, I believe, is Twitter (NYSE:TWTR). Twitter does not have the subscriber base of WhatsApp, but Twitter has a much more significant revenue base at the moment. As I discussed in a recent article, Twitter could exceed $2 billion in revenues next year. If WhatsApp can get $19 billion with limited revenues, Twitter's valuation argument at $30 billion could be backed up. Additionally, with Facebook shares continuing to rise and gain a higher valuation, it cements Twitter's valuation a bit more. Remember, Twitter is a few years behind Facebook in terms of the growth story. For the next couple of years, Twitter will have a much higher revenue growth rate than Facebook, which could justify a higher valuation for Twitter.
The second winner discussed heavily in this deal is BlackBerry (NASDAQ:BBRY). There are many out there who believe BlackBerry's BBM messaging service could be worth more based on the WhatsApp deal. A Wells Fargo analyst recently commented on this argument. While most seem to believe that the BBM valuation could be more than originally thought, the analyst cautions that this thinking assumes BlackBerry sells the unit. Until the company looks to monetize the unit, it's hard to increase the valuation, says the analyst, especially since the unit is losing money and will require further investment.
The third major winner, in my opinion, is Google (NASDAQ:GOOG). It was reported by Fortune that Google offered to acquire WhatsApp for $10 billion. Google is a winner here for two reasons. First, were Google to announce a similar deal of roughly $20 billion, it could have been twice what the company was willing to pay (assuming the Forbes report is correct). Given the reaction to Google's $12 billion or so purchase of Motorola Mobility, I don't think Google had enough investor goodwill for a $20 billion purchase. Especially given how WhatsApp's business fits more for Facebook, I think Google not overpaying is a win. Google's deal would probably have been more of a cash offer than Facebook's deal, given Google ended 2013 with nearly $60 billion in cash and investments on the balance sheet. A cash deal probably would have faced more scrutiny than a stock-based one. The second potential win is because Forbes stated Google was not offering a board seat like Facebook did.
The final winner in this deal is Apple (NASDAQ:AAPL), in my opinion. This one goes along similar lines with Google in terms of overpaying for WhatsApp. Apple doesn't make acquisitions in the tens of billions of dollars. Had Apple been the one making this acquisition, I think many would have believed it was an overreaction to concerns about Apple's growth. Given the limited revenue potential of WhatsApp currently, I don't see how many would have liked the deal for Apple. Additionally, because Apple is in the midst of a huge buyback plan, a mostly stock-based acquisition would not have seemed very logical. Apple probably would have had to use all cash, either depleting its domestic cash position more or facing repatriation if foreign funds were used. Perhaps Apple would have also taken out more debt. Instead, Apple used $14 billion to buy back stock recently, which got it enough critics. At least with the buyback, Apple has reduced its share count a bit more and boosted earnings per share right away. I don't think the reaction to Apple paying $20 billion-plus potentially for WhatsApp would have been pretty. Right now, Apple not doing something that might have put it in the "loser" category is a win.
An update on estimates and valuations:
Thanks to Facebook's large Q4 beat on both a revenue and earnings front, you probably have guessed that analysts have been busy to raise estimates. Going into Facebook's Q4 report, analysts were expecting about $10.41 billion in 2014 revenues and $1.13 earnings per share. Those numbers stand at $11.28 billion and $1.25, respectively, at the moment. The 2015 revenue average has soared from $13.52 billion to $14.81 billion, and the 2015 EPS average is up from $1.48 to $1.68.
Facebook is an expensive stock, any way you slice it, although not as expensive as Twitter. In the following table, I've compared Facebook against Twitter as well as industry giants Google and Apple. Except for Apple, all EPS and P/E numbers below are non-GAAP. You can see all of Facebook's estimates in the link above.
*Numbers are for Apple's fiscal year, which ends in September.
**Twitter lost money on a non-GAAP basis in 2013, so there is no true growth rate for 2014.
Facebook has a ton of growth potential, but that comes at a cost. Investors need to determine whether this stock is worth the price of admission. In my last article, I was a little worried about Facebook's excessive valuation because I was slightly concerned about the business. I think the WhatsApp deal does help with those concerns. Facebook's valuation should come down over time as revenues and earnings improve, assuming the stock doesn't rise at an equal rate. With Facebook approaching a $200 billion market cap, I don't think you'll see a continued rally at the recent pace, which can help get the valuation down a bit.
While the price may look staggering at the moment, Facebook made a move to protect and grow the business. Opinions may be mixed, but most analysts seem to agree that the deal is a long-term positive for the business. Additionally, other names like Apple and Google are winners, because they did not overpay. Smaller names like Twitter and BlackBerry could benefit as their valuations are reinforced or maybe increased. This could be a long-term positive for Facebook, even with the added dilution and brief cash hit. I've changed my mind on Facebook, and investors might want to consider this stock at the next pullback, like the one that took this name down after the deal was announced. Those investors were certainly rewarded.