Oculus Rift could become Mark Zuckerberg's worst acquisition.
33 million units of Oculus Rift have to be sold in order to reach $2 billion in retained earnings.
While Facebook may succeed, the chances of this occurring aren't as high as it was with other acquisitions.
If the acquisition turns into a loser, Facebook can absorb a $2 billion loss due to the success of its core portfolio of businesses.
Facebook's (NASDAQ:FB) buyout of Oculus Rift could perhaps be the worst deal orchestration we've seen from Facebook in quite a while. It's not exactly understood as to how Facebook actually plans to earn any money from this business, as the company knows very little about building compelling hardware. However, I think investors will have to become accustomed to out-of-the-blue acquisitions that cannot be easily quantified.
How many Oculus Rifts need to be sold in order to earn profit?
$300 is the targeted price point for the Oculus Rift, which is reasonable when compared to the tear down costs of other electronic devices, such as smartphones and console gaming systems. However, at this price point, it's unclear as to whether or not Facebook will recoup its costs in any reasonable timeframe.
So assuming the average selling price of $300 is accurate, for Facebook to recoup the cost of its acquisition at $2 billion, the company would need to generate $10 billion in revenue assuming a 20% net profit margin. Therefore, Facebook's break-even point is 33,333,333 units. If Facebook's profit margin is 10%, the company would have to sell twice the number of units in order to break even.
At the present moment, the Oculus Rift is sold for $350 to software developers. By the time Oculus Rift is released to consumers, I can imagine a lower ASP in the $300 range.
How could Facebook sell 33 million units?
That's a pretty interesting question, and perhaps tough to answer. On one hand, Facebook has to build partnerships with other companies such as Microsoft (NASDAQ:MSFT) to drive sales. A partnership with Microsoft will get the Oculus Rift past the product adoption stage as it will be sold to an established gamer base. But on the downside, the outside developers will have to come up with specialized software specifically for the Oculus Rift, due to 3D technologies.
Another alternative is that Facebook develops its own operating system for the Oculus Rift. However, this has limited scale, and it could not reach enough of a market. In this specific case, Facebook is selling a peripheral device, so it would have to work with Windows PC, Android, or Mac. At the present moment, PC gaming is all about 2-dimensional graphics. While, 3D has become more common in the movie industry, we haven't really seen the technology take off with flat panel LED televisions.
So for the Oculus Rift to become a mainstream device, Microsoft would have to encourage software developers to implement 3D functionality within applications. Furthermore, Facebook needs to encourage these software developers, who have software in mind for traditional computer screens, to adopt a different design philosophy for virtual reality.
Beyond creating a powerful software ecosystem, Facebook would have to partner with major retailers so it gains more visibility. Facebook would have to advertise across multiple media and step up on a rapidly advancing hardware refresh cycle. It would also have to encourage game developers, and perhaps movie studios, to change story lines to be first person. Without a first person view, it's hard to get immersed in virtual reality.
On the bright side, virtual reality headsets may allow desktop PCs to be a little more unique as it can offer a sedentary person the most compelling computing experience possible. Oculus Rift won't appeal to casual gamers, or those who want a mobile device, but it would keep the tower PC from becoming irrelevant, and that may be enough justification for Microsoft to hold hands with Facebook.
Truly disruptive technology takes a lot of work. Outside of having awesome hardware, you need to integrate the new product into an established computing ecosystem and include third-party software developers in the process. Furthermore, the device has to garner a lot of visibility, meaning effective retail partnerships have to be formed as well. I'm not sure if Facebook signed up for the right job.
While, the hardware works, there's a lot that needs to be done from a business context that simply hasn't been addressed. Unless the device generates over 30 million unit sales, attracts millions of compatible applications, it will remain a niche device resulting in a smoldering loss of $2 billion for Facebook shareholders.
Thankfully, Facebook's core businesses is doing extremely well, and is capable of absorbing whatever loss this acquisition may bring. Therefore, I'm a bull on Facebook, but this recent buyout just doesn't sit very well with me.
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.