I heard about Facebook's (FB) acquisition of Instagram after I submitted my last article about the company. Instagram was one lucky startup company with just a little more than 10 employees as the company turned out to be worth a billion dollars. That's almost 100 million dollars per employee. Facebook's acquisition of Instagram surprised many, because the news came so sudden and the amount spent was so large. Now the question remains: why did Facebook acquire Instagram for such a large sum, and did it do the right thing? I believe that acquiring Instagram added a lot of value to Facebook and I will explain why.
For those that don't know, Instagram was a small company that owned a mobile application of the same name. This mobile application allows its users to share photos with each other over their mobile devices. The application was founded only 2 years ago; however it gained huge popularity and achieved tremendous growth since then. Instagram is only available through mobile devices and this gives the application a unique status. This is an important piece of knowledge for Facebook as most of the company's recent membership growth came from mobile-device users. Facebook definitely sees a lot of potential in owners of mobile devices. By 2015, a third of the internet usage is expected to be from mobile devices such as cell phones.
Facebook members post 250 million photos everyday and many members use the website for photo sharing function alone. Because of this situation, Instagram became Facebook's competition even though the application transmits only about 300,000 photos per day. Maybe Instagram wouldn't pose much threat to Facebook as a small company with a few employees; however it could have been acquired by one of the larger competitors of Facebook such as Google (GOOG). This is one of the reasons Facebook had to be quick about acquiring this company before anyone else did.
Instagram was able to raise a venture capital of $500,000 in 2010, $7 million in 2011 and $50 million this year. Considering these numbers, Facebook's $1 billion dollar check might look giant, but keep in mind that this company has so much potential for growth. Instagram already enjoys 50 million members and its members are very active. The application's popularity stems from its user friendliness as the application makes it as easy as clicking a couple buttons to add a variety of effects to one's photos.
Facebook currently employs only 3,000 people and the company has many ongoing projects. This means the company's current employees are already stretched out and the company will have to hire a large number of people to grow. One easy way to do is to acquire smaller companies that already come with the features Facebook values. I believe that Facebook will continue to acquire smaller companies even though Mark Zuckerberg says it will not happen very often.
One problem with Instagram is that the application itself doesn't generate any revenue. It would be very difficult for Facebook to utilize this application in a way that it may generate revenues. At the moment Mr. Zuckerberg isn't that concerned with profits as his priority is to have Facebook reach its maximum potential in terms of number of active members. Perhaps he will not rest until every internet user in the world is a Facebook member. Sooner or later the company will have to generate a lot of revenue and Instagram's contribution to the company's revenue stream might be questionable. Many people see acquisition of Instagram as a defensive move in an effort for Facebook to remove a competitor from the game, and this could be the case.
One of Facebook's growth strategies relies on increasing user engagement in whatever ways possible. Instagram might help do that. As a result, Instagram might translate into higher advertisement revenue for Facebook. Integrating this application with Facebook would allow many people to share and view their photos through one platform instead of two, increase user engagement and time-spent in Facebook. This would translate into more advertisements, as someone who spends twice as much time on Facebook will be exposed to twice as many advertisements.
I believe that acquisition of Instagram is the right move; however the price of the acquisition is too high. Last year Facebook's revenue was $3.71 billion and it kept roughly $1 billion of this revenue. Considering these numbers, Facebook practically blew an entire year's earnings to buy Instagram. The company currently holds cash of $4 billion; however most of this money came from Goldman Sachs (GS) when the bank acquired shares of Facebook. A company on the verge of going public should probably spend the IPO revenue in smarter ways than Facebook just did, as this kind of money is likely to be a one-time gain. IPO money is meant to be spent on projects with high growth potential or high profit margin so that it justifies going public.
As for investors, I believe it would be wise to wait a couple quarters after Facebook's IPO to make a buying (or not buying) decision about this company. That's what I will be doing.
Disclosure: I am long GOOG.