One of this week's biggest market stories has been the decision by Yahoo (YHOO) to acquire social blogging network Tumblr for $1.1 billion. Given the sheer size of the price tag, all the buzz should not come as a surprise, as this outpaces even Facebook's (NASDAQ:FB) purchase of Instagram, which came in closer to the $1 billion mark.
At this stage, questions and criticisms are numerous. Did Yahoo pay too much for what is (at least at this stage) an unprofitable company? Are the cultures and goals of these two companies incompatible? Will Yahoo be able to overcome its weak reputation for successfully implementing the strengths of its startups? Can Yahoo actually establish itself as a formidable presence in the social networking space? Can Tumblr generate consistent revenues in an industry that has well-documented difficulties monetizing user activity on its web sites?
Critical Test for New CEO
In the past, Yahoo has had difficulty in growing its startup acquisitions and meeting its original goals when the company's were purchased. Key examples can be found in Flickr and GeoCities, and if Yahoo is unable to bring Tumblr to profitability, investor confidence in recently installed CEO Marissa Mayer is like to wane. It is clear that this acquisition is meant to help Yahoo build a larger presence in social networking and mobile device applications but some of the most critical challenges can be found in historical precedent.
Perhaps the biggest test will be for these companies to "eyeballs" into advertising dollars. Prior failures can be seen in Facebook's acquisition of Instagram, which generated negative headlines when the photo sharing site was unable to add significantly to Facebook's profit performance. Tumblr's site contains roughly 108 million blogs and reaches nearly 140 million users worldwide. But will this be enough to rectify Yahoo's late entry into the social network environment? Even if Tumblr can help Yahoo improve in these deficient areas, will this be enough to tackle the real issue at hand (namely Yahoo's declining market share in digital advertising)?
Challenging Google's Advertising Presence
While the more immediate solution Tumblr provides is to give Yahoo a foothold in social networking, the longer term goal is for these companies to build back Yahoo's position in digital advertising markets. Yahoo's first place position in this area has been handed over to Google (NASDAQ:GOOG), which now commands roughly 41% of all revenue generated by digital advertising. In addition to this, Google has already gained a strong position in the social networking space. The company's Google+ offering now ranks ahead of Twitter in terms of active users (with roughly 350 million worldwide), and is behind only Facebook in the social network space.
This creates some daunting prospects for Yahoo as the laggard in the group. Because of this, investors will be forced to pay close attention to Tumblr's performance for the remainder of this year. Given the size of Yahoo's purchase price, any weakness in the company's profit performance could disproportionately affect share values in Yahoo, and this creates extra downside risk for the stock into the end of this year.
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.