Why This Facebook (Nasdaq: FB) Acquisition Means Huge Profits

[Editor's Note: This inside look at why Facebook's (Nasdaq: FB) recent purchase of WhatsApp is such a huge deal for investors was first published March 7 in Michael A. Robinson's Strategic Tech Investor. To get all of Robinson's research as soon as it's released, click here.]

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When Facebook Inc. (Nasdaq: FB) recently announced it was buying the messaging service WhatsApp for $19 billion, it touched off an avalanche of controversy and criticism.

We saw comments from the usual market pundits and stock jockeys. But with WhatsApp - thanks to the unique name, and the immense purchase price - even the late-night comedians stepped up.

This line from new "Late Night" host Seth Myers pretty much sums it all up:

"President Obama has announced that 4 million people have signed up for ObamaCare," Myers deadpanned. "Obama says he wants to hit 7 million users by the end of March, at which point he'll sell it to Facebook for $10 billion."

The point of all these zingers was simple enough. To comedians - and the cable-channel stock jockeys - Facebook's decision to spend $19 billion on a five-year-old startup with just 55 employees and 2013 revenue of around $20 million just seems, well, insane.

But as someone who's been watching the tech sector, and who's watched sector transitions like this one before, I'm going to make a prediction .

Two, in fact ...

Facebook founder and Chief Executive Officer Mark Zuckerberg will have the last laugh here.

And if you follow my recommendation ... so will you.

Let's take a look to see why.

Killer Apps

Make no mistake: The WhatsApp deal offers enormous potential benefits for Facebook, which already derives something like 53% of revenue from mobile ad sales.

And WhatsApp can become the straw that stirs the drink.

The startup has already become a key player in the global mobile landscape. With WhatsApp pushing the boundaries of technology, apps are becoming high-tech cash machines.

To understand their value, look at two tech leaders - Apple Inc. (Nasdaq: AAPL) and Google Inc. (Nasdaq: GOOG).

In fiscal 2013, Apple had $10 billion in sales from its app store. And Google, with its ubiquitous Android operating system, dominates the mobile market. Strategy Analytics said Android had a 79% market share last year. And after crunching the numbers, Forbes recently calculated that Google's app store has enjoyed about 48 billion app downloads over the past several years.

The app market is huge. And apps play a critical role in the world's high-tech ecosystem.

WhatsApp's revenue stream model obviously doesn't approach those of Apple or Google.

In fact, WhatsApp costs nothing for the first year of use and then is just $1 a year after that. But the potential of this platform for Facebook is simply stunning.

This acquisition could bring billions in new sales to Facebook in a very short period of time. If it just captured $1 a month per user in fees, ads, and other services, Facebook would post around $5.4 billion in new sales on top of 2013 revenue of $7.8 billion - a 55% yearly increase.

No wonder Zuckerberg has been trying so hard to get into the messaging business. Just last year, he was spurned in a $3 billion bid to buy Snapchat, a messaging service popular with young users.

Facebook (Nasdaq: FB): Running the Numbers

When you compare the price Zuckerberg paid for WhatsApp with the value of another popular mobile product, the acquisition really begins to make a lot more sense.

Twitter Inc. (NYSE: TWTR) is a micro-blogging service that has become a great source of breaking news. Just last Sunday, Twitter received enormous attention when Academy Awards host Ellen DeGeneres tweeted a photo of herself surrounded by several movie stars.

And yet, for all the attention Twitter gets, it still has a user base that's only half the size of the one controlled by WhatsApp. But at roughly $55 a share, Twitter has a market cap of $29 billion. In other words, the market says Twitter is 55% more valuable than WhatsApp - with only half the user base.

Fortunately, we have another recent major acquisition by which to model the Facebook-WhatsApp marriage.

Let's take a look at the recent deal between Verizon Communications Inc. (NYSE: VZ) and Vodafone Group PLC (Nasdaq ADR: VOD). The nation's leading wireless carrier paid a whopping $130 billion to buy out Vodafone's 45% interest in the Verizon wireless venture they owned together.

By that comparison, WhatsApp appears very cheap indeed. Verizon got roughly 97 million active monthly users, paying about $2,980 for each one. With WhatsApp, Facebook adds nearly half a billion new customers for about $42 dollar each.

And remember, Verizon has limited upsell beyond its monthly rates, data plans, and roaming charges. But WhatsApp is a leading-edge firm in a new industry with unlimited potential.

In fact, WhatsApp founder Jan Koum plans to roll out a voice service in the next few months. He's still leery of ads - despite their revenue potential - but Zuckerberg will almost certainly find a way to either host mobile ads or find corporate sponsors whose deep pockets can defray the cost of the user acquisition. And he will add new mobile services.

So there's lots of upside on the revenue side.

On the flipside, WhatsApp doesn't have a lot of expenses - it has only 55 employees. Tell me another business that could service more than 450 million dedicated users scattered over several continents with just 55 employees.

That's actually the whole point of what makes mobile tech so profitable: You can "scale up" a business to a pretty hefty size - while maintaining a fairly small overhead.

This explains why Facebook stock is on a roll, rising 147% over the past year. The financials are great because the company is basically transitioning into a full-on mobile play.

The Next Phase

At the end of last year's fourth quarter, Facebook (Nasdaq: FB) had 1.2 billion active monthly users, up 16% from 2012. But active mobile users climbed 39% to 945 million, or 77% of its user base.

With a market cap of $172 billion, Facebook trades at roughly $67.50 a share. It has operating margins of 37% and an 11% return on assets. It has $11 billion in cash on hand and generated $2.85 billion in free cash flow last year.

Over the past three years, Facebook has grown its earnings per share by 32%. At that rate, earnings and the stock itself could double in less than 2.5 years.

That would imply a price of about $140 a share before factoring in the lucrative potential of the WhatsApp deal.

Thus, Facebook ranks as a classic growth play. It's a leader in the new field of social networking that has allied itself with the breakout firm in mobile messaging.

As I see it, tech investors have two choices with Facebook. They can give into the negative hype about this deal from the media and all those TV comedians.

Or they can take advantage of the huge upside and laugh all the way to the bank.

And laugh is what we're going to do.

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About the Author

Michael A. Robinson is one of the top financial analysts working today. His book "Overdrawn: The Bailout of American Savings" was a prescient look at the anatomy of the nation's S&L crisis, long before the word "bailout" became part of our daily lexicon. He's a Pulitzer Prize-nominated writer and reporter, lauded by the Columbia Journalism Review for his aggressive style. His 30-year track record as a leading tech analyst has garnered him rave reviews, too. Today he is the editor of the monthly tech investing newsletter Nova-X Report as well as Radical Technology Profits, where he covers truly radical technologies – ones that have the power to sweep across the globe and change the very fabric of our lives – and profit opportunities they give rise to. He also explores "what's next" in the tech investing world at Strategic Tech Investor.

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