A divergence from my normal posts. Indulge me please.
You likely have heard the news by now that the social
networking site Facebook announced its intention to acquire photo editing and
sharing service Instagram for the price of $1 Billion, astonishing given
Instagram has zero revenue. I happened
to hear the news via NPR, which also said that Facebook and Mark Zuckerberg had
no plans for such an acquisition again.
The price alone suggests that this Instagram service must be critical
for the future of Facebook (FB), I mean I personally couldn’t
come up with $1B easily, and doubt many of you could as well. (An aside, I called AMEX to check, and no
spending limit does not mean I can charge $1B.
Shucks. I digress.) Memories of the late 90s started flashing in
my mind; are we headed for a big crash again?
I owed it to myself, and my 401k, to check into it. Was this something that made sense, or is it
just good old-fashioned greed.
Being an Android user myself, I had only recently heard that
Instagram was available for my phone; however, had yet to check it out. Consider me curious: what does Instagram do
that FB needed so desperately? Is photo
sharing and editing seriously worth $1B?!
Mark Z. has plenty of programmers on his staff that could mimic this
functionality in a matter of days for a fraction of that price. What else is going on here?
I polled my friends who are far more Social Media savvy than
me. I got a wide range of answers, none
of which really made sense to me. Many
said I “had to understand Social Media” to understand the connection. I didn’t buy it; it reminded me of the .com
craze in the late 90s, where websites
without revenue or profitability are the new way of doing business. One friend went as far to say that my
thinking was too “East-Coast,” that if I lived in Silicon Valley, I’d
have a better appreciation of it. It
didn’t work then, and nothing has changed in the last 15 years to
change my thinking on that.
I asked different friends and received a better
hypothesis. FB did it to acquire the 30M
user base of Instagram users. Well, ok,
let’s do some quick math on it: FB paid about $33 per user (some
of which may already be FB users, but let’s ignore that for now). FB’s main revenue stream is advertising, so
how long would it take to recoup the investment? If I assume a (generous) Cost-per-click (CPC)
of $0.20, that’s over 160 clicks needed to just recover the investment,
completely ignoring the overhead to maintain said users over that
interval. I do not know about you, but I
use ad-blockers and do not click on many ads.
It’d take FB years to recover the investment alone on someone
like me. It’s math I can’t
do on my fingers, but it just doesn’t add up.
Those ideas are plausible but doubtful. Maybe this is what happened: Perhaps Mark Z. saw Instagram as a threat;
that they had to acquire it before someone else did, e.g. Twitter. There’s evidence to support this claim: they
were the #1 app in Top and Photography apps at various times in April,
2012. Their network was growing
exponentially. And a Venture Capital
(VC) firm had just given Instagram financing that valued them at $500M. They were on the rise, for sure.
Whether Instagram could or would displace Facebook is
unknown. What we know is that Mark Z.
definitely felt that it was a threat because he initiated the acquisition on
his own. He did not perform due
diligence, contact lawyers, or even discuss it with his board. He used some simple math: if the VC firm just
valued the firm at $500M, then double the investor’s money in a
week, make them happy, and get Instagram.
So the VC firm walks away with a 2x return in a week, versus a
potentially higher multiple in a year or so; they could be a little upset, but
wouldn’t be that hurt.
But analysis of this story should not stop there. Whether you call Mark Z.’s
move brilliant, greedy, controlling, or fearful, it happened. Mark Z., a non-professional business manager,
spent $1B on a whim. Unprecedented. What is to prevent him from making a similar
move again? He has a controlling stake
in the firm, so, in a word, nothing. If
I was a shareholder of FB, I’d be concerned... in the long run. Hold that thought for later.
Honestly, I’m surprised that a VC firm in the past
didn’t request that a professional take the helm. I thought, maybe the firm that takes them
public will insist? Goldman Sachs (GS)
has invested in FB in the early stages, but was denied the very lucrative IPO,
in favor of MorganStanley (MS). That’s
rare, one would expect that GS would have the inside track. So what was it that made FB go with MS? I’m only speculating here, but I can’t
help but wonder if GS insisted on professional management, akin to Eric Schmidt
at Google, and MS said they’d do the IPO with Mark Z. at the helm?
If that’s indeed what happened, I cannot really
fault MS. They have a duty to their
shareholders to make profits, and securing the largest IPO in recent times
(currently rumored to be $10B) would be extremely profitable for them. There’s no responsibility, law, or even ethic
compelling MS to make such a demand. If
they did not go after the deal, another investment bank would, and that’d
be profits lost for MS. This brings back
shades of the 2008 financial crisis, precipitated (along with many other
factors) by banks competing to write mortgages, regardless of the long-term
risks. We did not, and cannot fix the
true problem: the market values short-term performance vs. the long-term. The incentive is for all public companies to maximize
the short-term; each quarter the market expects them to show results. That really is counterintuitive to the way a
business should run if we ignore the markets, which we cannot do.
It is hard to ignore the markets these days. The FB IPO has been in the news often. Everyone will want to be in on it, meaning
even your casual investor will buy, despite valuations. (If you know of the “IPO Winner’s
Curse” theory, it will not apply here; if you get in, you’re
going to make money.) And if you do not
get in on it, you’re likely to lose out.
The rest of this article is pure speculation... but indulge
me if you would, please.
The problem is that people will take their hard earned
savings and put it into FB; far more than would normally be in the stock
market. Some may even make quick gains
and reinvest in other stocks without knowing what they are doing. FB’s IPO will drive the market up and
uninformed investors will keep investing.
Again, shades of the late 90s and 2007 come to mind.
Recalling a point made earlier, and I fully admit it is a
bit of a stretch: Mark Z. has no record
that he is a continual visionary such as Steve Jobs. According to the court papers, Mark Z. did
not even invent FB! Google, a firm that
supports R&D, put in professional management in Eric Schmidt to give them
rigor and structure. Even Steve Jobs had
good professional management around him; while he was amazing at setting the
direction of new products, he did not make acquisitions on the scale of Mark Z.’s. My fear is that, if unchecked, Mark Z. may
make another critical mistake like the off-the-cuff Instagram acquisition, and
FB will tank.
If (or when) that happens, some informed and many uninformed
investors, will lose. This to me has the
makings of another significant market drop: a lot of recent news about the
economy has been good, if not too good as of late. Interest rates are still low, those that can
save can't do it in a traditional savings acct as the market is often doing
much better. If (or when) FB and other tech
stocks (that exceed their “traditional” valuations)
drop, it will be an exponential effect: people who should have diversified and
people who started riding the IPO train… these people will lose their disposable
income. Discretionary spending will drop
again, it will be tough for some to make mortgage and rent payments... and
given that 2008 is still fresh in many American minds (or if they forgot, the
presidential campaigns over the next few months will surely remind them),
people will retract from spending and the marketplace. We have not solved any of the rules around proprietary
and/or algorithmic trading, as the Volcker rule does not go into effect for
some time… so the drop may snowball and the market may drop quickly,
again.
Or, I could be wrong; people will forgive FB and Mark Z.’s
transgressions. I can see it happening
in the short term, but not the long run.
I still cannot believe that a company whose estimated net profits of
$200M/yr commands a valuation of $75B.
That P/E ratio is astronomically high. At some point, common sense will reign. It did at the end of the .com craze, and it
will happen again; I just do not know precisely when.
MorganStanley begins FB’s IPO Road show on Monday, May 7. I have no choice but to keep my money in the
market and let it ride on the wake of FB’s climb.
I, like MorganStanley and all other investors, want my portfolio to
grow, and to do that means doing what the market is doing, instead of what I
think it should be doing. I personally want
us all to focus on the big picture but it is just not how the market
works. We all have to play by the rules –
which currently favor the short-term vs. the long-term. I just hope I recognize the down cycle better
than I did last time!
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