Yesterday, Facebook announced that they were acquiring WhatsApp for $19B. It’s easily one of the largest deals in recent memory and seems, on the surface, to be an absolutely insane price for a tiny piece of technology.
WhatsApp is a messaging and photosharing mobile app, similar to Facebook but only on your phone. So naturally most of the commentary seems to have been focused on the strategic nature of the acquisition. Each article argues a different point. Maybe Facebook is acquiring a threat, or wants to keep the company away from other competitors, or maybe there is some other strategic factor. While the acquisition was certainly strategic, none of the commentary helps explain why the price tag was so high.
A quick, back of the napkin analysis of the deal is a great way to illustrate how companies think about valuation during acquisitions. Considering Facebook bought Instagram last year for $1B, why would they suddenly pay $19B for a seemingly similar acquisition?
During any purchase, acquiring companies care a tremendous amount about metrics. Most acquisitions focus only on financial metrics like revenue, profits and business growth. But, typically for strategic (and certainly consumer technology) acquisitions, the most important metrics aren’t financial.
In the case of WhatsApp, the non-financial numbers are pretty incredible. The company has grown to 450M users in 5 years and is adding more than 1 million new users per day. Each day nearly 70% of their users login to share more than 50 billion messages and 500 million pictures. As a point of comparison, Facebook has 1.3 billion users active each month who are currently sharing between 350-400 million photos each day. The metrics will matter later when we compare them against other companies to help determine a valuation.
While WhatsApp was acquired for strategic reasons, the financials played an important part in their valuation. WhatsApp is one of the few consumer mobile apps that don’t serve advertisements. Instead, users get the first year free and pay $0.99 per year after that to continue using the service. Unfortunately, the financials aren’t public so we’ll have to estimate.
We know the company is growing quickly and most of their users only pay after the first year, but just for the sake of argument, let’s assume all of their users are paying – bringing in $450M in annual revenue. How much of that does the company keep?
WhatsApp has only 50 employees. Even if the company was paying everyone $250,000 a year, they’re only spending $12-15M a year on employees and other associated costs. Marketing and sales costs are minimal since growth has been almost entirely through word of mouth.
The most expensive part of running WhatsApp is actually the cost of storing and processing all of the messages each day. Twitter, which has half as many users, spent nearly $130M on hosting costs in 2012, or about $0.70 per user. In 2012, Facebook had a little more than 800 million users and was serving 300M photos per day. They spent $860M to host and serve the data – around $1 per active user. According to their SEC documents, their hosting costs were $0.60 per user in 2011 and $0.40 in 2010.
Being generous with WhatsApp, hosting probably costs around $150-300M per year – $0.30 to $0.70 per user. With a maximum of $450M in revenue, it would seem that hosting costs are consuming most of their income. But, since raising $8M in 2011 the company hasn’t taken any outside capital. [Update: They apparently raised a total of $60M, but $52M went unreported]. That means that at the least, the company is profitable or very nearly profitable.
From a strictly financial perspective, if we estimate that the company eventually gets to 1 billion users, and thus $1B in revenue per year, with the associated hosting costs of $.50 per user and a doubling of the staff, it appears the total costs would be in the $550-600M range. That’s a healthy $400M in profit within the next few years.
Discounted Cash Flow Valuation
Fast growing technology companies can rarely be modeled by discounting their future cash flow back to the present. Their current profits don’t accurately reflect the future and there are too many variables to consider. Will they grow faster or slower over the next few years? How profitable will they become eventually? How big is their future market? What will their cost of capital be? Which competitors will join in the near future? A DCF model is a great way to model mature companies but won’t work for WhatsApp.
Recent Comparable Transactions
A better way of valuing fast growing companies is to look at similar transactions. For WhatsApp, the most comparable acquisitions are Instagram, Snapchat and Tumblr. Facebook acquired Instagram for $1B in April 2012 and offered $3B to acquire Snapchat a few months ago. Yahoo paid $1.1B for Tumblr last year. The WhatsApp valuation is an entirely different order of magnitude – why?
Snapchat has 25-50M users sharing about 400M photos a day. Instagram users only share about 55M pictures a day. Neither share non-photo messages. And Tumblr, while still a social application, has only had 76B posts in its entire history with only 1.17 billion total pageviews per week. Compare all of those against the 500M images and 50B messages shared per day for WhatsApp and the valuation makes at least a little bit of sense.
To get a better view based on size, it makes sense to look beyond exact comparables. Silver Lake Partners, a private equity group, acquired Skype from eBay for $1.9B in 2009 before reselling the business to Microsoft for $8.5B in 2011. Three years later, Skype has around 300M total users. Last year, Silver Lake helped take Dell private for $24.4 B dollars – in the range of the WhatsApp deal. While Dell had $60B in revenue and earnings of $3B, the company is extremely mature and shrinking. WhatsApp by contrast is growing quickly and had tremendous strategic value for Facebook beyond simply the financial growth of the company.
Where the valuation really starts to make sense is when the company is compared to similar public companies. Since companies trading on a stock exchange are valued by the market in real-time, their valuations are considered fair value for the sake of similar sized, private acquisitions.
At the point where WhatsApp is making $400M from $1B+ in revenue, the $19B acquisition price is only 47.5x the company’s yearly earnings. Twitter, by contrast, is worth $29B despite the fact that the company had operating losses of $500M last quarter and has never made a profit. Pandora, worth $7.5B, made a quarterly profit of only $760k. Netflix, worth $26B, has a price to earnings multiple of 235x. LinkedIn has an 893x multiple and is worth $23.6B.
In that context, WhatsApp would only have to be earning $20-80M a year to put their $19B valuation between the LinkedIn and Netflix multiples. Our back of the envelope calculations certainly leave room for them to have that much profit. And the price tag definitely feels reasonable compared to Twitter’s $29B valuation while losing money.
The old adage of “you’re worth what they’ll pay for your company” is true, but almost every valuation has some foundation in real financial analysis. While Facebook was probably driven by primarily strategic factors to make the acquisition, the price they paid appears to make sense from a financial perspective.