Facebook’s $1bn (cash and stock) purchase of photography and social media start-up Instagram has been controversial to say the least. Launched just 18 months ago and already boasting 35 million subscribers, its quick online sharing appealed instantly to 20-something hipsters (see CBRs story here).
But it has just 13 staff members, and it has no revenue stream and has produced no profit – and has no methodology for producing either. This has caused further shouting from the rooftops of inflating a new ‘tech bubble’, driving a potential overvaluation of other hot start-ups.
LinkedIn IPO’d in the middle of last year, with an estimated market cap of $4bn – it is now worth $10.6bn. Its revenues come from premium subscriptions, advertising and other HR applications (such as selling CV data to head-hunters).
Zynga is another company closely tied to Facebook. Unlike many other young web firms, it actually makes money. However, this is selling virtual goods in popular games such as FarmVille, and its faddish nature means it could drop off the radar quickly.
Facebook recently admitted it accounts for 12% of its total advertising revenue – a symbiotic relationship that Facebook presumably will not want to fall on hard times. Zynga is now valued at $7.5bn.
Google wanted to purchase online voucher retailer Groupon for $6bn in 2010, which was rejected. Groupon then went ahead with an IPO the following year, which became controversial after its bookkeeping was called into question.
It, however, has managed to garner a colossal market cap of $7.8bn, although its business model is hardly new as it involves vouchers – it simply delivers them online (via email) or to smartphones. It needs economies of scale to work, and competitors such as Amazon are already moving in.
Facebook’s looming IPO (expected in May) is driving these tech stocks higher. Valued at $100bn, the company is expected to raise a record-breaking $5bn. Whether its valuation is realistic is up for debate; its revenue for 2011 was $3.7bn with a net income of $1bn.
Google, by way of comparison, had revenues of $37.9bn and profit of $9.7bn, with a market cap just short of $200bn. It also has a huge cash reserve of $45bn, and its business model is solid. Yet its cap is only double Facebook’s.
Risk
In a world where minerals and resource companies are sky-high, banks are loaded with toxic assets and there are calls for the gold standard to be revived, tech stocks appear to be the only place investors think they can get a decent return, so are prepared to take more risks.
So why is the Instagram deal so important in the midst of all these high-tech IPOs? It’s being seen as a bellwether.
The similarities to the dot-com boom are apparent, if not as black and white. The aforementioned IPOs, for the most part, do make some money – many of the dot-coms did not. For example, before its liquidation in 2000, UK fashion firm Boo.com burned through $135m in just 18 months without producing a cent.
Many of the big purchases made in the past five years have yet to produce any kind of proper return, in the classical business sense.
For example, Google’s much-hyped purchase of YouTube for $1.65bn in 2006 is only now beginning to produce a proper return, while eBay’s purchase of IP phone firm Skype ($2.6bn) didn’t work out, and they on sold it to Microsoft (£8bn) in the same year it posted a loss. The first social media boom caused AOL’s purchase of social network Bebo ($850m) and the now infamous News Corp purchase of MySpace ($580m). Both are now essentially worthless.
None of these companies appeared to learn the lessons of the initial dot-com bust, which saw web darlings such as Yahoo spend extortionate amounts of money on Broadcast.com ($5.7bn) and Geocities ($3.6bn) in 1999. It is no coincidence that neither business continues to exist in any meaningful form. Yahoo, meanwhile, is now a limping wreck looking for a buyer. Microsoft attempted to purchase it for $44.6bn in 2008, and is glad it didn’t.
Mobile is now pushing the next generation of change. While Apple and Amazon’s business models continue to be driven by the retailing of goods (which is relatively easy to move to the web), Google and Facebook’s advertising-focused models have been unable to crack the nascent smartphone sector.
Such is the market interest in the Instagram announcement that it has entered mainstream discussion as the dot-coms once did. UK bookies Paddy Power has even started taking bets on Facebook’s next acquisition. It has the early favourite as Foursquare at 4/1 followed by note-taking service Evernote at 9/2 and web-based file-hosting service Dropbox at 5/1. All are mobile-centric apps.
Foursquare has 10 million subscribers and has been valued at around $500m, even though it has no clear revenue stream. Yet it remains ‘hot’. However, Facebook copied it, introducing its own location-positioning additions rather than purchasing it outright.
So why not do that with Instagram too? Facebook has long been working on updating its own photography app, but Zuckerberg may have carried out a cost-benefit analysis and determined that the Instagram purchase is a cheaper alternative.
You could argue it is a savvy business decision to take out a fast-rising competitor in a market it hasn’t been able to monetise. However, Zuckerberg has said he intends to keep Instagram’s identity. And these kinds of start-ups, overvalued or not, are not going to bankrupt firms such as Facebook.
"The price of $1bn is certainly inflated in terms of the usual revenue multiples (Instagram has no revenue), but this will have been driven by Facebook’s main rivals and so the price tag also has an anti-competitive element driven by the cash piles of Apple, Microsoft and Google," said Ovum’s Mark Little.
"Rather than a bubble, these ‘inflated’ prices are perhaps better described as a temporary market condition centred around a limited number of acquisition targets perceived as valuable and driven by the cash of four high-rolling Internet giants," he adds.
As mentioned earlier, Google is valued somewhere in the vicinity of $200bn, with $45bn cash. Microsoft is worth $260bn with $50bn cash, and Apple’s value ($500bn and $100bn cash) has now become the source of jokes.
The other big non-web-based tech companies are still strong. They have the solid business fundamentals and actually sell hardware and services. IBM is worth $245bn, Oracle $144bn. But does anyone really think Facebook is worth the same as Cisco, which is worth $108bn?
Much like the iffy credit ratings dished out to the financial sector by agencies such as Moody’s, Fitch and Standard and Poor’s, the ratings of these ‘new media’ web-based tech companies are essentially subjective. The accountants, once again, will be making loose definitions of goodwill and intangibles on the account sheets to justify these valuations.
But the scary part is the market mentality – when the rest of the world is a bear market, tech remains bullish, idealistic even. Combine this with the real-time ‘push’ notification capabilities of smartphones, and experts are making the same old ‘new world’ dot-com argument: we are not playing by the same rules as before.
What also remains from the dot-com era is the ‘get big or go home’ mantra. The idea is that these apps companies need to produce a giant user base, then worry about monetising it later. Facebook and Instagram both followed this to a tee.
It all sounds eerily similar to the "irrational exuberance" of the last dot-com era that US Federal Reserve Board chairman Alan Greenspan presciently warned against in 1996. It has also created a climate where the CEO (who usually holds controlling shares in a dual-share arrangement) does as he pleases – instructing the board of purchases rather than consulting them as representatives of shareholders. Facebook has got away with this for some time as its value has never slumped. Google gets away with bizarre, revenue-less projects such as ‘internet glasses’ for the same reason.
Like the dot-com CEOs, Facebook CEO Mark Zuckerberg sees himself as a visionary, a breath of fresh air in an industry filled with old stiffs left over from a different era who ‘don’t get it’. He models himself on the ’90s vanguard of tech entrepreneurs who saw themselves as disruptors, renegades, hackers rather than businessmen. Napster creator Sean Parker is a close advisor and shareholder. The money men are subservient to the engineers.
However, the Instagram purchase may have been his last autocratic hurrah before becoming beholden to the whims of shareholders and a board. The Wall Street Journal has already reported that the Instagram deal was done with its CEO Kevin Systrom behind closed doors – the board were told of the deal after it had closed. Systrom wanted $2bn, the deal closed at $1bn.
Considering the company was valued at $500m six months ago (when Twitter was sniffing around) this is hardly a coup on Zuckerberg’s part. The 27-year old CEO admits it is the company’s first ‘major’ purchase; M&A is hardly his speciality. It’s also worth remembering he was just 16 when the last bubble burst.
Instagram has burned through venture capital in the past 18 months without producing a cent of revenue or profit. It does, however, have a ‘cool’ cachet that Facebook doesn’t. In fact, that may be all it has.
Zuckerberg will also justify the deal by the intangibles on offer – the subscriber base, the IP, the mobile-centric design team. But if you look strictly at the acquisition cost per user, Facebook paid roughly $30 for each of Instagram’s 35 million users. By comparison, using Facebook’s $100bn valuation, its users are valued at $118 each. It would appear to be a bargain.
The problem here is, if most of the Instagram users were on Facebook already, they’ve ‘bought’ their own customers, twice. So what then?
Ovum’s Little believes Facebook had become bloated, making its own key functions, such as photo sharing, difficult to access and manage.
"The positioning of the Facebook brand has also been slowly shifted by its wide popularity, with many parents and even grandparents of the younger users on the social network. Facebook needs new attractions to regenerate network effects and to continue to pull the younger demographic into its orbit," said Little.
Instagram is, in a word, cool while Facebook is losing its ‘cool’ rapidly. These acquisitions may be as much about expertise as anything else. Facebook’s Instagram purchase brings it some badly needed mobile know-how. Its own mobile app is slow and clunky, and it needs to stay relevant.
Fast-moving
While Instagram dominates its market in terms of subscribers, its model is not unique. There are several serious imitators, such as Hipstamatic, already.
Tech moves fast, often faster than many financial advisors and investment analysts can advise. Whole online communities can form around a hot new ‘killer app’ or piece of technology, and then dissipate within a year. Just ask Nokia and Research in Motion. RIM, for example, has lost 88% of its value in barely a year.
In the globalised world, users are fickle and there is choice aplenty, and a business model can be quickly copied in another territory, such as China. The most famous example is Germany’s Rocket Internet – it has built an empire in rolling out (alleged) copycats/clones of US start-ups such as AirBNB, eHarmony and Pinterest to great success, and this kind of cynicism was also seen during the dot-com era.
Accountants can rage all they want about the fundamentals of good business, but like the last dot-com bust, the market will not be ignored.
