My five (Value) cents on Whatsapp: Network effect meets Lollapalooza

No breaking news here, the acquisition of Whatsapp by Facebook for 19 bn USD has been widely commented already many times.

Some of the more notable comments were:

Damodaran looks at it from a value and trading perspective and sees only merit as a trade

John Hempton feels “out of tune with the time” about the deal becasue the Facebook stock didn’t fall after the announcement

Henry Blodget has a slightly more positive take on the deal

What those comments have in common is that they all look at Whatsapp as another social media app like Twitter, Tumblr etc. In my opinion and my experience, Whatsapp IS NOT a social media app, at least not intentionally.

Whatsapp is so successful because it offers two big advantages for users:

– its cheaper than traditional SMS
– it is also much easier to use (nicer smileys, you can look if someone is online, easily send pictures etc.)

In my opinion, Whatsapp only “accidentally” became something like a “social media” platform as it allowed group communication more easily und unobserved compared to Facebook. If you use facebook nowerdays, efficient communication among friends is not that easy any more with all those crappy “likes”, advertising etc.

Back to Whatsapp “roots” as an SMS killer: There was an interesting article on Bloomberg.com about the amounts lost by mobile carriers due to Whatsapp & Co with the following estimates:

Free social-messaging applications like WhatsApp cost phone providers around the world — from Vodafone Group Plc (VOD) to America Movil SAB (AMXL) and Verizon Communications Corp. — $32.5 billion in texting fees in 2013, according to research from Ovum Ltd. That figure is projected to reach $54 billion by 2016.

So instead of thinking about a “social media app” one could also think of Whatsapp as a “Mobile communication company” which concentrates on a very specific part of the value chain of mobile phone carriers.

After the initial euphoria, mobile telecommunication has not turned out as such a great business as one would have thought. The high capital required for licences, tower infrastructure, retail outlets etc. plus the regulation has turned the business pretty much into a commodity business. As in many commodity business like car insurance etc., the carriers tried to discount their main offer as low as possible and then charge all different extra stuff, especially SMS. There was for instance a “scandal” in Germany, when providers let people especially kids, send SMS although the prepaid money was already used up. Many parents then were surprised when they then got extra bills or had to load unexpected high amounts in order to get the phone working again.

So one can imagine how quickly especially kids or poorer people with limited prepaid budgets (but a data plan included) adopted a free service like Whatsapp. This also applies to generally poorer countries where mobile phone expenses use up significantly higher shares of total budgets than for instance in Germany or the US.

Compared to the full value chain of mobile carriers, a texting app requires almost no infrastructure, no retail outlets etc. You can easily rent cloud processing capacity for very small money from Amazon on a variable basis and scale up if you need more.

Similar cases: Mobile phone contract resellers

A very similar business model is that of the classical mobile phone contract “reseller”. Freenet AG for instance, a German mobile phone “reseller” managed to get a 3 bn market cap just by reselling plans from existing mobile phone Providers.

Compared to moble phone carriers, this business is clearly attractive as one doesn’t need to buy the licences ec. Compared to Whatsapp however, the business model looks rather shitty as you need to advertise constantly, prefund the phones, maintain a retail outlet etc. And remember: This 3 bn market cap has been achieved with “only” 8.5 mn clients in one country. If Whatsapp for instance would decide to go into reselling, they could make live difficult for those guys as well.

No cashburn

What I found also very interesting is the fact, that Whatsapp didn’t burn a lot of cash. According to some articles, Sequoia capital only injected 58 mn UD in total “outside” capital. So this is another big difference to many other internet or social media companies: very little “cash burn”. I guess one reason is that they didn’t need to make a lot of advertising. As the reputation of mobile phone companies is bad enough, their service was just such a “No brainer” or “killer app” for many that it went “viral” without spending any money on advertising. I am not sure if they have to pay to Google or Apple for the app stores, but overall, distribution cost seemed to have been quasi non-existent.

Moat /network effect

In another comment on Slate about the Whatsapp deal, the author says the following:

The different pricing schemes they come up with are just different ways of trying to maximize the value they extract from consumers. In a world without WhatsApp, selling SMS separately from data is the best way to do that. Then along comes WhatsApp to exploit a hole in the pricing system. But if WhatsApp gets big enough, then carrier strategy is going to change. You stop selling separate SMS plans and just have a take-it-or-leave-it overall package. And then suddenly WhatsApp isn’t doing anything.

I can clearly not look into the future but there are some obvious mistakes in that argument for instance:

1. Big companies hate to cannibalize itself. Whatsapp is already big enough but they haven’t done anything because more often than not, it is “easier” being cannibalized by someone else than by a guy or a division within the own organization
2. Anyone using Whatsapp will not go back using SMS again. Only few people prefer to live in the stone age if they have a choice
3. Although it was easy and cheap for Whatsapp to get to this stage, it is not as cheap and easy for any potential competitor to achieve critical mass. Absent any further technological break through, the “network effect” of the established leader will make it extremely expensive for any competitor to “scale up” in this business. In a sector where the network effect is so string, the “barrier to entry” increases tremendously if there is a dominating player with a large market share.

Especially the last point is important in my opinion. As long as this segment is growing, it makes a lot of sense for Whatsapp to provide this service as cheap as possible in order to avoid making it attractive for other competitors. Especially as it doesn’t seem to cost a lot of money to run it for a couple of hundred million people, they have a lot of time to actually increase profits.

Oh, and by the way, forget about that shitty Blackberry messenger app, this won’t save them (see number 3 above).

Lollapalooza effect

Warren BuffetT‘s “sidekick” Charlie Munger has coined this term. I copy the definition from this blog post:

The lollapalooza effect is what happens when you have more than one bias/incentive acting at the same time. It means the confluence of several themes heading in the same direction to produce a given result which can either be positive or negative. And, as it becomes hugely powerful, it also becomes a major driver of human misjudgment.

The current confluence of at least 4 important “streams” that are mobile communicication, faster internet, smartphones and Mobile micro payment is a good example of such an effect. On a single basis, a “product” like Whatsapp would not even exist. With my old Nokia 6110, I could only send sms and take calls. With my first “multimedia” phone (a Siemens Benq…what was that again ?) I could only surf some specialised web sites chosen by the mobile carrier at a horrendous cost and slow spead. But now, with full and fast internet access, easy to navigate touch screens, app stores and a cheap internet data plans, a couple of guys in SFC can create a product at a cost of 60 mn USD which is used by 450 mn people globally after only 5 years.

Valuing companies in such an environment is indeed very difficult as anything could happen, both to the positive and the negative side. I think we should prepare for much more “killer apps” coming out of this Lollapalooza environment which have the capacity to challenge or even destroy other established business models. And I do not mean only print magazines, Nintendo DS or alarm clocks.

What about the 19 bn USD paid ?

If we look at the Bloomberg article above and i we consider Whatsapp as a mobile communication company, one could make the following calculation:

If messaging really lowers mobile carriers revenues by 56 bn uSD globally in 2016, one could argue (among many other scenarios) in the following way:

– if Whatsapp is responsible for 20% of this, then their “damage” or cost saved for the mobile client is 10.8 bn annual
– if Whatsapp manages to charge 25% of the saved amount at some time, this would mean around 2.7 bn USD p.a.
– as the costs seem to be low (they don’t need to buy licences etc.), a net profit margin of 60% might not be unreasonable

So all in all we would expect under those (maybe too optimistic assumptions) around 1.6 bn in profits. Going back to professor Damodaran, this would be still lower than to justify the paid value:

Whatever the model, though, you would still have to generate at least $2.2 billion in after-tax income from advertising to Whatsapp users to break even.

but still, Whatsapp could turn out to be quite a valuable asset. This does not even include the possibility that Whatsapp moves further along the mobile communciation value chain, like actually handling all communication including calls and “degrading” carriers to exchangeable capacity providers which would be one option.

Now how about Facebook ?

First a short disclosure: I have never owned and will never own Facebook shares, that is on my “too hard pile”.

But overall, I am not sure that Facebook is the best fit for Whatsapp. Facebook didn’t get mobile unless a few months ago and I am not sure if they will get it now. For me, Google would have been a much better fit or even Microsoft or Apple. But again, who knows ? The biggest danger for Whatsapp in my opinion would be indeed if facebook would force a connection with their services or something similar as, in my opinion, Whatsapp IS NOT a social media app but a mobile communication platform with the potential to take out an even larger share of mobile carrier’s revenue in the future.

Summary:

Many people see the 19 bn Whatsapp purchase as a sure sign for a top in the social media hype. Although it might turnout as such, in my opinion Whatsapp itself is a very interesting mobile communication business with the potential to further shaka up this business.

Due to the network effect, Whatsapp has created a huge barrier to entry for any competitor, supported by the fact that they still offer this at basically no cost. The pricing power of Whatsapp in my opinion is much bigger than “social media” as customers clearly understand the savings against traditional mobile carrier charges. Going forward, Whatsapp seems to be well positioned to move even further into the territory of mobile carriers, resellers etc.

The price paid by Facebook clearly looks very rich, but looking at mobile carriers and the implied profit potential rather that social media businesses, it might not be unreasonable. It remains to be seen however what Facebook is doing with this acquisition.

If Whatsapp would be a listed company, I might even forget my traditional value metrics and buy it, maybe not at 19 bn but still, at a “non-value” valuation.

35 comments

  • I’d just like to add one last thing … I’m impressed (and happy) about the quality of discussions here. Lots of facts and opinions, no emotions. I really like that!

  • Another great post! I liked the way you described the Lollapalooza effects, but I do have concerns with identifying them as engine for WhatsApp’s value.

    As I see it, Whatsapp is not the one doing the ‘damage’ of 56 bn USD to mobile carriers, it’s time itself. Messaging is losing its price through faster internet, smartphones and applications, but it does not necessarily make the apps more valueable.

    I also agree with Costas’ point: I think there is low stickyness in the business, in fact I think it’s an almost completely competetive market and there is no real moat, driving the cost of a single message (even including a picture or multimedia etc) to about zero. Also, there are no user switching costs and server capacity is available at constant prices at every scale. There is no marketing that would create advantages out of the great size. Plus there are not (yet) any synergies with the social network, which might change.

    I highly doubt Facebook will be able to turn its market share into money, but of course, I can be wrong.

    • thanks for the comment. I agree with most of what you say but not everything.

      Yes, (almost) everyone can start an app service, but if there is already an established player then it is more difficult. Don’t forget, if you look at the specs of the different services, there are differences (local languages, voice messaging etc.).

      The big issue is: You have to motivate people to switch services as a Group. The switch of an individual is meaningless, as he/she will not find his/her friends in the other service.

      When Amazon started its book delivery service, there was also no real entry barrier. Anyone could set up a web site and connect to the distributors. Why did they succeed ? In my opninion one of the reason was (and is) that they kept out the competition by deliberately not making a profit until they were big enough and the network effect (among others: more Reviews, ratings etc) created a factual moat.

      I believe that you can create a moat via the network effect even when the ntry barrier is very low.

      Again, if this is worth 19 bn is another question.

  • I agree with a lot of this, but cant agree on the prospective profits. WhatsApp can’t get away with charging, at best they can continue to charge a nominal annual fee like $1-2.

    Skype already has an app, it isn’t too much of a leap for them to create a competing free app that does everythin WhatsApp does, considering most say WhatsApp is only a basic bit of code.

    If they every introduced charging people would drop the app. In the UK all mobile contracts already come with unlimited free SMS messages, I expect the rest of the world to follow suit if it isn’t like that already. WhatsApp for me is great for 3 reasons

    1. Free international messaging
    2. Easy photo transfer
    3. Group conversations

    But I wouldn’t pay for any of those.

    • hi,
      thanks for the comment. I agree with you on most of this. Whatsapp clearly cannot charge a lot for the existing stuff, as people don’t like it when something becomes more expensive. On the other hand, they have a good chance to add stuff and then charge for the additional features. But who knows ? Nevertheless, 500 mn users imply some optionality to the upside. 19 bn is surely a lot but it is definitely worth something. My best guess would be like 5 bn or so…

      mmi

  • Just in from Mobile World Congress 2014:
    Koum ‘s big announcement: free in-app voice calling on WhatsApp will be launched in the second quarter of 2014. WhatsApp inches further in to phone operators’ territory…

    Does that make WhatsApp a Skype-clone? Why would somebody …. ANYbody use WhatsApp for $1 a year when he can use Skype for free? And now let’s talk about the network thing … Skype hat some 660 mln back in 2011.

    Epic fail in my opinion …

    • Just saw that announcement as well. Well, we will see, but Whatsapp is definitely moving along the mobile communication chain as predicted.

      The problem with skype in my opnion was that you had to have your pc running to receive a call and most people have their pcs somewhere else.

      Whatsapp offering cheap mobile calls via the data plan is actually a real mobile carrier “killer” in my opinion. If they make money is a different question.

      • I don’t see that … it’s in every carrier’s power to stop offering flat rate data plans if that is what canibalizes their business. Considering that a one-minute Skype call transfers about 3MB of data (Skype website says so), carriers would make a very nice cut out of $/MB plans.

  • I have another two thoughts

    1) Do not forget that WhatsApp requires data to send/receive messages while SMS needs GSM only. That might limit WhatsApps advantages when being abroad and for prepaid phones. Thinking emerging markets here I’m not sure how many phones are sold with an all-data included contract, therefore again limiting the growth potential for WhatsApp.
    2) Do we have any data on Apple users using Whats App? As far as I know (never had an iPhone, Mac or anything) Apple offers a messaging service where you can send messages within the Apple-Ecosystem (from iPhone to iPad to Mac). Same thing for Samsung and Nokia (Windows) might make WhatsApp obsolete. Also considering the substantial programming power of the mentioned phone producers.

    • One remark to that: In the age of Mobile apps, “programming power” is absolutely meaningless. With modern programing languages, large organizations are actually at a disadvantage as the are usually much to hierarchical and unflexible.

      What you need is speed and flexibility. How many people worked at Nokia for Symbian ?

    • regarding your first point, that’s what Zuckerberg said today:

      http://www.valuewalk.com/2014/02/zuckerbergs-mwc-2014-speech/

      Zuckerberg argues that the outstanding barrier in connecting people to the Internet in emerging markets is no longer the cost of phones, but expensive data plans. The only way this will change is if more operators introduce unlimited bundles with free access to basic Internet services like Facebook Messenger and WhatsApp, along the lines of the bundle Globe Telecom offers in the Philippines. Messaging services, social networking, and search will in turn be the key platforms for offering access to a wider range of Internet services.

      Zuckerburg, teen billionaire and Robin Hood for emerging markets ? Who nows….

  • I’m loving the addition of the T on Buffett! haha – I noticed! ; -)

    Great post.

  • Ich sehe die Markteintrittsbarierre als nicht sehr hoch an. Es wird interessant sein wie sich Theerma etabliert. Wenn man Whatsapp intensiv nutzt und die Entscheidung von ein paar/ allen Leuten im Gruppenchat gefallen ist zu wechseln kann das mE einen Schneeballeffekt auslösen.
    Das sollte man im Hinterkopf haben.

    Es geht zunehmend um die Datensicherheit. Stichwort: NSA. Und da werden amerikanischen Großkonzerne als nicht wirklich vertrauenswürdig eingestuft.
    Mir ist schleierhaft wie Whatsapp mit dem bestehenden Dienst Geld verdienen will. Skype ist ja auch nicht dermaßen erfolgreich dass dies ein Geschäftsmodell darstellt. Aber in die Richtung könnte es gehen für Whatsapp.

    Gruß
    Chris

  • Hi MMI, whats happening, are you becoming a growth-investor now?!
    😉
    Cheers,
    Woodpecker

  • In 2005, when Facebook was a one-year start-up, News Corp. acquired MySpace for $580 million. In 2011, MySpace was sold for $35 million.
    Now we are talking about $19 billion.

    Instant messaging will become a part of every mobile OS. In addition, there will be other (fashionable) services such as WhatsApp, Threema, and so on.

    • Well we will see. According to some rumours, even Google wanted to pay 10 bn a year ago:
      http://www.manager-magazin.de/unternehmen/it/whatsapp-google-facebook-bewerber-a-954898.html

      And Google should be the company to most easily copy whatsapp.

      • Another example: Microsoft paid $8.5 billion for Skype and integrated it. Facebook and Google were also interested at that time.
        Therefore the latter will have to come up with something.

      • Google’s copy is there: it’s called Google Hangout, which is their previous chat software remixed with WhatsApp style sms integration, people discovery and user experience, and they’ve been quite aggressive at opting in people by default (on Android where they can). Functionaly WhatsApp has no advantage left, it’s pure network effect and first mover advantage, but then that worked in the Google+ vs Facebook case. The one sure way to kill WhatsApp would be for Apple and Google to do a deal so that Hangout and the ios chat thing talk to each other.

  • Ich wollte zuerst auf Englisch kommentieren, doch ich habe davon Abstand genommen, da meine Fragestellung zu spezifisch ist, und mein Englisch zu bescheiden. Hier meine Fragestellung:

    Annahmen:
    1. Markteintrittsbarrieren sind sehr niedrig, da die Anfangsinvestitionen sich in überschaubarem Rahmen halten und die weiteren Kosten variabilisiert werden können.
    2. Markterfolgsbarrieren allerdings sind sehr hoch, wie du sehr schön in Punkt 3. mit dem Netzwerkeffekt beschrieben hast.
    3. Irgendwann muss/will what’s up Geld verdienen, idealerweise in einem “natürlichen” Monopol.

    Jetzt gehen wir davon aus, dass what’s up irgendwann anfaengt, seine Kundenbasis zu monetarisieren, und Milliarden verdient.

    Was würde einen anderen Anbieter davon abhalten, erst einmal in den Markt einzusteigen und kostenlos dieselbe Leistung anzubieten. O.K. ich höre schon deinen Einwand, dieselbe Leistung kann es nicht sein, wegen des Netzwerkeffekts. Aber kostenlos waere erst mal problemlos möglich, so dass ich versuchen könnte, zumindest den kostensensitiven Teil der Kundschaft abzuwerben, um eine kritische Masse zu bekommen.

    Was wenn ich als Alternativanbieter jeden Kunden zusaetzlich belohne? Also, mehr als kostenlos. Wenn ich z.B. Amazon bin, ein Alternativprodukt auf den Markt bringe und dann sage, jeder der dieses Produkt nutzt (mind. X-mal im Zeitraum t mit y verschiedenen Menschen textet/spricht) bekommt ein Buch geschenkt. Oder eine CD. Oder Telefonminuten für seine prepaid card. Oder eine FC Bayern Karte, oder, oder, oder.

    Ich könnte mir das problemlos leisten, da ja die Erbringung der Hauptdiensleistung von what’s up fast nichts kostet. Jedenfalls für die Taschen von Amazon, Ebay, Apple oder wen auch immer.

    Würde dann, wenn nur das Incentiv für die Kunden zum Wechseln nur gross genug ist, nicht irgendwann ein Prozess in Gang gesetzt werden? Es würde mir ja schon reichen, wenn mein Alternativprodukt erst einmal nur parallel genutzt wird, und dann peu a peu mehr.

    Und wenn ich es schaffe, hier einen Prozess in Gang zu setzen, muss dann der Marktführer nicht mit seinen Preisen heruntergehen (was eben heisst, seine Deckungsbeitraege schmelzen weg).

    Und wenn das ein Zweiter schaffen kann, warum nicht auch noch ein dritter oder ein vierter Anbieter, so dass am Ende im Extrem die Grenzerlöse von what’s up = Grenzkosten sind?

    Was ich eigentlich fragen möchte ist folgendes:

    Ist es denkbar, dass eine Dienstleistung, die für kaum ein Geld angeboten werden kann, auf Dauer hohe Profite erzielen kann, gestützt nur auf die Markteintrittsbarriere “Netzwerkeffekt”?

    Oder kann man nicht als Alternativanbieter für die Nutzer die Incentives nicht einfach so gross werden lassen, dass sie zuerst mein Alternativprodukt als Back Up System und irgendwann als Hauptprodukt nutzen?

    Facebook hat StudiVZ schliesslich auch verdraengt, indem sie zuerst ZUSAETZLICH genutzt wurden und dann irgendwann HAUPTSAECHLICH.

    • alles berechtigte Punkte. Ich vermute auch ganz stark, dass mit dem reinen messaging vmtl. nicht da ganz große Geld verdient werden kann, aber wenn Whatsapp clevere Zusatzfunktionen darauf aufbaut sieht es schon besser aus.

      Klar könnte jemand jetzt versuchen das zu kopieren, aber das geht wohl nicht ganz so schnell, sonst hätten es viele schon gemacht….Was ist eigentlich mit ICQ ?

      mmi

      • It will be quite informative about Whatsapp’s future to know how many (%, millions) subscribers after one year have really been billed $1.00. no one of my 100’s of colleagues on the service has been so far. the company is also rejecting advertising. so how is it going to make money?

        and as Halil above mentioned, the barriers to entry are from very low to non existent. Whatsapp has just 55 employees, it won’t be difficult to assembly a similar team, get some (minor) funding, develop and give away the service for free to as many subscribers as possible as quickly as possible and then ……. sell yourself to the highest bidder (msft, goog, appl,..). that seems to be the “business model” these days.

    • The problem could be: One reason to switch to another messaging app could be privacy concerns (encryption).
      As Halil put it, one would use it additionally, for the contacts who also use it, and WhatsApp for the rest who still doesn’t.
      To turn over 2.5 bn USD just with the annual fee for the app, you would need more than a third of the world’s population as (permanent) customers.

      • You are certainly right if Whatsapp will remain asimple messaging service forever. But if the transforminto something else,everything is possible. Of course, they can be out of business in 3-5 year, or they are a kind of “new style communciation” company dominating global communication by doing much more then messages.
        mmi

  • Whatsapp will become one of the ‘toll houses’ through which lots people (1, 2, 3 billion?) will get their content (a filter on the world — very necessary in this information world) and will make transactions.

  • Whatsapp is already allowing sites to add whatsapp share buttons, allowing you to share content to 1 friend or a group of friends (not possible with SMS, Facebook or Twitter).
    These friends are mobile contacts from your phone… No need to friend them, follow them,… Just install whatsapp.
    Whatsapp will also become a platform for payments, again from your own personal mobile phone.
    Lollapalooza is the right word!

  • my 5-cents opinion:
    1/ if the cost of setting up a service for 100’s of millions of participants is so low, what prevents others imitating it?
    and
    2/ participant / subscriber loyalty is nil, and the cost of switching over to another service is also low, no network effect here, no stickiness!

    at any rate, i do agree with your thesis that WhatsApp is NOT a social media platform.

    • fair points BUT: It is much harder to get people to switch from one established platform to another now. Why should people switch ? The cost of setting up another 100 mn user service now is much higher with Whatsapp already there. This is the trick.

      re 2/: Yes, for the time being correct. But with the currently low revenues, there is no incentive to create another service. This is trick number 2. In the meantime, Whatsapp can add a lot of other stuff to make it sticky.

      • we are running a 30-engineer $2.5m p.a support business using whatsapp messages on mobiles, no sms, no phone calls. it costs $1 per engineer per annum. it will take us a couple of hours to switch to any other platform, if they start charging comparable to telco sms services. as far as i can judge, whatsapp is running a charity not a business.

    • By the way, here is an interesting comparison between Whatsapp and 2 competitors (german)

      http://www.chip.de/news/Kostenlos-sicher-WhatsApp-Alternative-Telegram_67762315.html

      I am not sure if I would prefer Russian servers……

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