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.
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).
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.
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.