Case Study IV PDF

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The case study provide information regarding acquisition of WhatsApp by Facebook and answers several questions....

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Case Study IV

Facebook’s acquisition of WhatsApp: The Rise of Intangibles

Facebook’s Acquisition of WhatsApp 1. What array of reasons possibly prompted Facebook to want to buy WhatsApp?

While it is not formally identified, Facebook’s interest, and ultimate acquisition of WhatsApp can be linked to Facebook’s consistent pursuit of control over the greater social media space, and to mobile specifically.

While Facebook dominates the US mobile app market for iPhone and Android operating systems, WhatsApp was growing steadily and consistently with its percentage of market reach, and surpassed common applications which included Pinterest, Tumblr, and FourSquare.

Another key attribute that compared WhatsApp, to Facebook’s Messenger app, where WhatsApp users were sending 8.2B messages per day, which more than doubled Facebook’s Messenger, accounting for 3.5B. This according to statistical research company Onavo. While WhatsApp drew users from the same pool as Facebook, they showed that even despite not having the market reach of Facebook, they were demonstrating that they were able to steal their user and thus market share in the mobile space. Similar messaging apps (WeChat, Viber, Kik, Line) during this period were also showing promising signs of growth, and in some instance’s growth in Asia, this likely lead Facebook to a feeling of vulnerability. WhatsApp had a very strong presence in developing countries, paired with Facebooks strategy of bringing subsidized internet to developing locations, they would be able to establish themselves in a first to market scenario. 2. What did Facebook actually get from buying WhatsApp?

From the WhatsApp acquisition, Facebook gains increased mobile connectivity. With their focus on mobile, this was a strategic move for Facebook to bring connectivity to the world. Their Messenger application did not provide the expected success that they anticipated. WhatsApp current replaces SMS communication, which currently dominates the mobile market in many countries worldwide. With this increased global market presence, with the acquisition, Facebook gains the fastest growing company in terms of users, since it managed to reach 419M users in just 4 years, and it is estimated that close to 1M users join WhatsApp daily, which would add to Facebooks growth. Further focusing on growth, WhatsApp at the time of the acquisition was purely a mobile platform, which is the primary way of communication. This takes Facebooks mobile communication to the next level with the WhatsApp integration. Through this communication, engagement on WhatsApp is what sets them apart from their competitors, it is estimated that 70% of WhatsApp’s users, use the application every day, and send around 1,200 messages per month. This indicates that for 70% of WhatsApp users, it is their primary messaging/communication platform, and in developing locations replaces SMS messaging. This made WhatsApp the only other application that had more engagement and a higher percent of people using it daily than Facebook. By leveraging the WhatsApp acquisition, Facebook gains an extremely engaged global user base. By integrating the WhatsApp data, with Facebook’s data, Facebook can learn more about their existing users, and new users than ever before. With this information, Facebook possesses the ability to carry their mobile advertising from Facebook, into WhatsApp, leading to what could be staggering monetization numbers. WhatsApp provides what many would agree is the richest

messaging source outside of standard SMS text messaging, and if integrated correctly will give Facebook an invaluable data source for its advertising business. 3. How might the $19 billion purchase price have been derived? When Facebook acquired WhatsApp in February of 2014, there is no doubt that the purchase price of $19 billion shocked many investors, even the experts. At that time, it was a small company of only 55 employees, and they were not even making a profit. WhatsApp does not use advertisements as a source of revenue, and while they do charge users a $1 per year subscription fee, the first year of subscription is free. At the time of the acquisition, the fair value was far short of the $19 billion price tag that Facebook paid. While current metrics may not value WhatsApp near the $19 billion purchase price, Facebook likely looked at many other non-financial metrics to derive this price. In only 5 years, WhatsApp had 450 million users and was noted for gaining 1 million users every day. This rate of growth exceeded the competition. Even if growth rates slowed and user retention was not at 100%, there was an upside to having over 1 billion users paying $1 a year for a subscription in only a few short years, generating over a $1 billion dollars in revenue. While there are costs associated with the service provided, these trends show that there would still be substantial revenue to generate a good profit. The purchase price also took into consideration Facebook’s desire to acquire a potential competitor in the social media space, as well as the primary competitor of SMS. WhatsApp’s users were shown to be more active than just about any other social media or messaging app that was in the market. Facebook saw added value in acquiring WhatsApp due to the international market that WhatsApp had already held. These additional characteristics of WhatsApp were valuable to Facebook, and created future opportunities for growth and profit, which is how the $19 Billion purchase price was derived.

4. Given the information in Exhibit 3, what summary accounting entry was made on Facebook’s books to record the WhatsApp deal’s closing using the amount to be entered into the Additional Paid in Capital (APIC) account as the amount (i.e., the “plug”) to make the entry balance? During Facebook’s acquisition of WhatsApp, the fair value of all tangible and any identifiable intangible assets are booked, as well as any liabilities that are being assumed by the new owner. In a case where the purchasing price is equal to the fair value, the fair value would be booked. However, most acquisitions are made in order to increase the value of the combined firms, and therefore the purchase price paid is often greater than the fair value of the acquired company. In this case, the difference between the purchase price and the fair value is booked as goodwill and is necessary in order to maintain balanced books. As stated in the case, “Goodwill from the WhatsApp acquisition is primarily attributable to expected synergies from future growth, from potential monetization opportunities, from strategic advantages provided in the mobile ecosystem, and from expansion of our mobile messaging offerings.” In 2014, Facebook added approximately $17 Million in goodwill to their balance sheet, including the acquisition of WhatsApp, which ideally will lead to future growth and profit for the company. 5. What specific ways did some key financial ratios differ for Facebook for 2013 vs. 2014, and what sort of performance pressures did those differences point to? Since Facebook’s IPO went public in 2012, the company has recorded double-digit Revenue, percentage increases each year. Despite the acquisition of WhatsApp in 2014, revenues continued to increase from 2014 to 2015 by 44%, which is an indicator that the acquisition did not have a negative effect on Facebook’s net worth. Earnings per Share increased by 83%,

between 2013 and 2014. When Facebook agreed to purchase WhatsApp, the stock price soared from $68 to $77.56 per share. Needless to say, investors were very pleased with the increase in value. With a new subscriber base and a more worldwide position in the marketplace, Facebook’s Net Income increased by 96%, between 2013 and 2014. The increase was just another indicator of how these synergy’s worked well together. Facebook’s Return on Equity increased by 3.6%, which measured how well Facebook used investments to generate earnings growth, after the acquisition of WhatsApp.

Following the acquisition, Facebook’s stock and other intrinsic values increased. However, we must be mindful that there are so many mobile messaging services, many of whom are crossplatform, WhatsApp might not be able to get enough paying customers into its fold, which makes it's rather difficult to justify such a large price-tag, paid by Facebook. So at some point in the future, Facebook will have to introduce ads to WhatsApp to make the acquisition incremental to its earnings.

Are there dangers in this deal? Of course! First, it is possible (and perhaps even probable) that the market is over estimating the value of users at social media companies across the board. However, Facebook has buffered the blowback from this problem by paying for the bulk of the deal with its own shares. Thus, if it turns out that a year or two from now that reality brings social media companies back down to earth, it might be fair to say that Facebook would have overpaid for Whatsapp. Second, as social media companies move up the life cycle, the variable(s) that even traders user to price companies will change from number of users/user intensity to revenues, earnings and cash flows. When that happens, there will be a repricing of

social media companies, with those that were most successful in turning users into revenues/earnings being priced higher. The problem for companies (and investors) is that these transitions happen unpredictably and that markets can shift abruptly from focusing on one variable to another. For Facebook, the path to success with this deal is therefore simple, albeit not easy. Start by trying to attract Whatsapp users to the Facebook family and hope and pray that the market's focus stays on the number of users for the near term. Follow up by trying to monetize these users, with advertising revenue being the obvious front end but perhaps other sources as well.

6. How will the intangible assets that Facebook acquired in the WhatsApp deal be accounted for going forward? With Yahoo purchasing Tumblr and Microsoft purchasing Skype, Facebook’s acquisition of WhatsApp, was strategic and placed the company ahead of the competition. Each of the aforementioned acquisitions, were considered companies that were not generating a profit, but these moves were necessary for the growth of each of the acquiring companies. The most notable change in Facebook’s Balance Sheet from fiscal 2013 to 2014 was Goodwill, with a net change of $18 billion, after the acquisition. WhatsApp’s company brand name, solid customer base, good customer relations, good employee relations and any patents or proprietary technology represent the goodwill to Facebook. Another way to look at the acquisition, was to view it as an insurance policy for when Facebook ultimately wanes in popularity. However, Goodwill exists, such that when companies make acquisitions and pay a premium, they don’t have to register an immediate steep or excessive loss. Instead, they can just claim that they

bought something “intangible.” In the meantime, Facebook’s Goodwill will be tested for impairment at least annually and more frequently if certain indicators of impairment are present. Going forward, write downs could occur if, the company detects that the goodwill has become impaired, because it is not realizing the expected synergies from future growth, from potential monetization opportunities, from strategic advantages provided in the mobile ecosystem and from expansion of mobile messaging offerings. If the goodwill is written down, the losses from goodwill impairment won’t be tax-deductible.

As one can might imagine, this acquisition can raise some major problems down the road. In 2011, Hewlett Packard’s (HPQ) acquisition of Autonomy (software maker) for $11 billion, made headlines. One year later, HPQ and Autonomy had major issues and HPQ was forced to take a $8.8 billion earnings write-down as a result of a drastic overpayment for the asset and it also sparked a Department of Justice investigation. Facebook stock could suffer a similar fate if WhatsApp doesn’t start proving its value soon. However, Facebook has vowed to review WhatsApp’s goodwill annually, putting pressure on the messaging app to make itself worthwhile....