Mark Zuckerberg, value investor: James Saft

Thu Feb 20, 2014 4:38pm EST

Mark Zuckerberg, Facebook's co-founder and chief executive during a Facebook press event in Menlo Park, California in this file photo taken April 4, 2013. REUTERS/Robert Galbraith/Files

Mark Zuckerberg, Facebook's co-founder and chief executive during a Facebook press event in Menlo Park, California in this file photo taken April 4, 2013.

Credit: Reuters/Robert Galbraith/Files

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(Reuters) - So now we know: Mark Zuckerberg is a value investor.

That's true, at least if you accept his logic, which lays great emphasis on the sheer scale of users of mobile messaging company WhatsApp, which Facebook is buying for an astounding $19 billion.

"WhatsApp is on a path to connect one billion people," Zuckerberg said in announcing the deal. "The services that reach that milestone are all incredibly valuable."

Zuckerberg's Facebook update about the deal only mentioned two numbers (neither of them with a dollar sign in front): WhatsApp's current 450 million active users and the aspirational one billion.

So on the basis that this is all about scale, we find that Facebook, the current market valuation of which works out to about $140 per active user, is paying roughly $40 per WhatsApp client.

See what I mean, value. Maybe even deep value in the somewhat askew world in which Zuckerberg operates.

Now, to be clear, I think this is a crazy valuation. WhatsApp is said to be profitable, but its only revenue source is a modest annual $1 subscription which only is levied after a year of free use. Even if it gets to that billion and even if they all pay up, that means it will take Facebook more than two decades to earn that $19 billion back. And opportunities for other income are limited by a (for now) vow not to sell advertisements or user data.

But seen from Zuckerberg's point of view, the deal makes a certain bizarro world kind of sense.

Zuckerberg has, incontrovertibly, two assets going for him: a company and a currency. The company, Facebook, is profitable but vulnerable. The currency, Facebook shares, is unbelievably strong, astoundingly over-valued.

And it is not just that Facebook's franchise, which allows it to make a slender profit, is vulnerable - to new entrants, to teenagers who rightly want to avoid the likes of me - the currency is a massively leveraged bet on that franchise.

The market says Facebook is worth more than $170 billion, or about 110 times trailing earnings. Any hint, not just of displacement by other products, but simply of less rocket-fueled growth, and that currency is going to go down very quickly.

A MAN POSSESSED OF A VALUABLE CURRENCY...

A man possessed of a currency which is very valuable but likely to go down quickly in the face of competition is quite right to use that currency to buy cheaper things, especially the competition. That's particularly true if that valuation isn't moored to a genuinely rational view of future profitability, but rather to the perception that Facebook has a special or unique franchise.

It is much harder, however, to view Facebook as unique if a company like WhatsApp can come along and build another one-billion-user operation in a few short years. Just as 19th-century investors, faced with the innovation of the railroad, made bad decisions because they failed to see that railroads wouldn't just change the world, they would change the world for other railroads as well, so may we be failing to recognize that Facebook, or WhatsApp, may look in several years like just one of many such outfits.

Benedict Evans, of Andreeson Horowitz, a Facebook investor, says in a blog post the correct question is not about the $19 billion sticker price but rather "is this worth 10 percent of Facebook?" (here)

I think that is exactly right, but I come to a different conclusion.

The deal is mostly in shares and as such we should all be aware that this rough $40 per user (or $19 per user at one billion) figure is purely notional. It is not simply that the number of users may go up or down, so may the currency.

Scale that currency back enough and the deal starts to make sense.

My larger sense is that Zuckerberg, having identified the phenomenon that big networks command big prices, is trying to buy up the competition. That, strangely, is an acknowledgment that innovation is a threat and a bet against future innovation.

Both things can't be true.

Zuckerberg, trapped in a bubble not of his own making, is executing the standard plays.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at jamessaft@jamessaft.com and find more columns at blogs.reuters.com/james-saft)

(James Saft is a Reuters columnist. The opinions expressed are his own.)

(Editing by James Dalgleish)

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