Facebook's (NASDAQ: FB ) $1 billion acquisition of Instagram looks rather small compared to the $19 billion paid to acquire WhatsApp. While both acquisitions have large user bases, Facebook has paid bubble-like premiums and is in serious danger of facing the same problems of Yahoo! (NASDAQ: YHOO ) during the first dot-com bubble, something peers LinkedIn (NYSE: LNKD ) and Twitter (NYSE: TWTR ) have thus far avoided.
Don't forget history
Those who don't know history are doomed to repeat it. – Edmund Burke
During the dot-com bubble and burst of 2000, Facebook CEO Mark Zuckerberg was a 14-year-old high school student, and was most likely more concerned about programing or code writing than he was about economic events. It's understandable that the dot-com bubble is not fresh on his mind.
The dot-com bubble was caused by many factors, mostly greed, but a lot of excitement regarding a new industry being built on the web. As a result, private equity funds and other financiers were willing to make big investments in unproven companies, followed by banks willing to take them public. The demand was high, so initial investments and underwriters could be rewarded in a short period of time.
The government also played a role in the dot-com bubble. Low interest rates in the late 1990s helped to boost capital investments, but in 2000 the Fed raised interest rates several times. As a result, the economy grew slower, investments were more modest, and dot-com companies with zero earnings began to run out of money.
Essentially, dot-com companies of the late 90s lived with the motto, "get big fast," ignoring the need for monetization and hoping to capitalize on growing subscribers and users. With the demand that was present, there seemed to be no need to start generating revenue quickly. The problem was that none of these models had been put to the monetization test, and when they were, many failed.
No company knows better the struggles of the dot-com era than Yahoo!. The company acquired many dot-coms during this era, but the two biggest were Broadcast.com and GeoCities. Broadcast was supposed to take online media and radio to a new level, and Yahoo! bought it for $5.7 billion. GeoCities was a web-hosting service, and Yahoo paid $3.5 billion for it. Today, both companies are shut down. Acquisitions such as these helped push Yahoo! shares north of $100 before dragging it back down to below $5.
$19 billion isn't just a number, it's a lot of money!
Facebook is not buying businesses with fundamental growth -- it is investing in eyeballs, or users, in hopes that such acquisitions can remain "cool" and that future monetization can support inflated valuations.
In many ways, Facebook's actions can be traced back to a young Yahoo!. Facebook is making large investments in companies with "get big fast" mottos, while a low interest rate environment has helped to boost initial investments and valuations of such companies prior to Facebook's acquisition. Perhaps most damning of all, Facebook is buying companies with unproven monetization strategies -- WhatsApp is believed to have generated just $20 million in revenue last year.
Instagram and WhatsApp might seem cool today, but what happens when both platforms are filled with advertisements, or if Facebook is forced to boost the annual charge of WhatsApp services? The answer is unknown, but eventually, Facebook must fundamentally support the high-priced acquisitions. If it does not, its stock will most certainly suffer.
Age has to play a role
When we look at Facebook's two main peers, Twitter and LinkedIn, we see something very interesting as to how each is doing business.
Twitter is grossly overvalued, trading with a $30 billion market cap despite not yet producing $1 billion in annual revenue. Like WhatsApp, we could ask the question of whether its market cap will ever be supported by fundamentals. Given its slowing user growth, that answer might very well be no.
LinkedIn generates about twice the revenue of Twitter and has a smaller market cap at $24 billion. LinkedIn is profitable, having operating margins of 3%. But it's not the fundamentals and valuation of these two companies that are most interesting; it's that neither has felt obligated or inclined to match Facebook with multi-billion dollar acquisitions.
A speculative reason: Twitter and LinkedIn's founders Jack Dorsey and Reid Hoffman are 36 and 46 years old, respectively, and likely remember the dot-com era vividly. Therefore, unlike Facebook, both LinkedIn and Twitter may fall if this bubble bursts, but it won't be due to multi-billion-dollar acquisitions of start-ups.
In many ways, Facebook looks like the Yahoo! of 1999-2000. Both appeared invincible and made acquisitions that could only be explained in the moment. Both Yahoo! and Facebook have used stock to fund acquisitions.
Investors tend to rationalize such acquisitions by noting the valuation and growth of Facebook without WhatsApp or Instagram. These investors must realize that Yahoo! was a near-$100 billion company at the peak of the dot-com bubble, but its collapse dragged its valuation down to around $5 billion.
Today, Yahoo! looks well-positioned to capitalize on the insanity. Yahoo! is taking advantage of the high demand for fast-growing Internet companies like Alibaba -- valued at $150 billion -- and a mind-set it did not possess in the early 2000s. Yahoo!'s ownership of Alibaba alone will likely create tens of billions in cash, which shows that Yahoo! learned how to be a beneficiary of these premiums, rather than a victim. As a result, one might imply that Facebook's real upside comes after the collapse, perhaps when Zuckerberg is older, and can then look back and reflect on his youthful investment decisions.
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