Snapchat, a widely popular mobile app that lets users send photos that automatically delete after a few seconds, has taken Silicon Valley by storm. Teens love the app, which now has more than 350 million photos sent each month. And Facebook (NASDAQ:FB) , which is losing teens to trendier apps, just tried to acquire the fast-growing app for $3 billion in cash last week.
Surprisingly, Snapchat management spurned Facebook's offer. It also rejected a tempting investment proposition from Tencent Holdings (NASDAQOTH:TCEHY), which could have valued the company at $4 billion. Now, even Google (NASDAQ:GOOGL) could be considering taking a run at Snapchat. Clearly, Even Spiegel, Snapchat's 23-year-old co-founder, has an ambitious growth plan for its app, which does not generate meaningful revenue at the moment. But why do these tech giants want to buy Snapchat?
Why Facebook wants to buy Snapchat
First of all, Snapchat uses scalable technology, and therefore it can grow without Facebook's help. As Josh Brustein of Bloomberg Businessweek notes, new technologies are not dependent upon a strong platform to grow. However, to protect its leading position, Facebook has to compete on equal footing with each new communication app that comes along.
Furthermore, because Facebook already has more than one billion users, it faces increasingly expensive user acquisition costs, due to market saturation. Snapchat, on the other hand, is still at an early phase, with 26 million users in the U.S., according to a Pew Research Center study.
Note that Snapchat's main demographic segment is users between 13 and 23 years of age, which use the app to send self-portraits. 80% of its users are located in the U.S., according to a conference talk given by Spiegel early this year.
This is probably the strongest reason why Facebook wants to buy Snapchat. Rumors that Facebook is no longer perceived as "cool" by young teens, as nowadays even grandparents are on Facebook, have kept investors worried. By targeting a specific demographic segment and providing teens with a comfortable space, Snapchat has built a strong and highly engaged user base in Facebook's weakest demographic segment.
Why acquisitions hardly ever create value
Investors should keep in mind that acquisitions hardly ever create value for shareholders of the acquirer company. That's what Kengelbach and Roos, from Boston Consulting Group, found after analyzing more than 26,000 transactions.
Particularly in the tech world, acquisitions tend to hurt the acquirer more, because the industry is accustomed to see expensive premiums. In the case of Snapchat, although users are engaged, and there is a growth story in motion, the app does not generate meaningful revenue. It does not run ads, making conversion power remain uncertain. Furthermore, according to TechCrunch, if Snapchat were to go public and try to achieve a $3 billion market value, it would face a revenue deficit of almost $88 million.
There are great exceptions
Google's acquisition of YouTube for $1.65 billion in stock became a great success story. For a relatively low price, Google acquired a market leader. The video sharing service was estimated to have generated $4 billion in revenue last year. Just consider that the average top 1000 YouTube channels make $23,000 per month in ad revenue.
However, Google has also acquired several start-ups that failed to become an important source of revenue. Due to the heavy risks involved in acquisitions, investors could find interesting focusing on holding companies specialized in tech investments, like Tencent Holdings, which has more than 15 years of experience identifying and building valuable apps, and owns a diversified portfolio of social networks, web portals, e-commerce and multiplayer games.
Tencent saw its net profit rise 20% recently due to higher advertising and gaming revenue. One of its latest ventures, mobile chat service WeChat, is on its way to become a global communication platform, with more than 100 million users outside of China. Tencent is already using WeChat to generate indirect revenue, by driving traffic to its e-commerce sites.
Foolish bottom line
By targeting a specific demographic segment and understanding its unique needs, Snapchat has managed to become amazingly popular among teens. This segment is particularly active on the net. Furthermore, companies that provide general services usually find the segment challenging, because teens want to own their own space.
However, the power of Snapchat as an advertising platform needs to be proved. Because the company is not generating meaningful revenue, and because its targetable audience is smaller than Facebook or WeChat, a $3 billion valuation is hard to justify at the moment. Perhaps this is why many investors saw a sign of desperation in Facebook's Snapchat offer.