Facebook Proves It Can Be Smart to Overpay for Acquisitions

(Bloomberg) -- Walmart is trying to solve its online problems with a $3.3 billion acquisition that can't be justified with any conventional financial analysis. 

But for validation of its deal splurge, the folks in Bentonville, Arkansas, can look west to Menlo Park, California. There, Facebook CEO Mark Zuckerberg made three overpriced acquisitions that turned out to be the smartest moves the company ever made.

Facebook has struck a collective $22 billion worth of acquisitions for Instagram, WhatsApp and Oculus. Facebook issued 279 million shares -- or 10 percent of the company's total outstanding shares as of July 25 -- for three companies that barely had revenue, let alone profits, at the time of the acquisitions. Oculus didn't even really have a product for sale when Facebook agreed to buy the virtual reality startup in 2014. When Facebook agreed to pay up to $19 billion for WhatsApp, the deal was so surprising and costly that some people thought the initial acquisition announcement might be a hoax.

Facebook's trio of deals makes Walmart's spending 1.4 percent of its stock market value for Jet seem sane -- as though Walmart bought a sensible Hyundai after a careful reading of Consumer Reports, while Zuckerberg went out for a gallon of milk and happened to come home with a fleet of Ferraris.

Yet Facebook's acquisitions have since become foundations for the company's user growth and strategy long into the future. Facebook now has four products with at least 500 million monthly users. Two of those are the acquired Instagram (500 million monthly users) and WhatsApp (more than 1 billion at last disclosure in February). 

Of the three, Instagram is the only one that so far has started to carry its weight financially. Research firm MoffettNathanson has estimated Instagram's yearly revenue could reach $3.7 billion in the next few years. Instagram also is Facebook's best chance to blunt the threat from teen favorite Snapchat. The sales and the competitive parry have already more than justified the Instagram purchase. 

Oculus is on its way to sanity status, too. The company started selling its first virtual reality headset this year, and Cantor Fitzgerald estimates VR could account for roughly 10 percent of Facebook revenue by 2020. 

For the moment, Facebook has been appropriately cautious about squeezing money from WhatsApp. The smartphone calling app has dropped its tiny subscription fee which was WhatsApp's only source of revenue. Executives have talked in broad strokes about how WhatsApp could make money by connecting businesses with their customers Delta, for example, might pay WhatsApp to contact frequent fliers left stranded by Monday's flight-system glitch For a glimpse at the financial potential of WhatsApp's audience, if the app started making one-tenth of Facebook's current average of for each user, WhatsApp could churn million in yearly sales. 

Of course, the ink is barely dry on Walmart's acquisition contract with Jet, and it remains to be seen whether Walmart has the same acquisition wisdom as Facebook. Plus picking the right deals is only half the battle. The other trick is what happens after the purchase, when the buyer has to integrate a new company's operations with its own or let it carry on with relative independence. 

Facebook has opted for the light integration approach.

It basically set up Instagram, Oculus and WhatsApp as independent fiefs inside of Facebook. Even now, Instagram is the only one of the three that is even marginally part of Facebook's broader advertising sales machine. Based on Walmart's early comments about its Jet deal, the big box retailer plans to leave Jet as an autonomous island and seek to harness Jet executives' experience in e-commerce to help cure Walmart's decades of incompetence in online shopping. 

There's an axiom of dealmaking that most corporate acquisitions aren't worth it. But it's interesting that both Google and Facebook -- arguably the two most ascendant of the tech superpowers -- turned acquisitions that looked like expensive head-scratchers into foundations of their tech empires. Just as it would be hard to imagine Facebook without its trio of deals, Google wouldn't be Google without its purchases of DoubleClick and YouTube.

Walmart is all about encouraging shoppers to hunt for good prices. But sometimes expensive deals wind up looking incredibly smart. 

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

1. The count of issued shares includes restricted stock doled out to employees of the acquired companies. 

2. I'm less sanguine about Google's priciest purchase, its billion deal for Motorola struck in its more recent purchase of thermostat maker Nest Labs. 

To contact the author of this story: Shira Ovide in New York at sovide@bloomberg.net.

To contact the editor responsible for this story: Daniel Niemi at dniemi1@bloomberg.net.