I'll trade my two $50K cats for your $100K dog

Michael Arrington thinks Photobucket was a steal at $250 Million versus YouTube for $1.65 Billion. Maybe...and maybe not. It is hard to apply standard valuation metrics to these companies with free services and very little revenue. Michael lays out comparisons between the two deals that seem logical.

I grew up in Maine, and I am reminded of the negotiations between two farmers from Maine at the county fair. One farmer was showing off his "blue ribbon" dog and proposing to sell it for $100,000. The other farmers were laughing hysterically at the idea of a $100K dog. Dogs don't produce income. How could a dog be worth $100K? Then one farmer stepped up and offered to trade two of his $50,000 cats for the $100K dog. The dog owner quickly agreed and bragged to all his friends how he sold his dog for $100K.

Acquisitions that are done as stock swaps are obviously not the same as cash transactions. Public companies often use their stock as trading currency for acquisitions since it has no cash impact on their business. However, stock transactions dilute the value of other shareholders, sometimes significantly. In a rising stock market no one really notices because the steady share price increase masks the dilution. When the stock market turns the problems are exposed...and magnified.

It will take several years to see how these acquisitions really work out. Success depends on how the new owners leverage the new properties, find synergies with their existing products and services, and monetize the user traffic. The value of acquisitions is always about what you can do with them in the future, in the context of your business, not about applying standard multiples to existing revenues and profits.

The concepts of synergy and leverage are simple enough to understand. Translating those concepts to $250M of bottom line profit, or $1.65B, are not so simple. Top tier Internet growth companies can make about 33% profit on each dollar of sales. So, triple the acquisition price to get to the revenues needed to break even. It is a tall order for free services layered on top of other free services.

At some point the end user of all these free services is the same user and they can't be monetized any further no matter how many new services are added. Advertisers will eventually figure this out. Ad rates will drop. Revenues will drop...and stock prices will drop. It is all about the stock price. No one cares about real revenues and earnings as long as the stock price is high.

When stock prices drop everyone along the chain starts to rethink their assumptions about value and ROI. The changes ripple all the way back up the food chain. The individual stockholders get more conservative and move out of bubble stocks. The Internet companies stop acquiring because their stock price has deflated. The entrepreneurs stop agreeing to acquisitions because the rewards are less. The VCs stop funding new startups because the risk/reward ratio doesn't work.

We have seen this before. It was the nuclear winter that lasted from 2000 to 2003. It is amazing how quickly we forget. As I always say "fear is temporary...greed is permanent".

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Comments

[Abraham Sultan]

Don well said,

This nonsense has to stop at some point.

Abe

[Fareed]

People said this about Fox's myspace acquisition as well. However, by all accounts, that acquisition has already turned out incredibly profitable.

[Prashant]

Great Post Don , you are right that a limited user base can't be monetized further beyond a certain limit and all this web2.0 companies are almost on the verge of reaching that limit

[Tahir]

Nice post Don.

IMO, Photobucket is lucky for being acquired and 250M + 50M really is a nice deal for a site like Photobucket.

YouTube deal is completely different. Video is much more interesting and striking than pictures. Plus you can look at a picture less than 3 secs however videos are usually much more longer. It is much more convenient to add video ads to video content.

[Alfred Chew]

This is the legitimate way to 'rob' the investors!

[Alfred Chew]

This is the legitimate way to 'rob' the investors like you and me!

[vishal]

Very very well said