This week, Instagram CEO Kevin Systrom and CTO Mike Krieger split from Facebook (NASDAQ: FB). Shortly after, WhatsApp co-founder Brian Acton, who also left the social media giant, gave a public interview explaining why.
In this week's episode of Industry Focus: Tech, host Dylan Lewis and Motley Fool contributor Evan Niu explain why these start-up founders left the company, what this all says about CEO Mark Zuckerberg's management style, and what long-term shareholders should watch going forward.
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In happier news, Sirius XM (NASDAQ: SIRI) finally acquired Pandora (NYSE: P). Tune in to find out what this deal will mean for shareholders, what these companies are trying to achieve by joining forces, and why some analysts and investors are skeptical.
A full transcript follows the video.
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This video was recorded on Sept. 28, 2018.
Dylan Lewis: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It's Friday, September 28th, and we're talking about the marriage of two tech companies and a very public separation. I'm your host, Dylan Lewis. I'm joined on Skype by senior tech specialist, Evan Niu. Evan, what'd you think of that intro? A little drama, a little intrigue?
Niu: I like the marriage and the separation wordplay there.
Lewis: Yeah! I try to be a little quippy here. Today, we're going to be talking about the recently announced Sirius XM-Pandora deal, and the departure of Instagram co-founders from Facebook. Why don't we start out with the happy news? Let's talk about the matchmaker deal that happened. At announcement, Sirius said that it would be acquiring Pandora in an all-stock deal which would value Pandora at around $3.5 billion. I think this is something we can file into the "they finally did it" category.
Niu: Yeah. People have been speculating about this for a while. Sirius took a 15 or 20% stake in Pandora last year, so these two companies already have an investment relationship, and they're partnering. So, I don't think this really caught too many people by surprise.
Lewis: It was like those two friends that, will they, won't they, they finally do at the end of the sitcom special. I think everyone's happy about this on their end. The original deal terms had roughly a 14% premium. This is based on trailing stock price calculations. What's weird about this all-stock deal is, they set an exchange rate. This is the case with all all-stock deals. You have a certain number of shares you receive for each share you own of the company that's being acquired, but because of that, the value of the deal can swing as stock prices move. The math that they laid out in the original announcement that each shareholder for Pandora, for every share they own, would get 1.44 shares of Sirius XM. That works out to an equivalent of $10.14 per share. That meant that, at the time, Sirius shares were worth roughly $7 when they were crunching the numbers for this.
The problem here is that the market wasn't really thrilled with the deal. Sirius shares dropped 10% as a result. That throws off some of the calculus they did. Now, shares are down around $6.35, meaning that Pandora shareholders are getting $9.15 cents, roughly, in value for their shares. That's below what Pandora shares are currently trading for on the market. So, there's this wonkiness to it because it's an all-stock deal.
Niu: It's funny because Sirius' chairman had always talked about trying to buy Pandora at $10 a share. That's basically exactly what they're offering. When Pandora's value was much higher, it didn't really sound viable. But now, it actually seems like it could go through.
I think another thing that's also worth noting is that, generally speaking, the more stock that's included in a deal, it signals to the market that management is less certain, that the benefits will materialize. If you're really confident that the deal is going to create a lot of value, the best thing to do is offer all cash so that the acquiring company can basically keep all the value that's created from this deal in future. When you do an all-stock deal, you're essentially sharing the future upside or downside with the company you're acquiring, or at least the shareholders of the company you're acquiring.
That's like a general thing. Of course, there could be other factors like whether or not the company has enough cash to do an all-cash deal. In this particular case, Sirius definitely doesn't have $2.5 billion in cash on the balance sheet. They only have about $65 million. So, the only real alternative is either you take out a ton of debt to fund a cash deal or you offer stock, which is what they're doing.
Lewis: Yeah. We're focusing on the details here because this is something that could come to play with shareholder approval down the road. If the market price is higher than whatever deal is being offered, it could go through several rounds. It might just be that there's a large majority of shareholders that aren't happy with the deal.
I put out on Twitter that we were going to be talking about the Sirius-Pandora deal and got some questions from followers of the show. The first one comes in from Riley, who asks, "What redeemable value does Pandora even have? It seems like a bad move to buy an asset that does not make money." To Riley's point, Sirius is a profitable company that has about 30% operating margins. Pandora posts operating losses and does not even really have the excuse of being a high-growth company.
Niu: I've never liked Pandora. It's been kind of incredible watching them fail on execution for as long as I can remember. They've done basically everything wrong. They were a pioneer in online streaming music and they're so irrelevant today relative to the Spotify or Apple Music. Yeah, it is kind of questionable. What does Sirius see that they think will click for them?
Lewis: I think it comes back to this idea that they have roughly 30 million subscribers. Pandora has something north of 75 or so million. That combined 100 million number is a compelling group to market to.
Niu: I should point out that Pandora's 75 million, those are predominantly free users. They only have about six million subscribers. Sirius has about 33 million. It's kind of crazy. Sirius is profitable but they're not some high-growth business, either. They're also not where music is heading. For example, it's taken them seven years to grow from 20 million to 33 million subscribers. Seven years! Compare that to Spotify, Spotify now has 83 million paid subscribers, and they've added 50 million paid subscribers in the last two years alone. Where music is going is not generally toward Sirius or Pandora. And now they're just going to combine and hope that solves the problem. [laughs]
Lewis: Yeah, this seems like the type of consolidation that you would see as two people realize, like, "We need to band together and try to put our strengths together because the industry is moving past us right now."
Niu: Right. Exactly.
Lewis: If you're trying to make the case for this acquisition and why it makes sense, I have seen some points made that Pandora could become the free on ramp to Sirius. They could look at this group of 70 million or so people that are using Pandora regularly and try to build out the case for upgrading and up-selling to Sirius subscriptions. So much of the Sirius model right now is locked into auto sales and these trials that come with cars.
Niu: Yeah. We just bought my wife a new car last month. Sirius just keeps harassing me to renew my subscription, all the stuff that they've been doing forever. It's just so annoying. I've never been a fan of Sirius XM, myself, and will never subscribe.
Lewis: This idea is backed up by comments that we're getting from Sirius CEO James Meyer, some of the things he was talking about in the call here. He says, "As I've said many times, we would benefit from having a free funnel. When this transaction closes, we will have a scaled engaged user base of 65 million people who listen monthly to free ad-supported digital radio, which would give them this opportunity." But, to our conversation earlier, I don't know that this is really where the industry is going. I think Sirius already has its efforts in place to upsell people to premium. They get enough people on the car side. I guess this gets them outside of this market, but it's not a super compelling reason to me.
Niu: No, exactly. You can create a free funnel on your own for your service without spending $3.5 billion in stock. You can make a service for much cheaper than that using your existing distribution, your existing infrastructure, without having to integrate a whole other company into it. I agree with you. I don't really see that as a strong argument.
Lewis: Our second listener question comes from Chris. He asks, "Does the combination of Sirius XM and Pandora as a service package make them able to compete with Spotify, Amazon or Apple Music? I see the potential for them to stay relevant, but I think it is going to be hard." My immediate reaction is probably no.
Niu: I agree. Music is heading toward on-demand streaming. That's where it's been heading for many years. Pandora has been so late to get onto that boat. Sirius is not really on there, either. I don't really see them being all that relevant to where the music industry is clearly heading.
Lewis: It's kind of amazing, if you go back 10 years ago, and you say, "The industry is moving toward on-demand streaming music. You can pick two companies to bet on for who will be dominating this space in 10 years." I think it's probably Apple and Pandora, right? They had a huge presence. They were already where people were consuming this content. And both companies got blown by in the streaming space.
Niu: Like I was saying earlier, Pandora failed the execution for so long. Like you said, it's probably been 10 years. I agree, 10 years ago, I would probably say Pandora would be the leader in music streaming. But their unwillingness to ink direct licensing deals with record labels in order to expand internationally and offer on-demand music… They rely on this whole idea of statutory licensing rates. That basically limits them to the U.S. only. They were in Australia and New Zealand for a little bit, but they discontinued those operations.
They had this opportunity in front of them, first mover advantage. And they just completely squandered it by not seeing where the market was going and not knowing what to put in place to capture where the market was going.
Lewis: Of course, thinking about all this is not necessarily just a matter of Sirius and Pandora. Media conglomerate Liberty Media owns 70% of Sirius. That stake is controlled by John Malone and Greg Maffei, two folks that are titans in the media landscape and have done quite a bit to steer media where it is right now. They have a very good feel for the industry. I think there's a case to be made that if anyone's going to unlock value out of Pandora, maybe it's a John Malone type. But the best-case scenario that I can paint is that they can leverage the cost structure that Sirius has mastered and been able to make pretty decent money on with the audience that Pandora has. I think that's a long shot, though.
Niu: Yeah, I wouldn't bet on it. I don't think the odds are that great.
Lewis: News item No. 2: Instagram's co-founders are resigning. CEO Kevin Systrom and CTO Mike Krieger have decided to leave the company to build something else. What do you make of this?
Niu: They've stayed on at Facebook for about six years, which is actually a bit longer than most start-up founders stay when they're acquired by a larger company. There's always a large stock component in these types of acquisitions. The common vesting time frame is four years. So Systrom and Krieger stayed on about two years longer than that. So, there's some credit there. They didn't just jump ship immediately. And it is pretty for start-up founders to leave once their stock vests.
I think the really damning part of the story is less about the fact that they're leaving, and more about why they're leaving.
Lewis: And this all plays into Mark Zuckerberg's management. This is what we've seen countless headlines about this week — the role that the higher-ups at Facebook play when it comes to the properties that they acquire.
Niu: Right. What we've seen play out with Instagram was, when they were first acquired back in 2012, Zuckerberg made a vow to let them operate independently so they had this autonomy. But now, what we're seeing is, over the past couple of years, Zuckerberg has reportedly been exerting increasing control over Instagram. For example, we've seen a lot of these things in media reports, he reportedly decided to pull back Instagram's promotion within the core Facebook app, which hurt referrals and signups by hundreds of thousands of users per week. They removed a label that identified Instagram posts as such that were being cross-posted on Facebook, which made it appear like that content was being originally posted to Facebook instead of originally being posted to Instagram.
It might sound minor, but it really bothered Instagram because it made it seem like Facebook was taking credit for all this engagement that Instagram was creating, at a time when it seems increasingly like Facebook is desperate for engagement, trying to pull these levers to poke you more to get you to engage. Instagram's is more organic. And now they're taking credit for by not clearly labeling it?
There's no doubt that Facebook's deep pockets and back-end ad infrastructure had been instrumental in helping grow Instagram from about 30 million users when they were required to a billion today. But I think it's also clear that Systrom and Krieger were really crucial in creating that culture and product roadmap that got it there, too. There's a lot going on here.
Lewis: I think that's part of the reason why this is a little concerning for some folks. They were huge in creating what we know today as Instagram, this platform that has a billion users and is one of the fastest-growing, if not the fastest-growing social media platform out there.
Given that this is the future for Facebook, you can see that with the growth rates on the user side for their namesake platform, I think a lot of people are wondering, "What does that say about what we're going to be seeing on this platform going forward?"
Niu: Another thing that's going on in parallel is, this isn't the first time we've seen something like this play out. It's eerily similar to what we saw happen at WhatsApp. WhatsApp co-founder Brian Acton left last year. He came out in a public interview this week, just days after this Instagram news, basically saying the same thing. It was kind of a shocking thing, for him to come out so publicly in an exclusive interview with Forbes. He left last year, and be forfeited $850 million. But don't worry too much about him, he's still worth over $3 billion.
Lewis: Must be nice. [laughs]
Niu: His other co-founder, Jan Koum, left this year after his four years of vesting. Now, WhatsApp's co-founders have also left for basically the same reasons. They were initially promised autonomy and independence. Then Zuckerberg just came in and started meddling more and more in their business and strategy.
For WhatsApp, the conflict was even starker and arguably more predictable. Koum and Acton had always hated ads. They hated them with a passion. They were all about end encryption, user privacy, etc. Never wanted to monetize their messaging service with ads. But then they're bought by one of the biggest ad platforms on earth, and, I mean, what do you expect to happen? [laughs]
Lewis: I think the struggle here is, of course Mark Zuckerberg's doing some of this stuff, right? He has bought these platforms, and it's his goal to make the most out of them, and to monetize them and provide value for shareholders as the CEO. In some ways, he's given these people who he's acquired the freedom to run the product and not worry so much about monetization because he is the "Big Bad Wolf" that's begging for ads that's going to be the monetizer.
Niu: Right. Initially, he agreed that advertisements were not the right way to monetize the messaging service. But now that's exactly what he wants to do. But there's also been other conflicts about data sharing between Facebook and WhatsApp, similar to what we've seen with Instagram. There's always this tension of how much information and data is shared between all these platforms. Facebook wants as much information as it possibly can, through whatever means necessary. These other companies are trying to stand up for their users' privacy. That's what's creating these clashes with Zuckerberg.
For what it's worth, David Marcus, who now leads Facebook's blockchain research, previously was in charge of the next-closest service to WhatsApp, it was just Messenger. He used to be in charge of Messenger. He actually lashed out at Acton for publicly airing his grievances, calling him low-class and all these things, because Facebook made Acton a billionaire many times over. Marcus basically said, "Zuckerberg really does give these founders autonomy," and tried to defend Zuckerberg publicly. But, I mean, you tell me whose side is right. [laughs]
Lewis: [laughs] I think at a certain point, when you're willing to take the paycheck, and when you're willing to sell your company, you have to understand that it's going to lose some of the control you've had over it. You're not going to be able to have it be this dream product that you've always wanted to be, especially if you're selling to a publicly traded company. They have certain obligations to shareholders.
Niu: Exactly, of course. It's certainly within their rights, and they do create these obligations to investors, when they buy these companies, that they're going to create value out of it. It's certainly justifiable from their standpoint, as well.
I think the real risk here is that Facebook and Zuckerberg fumbled the execution of not only these two incredibly important properties, but also any potential acquisitions in the future. Facebook is very active in acquiring any upstart social media company that's growing well and Zuckerberg perceives as some type of threat. It really changes the dynamics of how any future start up that's approached with an offer is going to respond to an acquisition offer from Zuckerberg.
It's also worth noting there's a huge disparity in what Facebook pays for these companies. Keep in mind, the prices varied from the time of the announcement to the time of closing, due to the stock price fluctuations, like you mentioned earlier with the Sirius deal. Instagram was announced at $1 billion. They ended up closing it at about $715 million. WhatsApp was announced at $19 billion and ended up closing at $22 billion. Some $700 million vs. $22 billion, it's worlds apart.
Lewis: Which is amazing, and it speaks to the user bases that those platforms had at the time. I think Instagram had maybe tens of millions of people online.
Niu: 30 million.
Lewis: 30 million. WhatsApp had hundreds of millions.
Niu: It was like 450 million.
Lewis: That's a big part of it. But you look at those two different sticker prices, and you think about the value that has been extracted from those two platforms — Instagram has been a wildly successful acquisition. WhatsApp, a lot of that value has yet to be realized.
Niu: I think that's a big irony here. Instagram is much more promising because it's an actual business. Analysts are modeling for it to bring in something like $8 billion in ad revenue this year, despite being so much cheaper. Even right now, Facebook still isn't sure how to monetize WhatsApp, which has basically immaterial revenue, if any, right now, even though they paid these $22 billion.
I've been harping on this for years. At the risk of beating a dead horse, I still think Facebook will eventually eat a massive goodwill charge for WhatsApp because it paid so much and didn't really know how it was going to monetize and make money off this platform, build a business. For reference, over 80% of Facebook's current goodwill carrying value is directly attributable to WhatsApp.
Lewis: Just to back it out for people who don't know the concept, do you want to explain what goodwill is?
Niu: Goodwill is when a company pays a premium for another company. The company that's being acquired has a certain amount of book value on its balance sheet. Basically, the premium that you're paying over that book value gets quantified and accounted for as goodwill that you carry on your balance sheet. In the future, you basically need to say, "Hey, this deal was worth it," and then that goodwill just stays there. That goodwill is tested for every year. If it ever turns out that, "Hey, we paid way more than we should have," then the company has to eat a big charge to write down the value of that goodwill. That does get reflected directly on the income statement in the quarter in which it's recognized. So, they could potentially take a massive hit at some point in the future. I still think they will. I've been saying that for a few years, they still haven't. We'll see.
Lewis: This is something that you've written about quite a bit for fool.com, right, Evan?
Niu: Yeah, like every year. [laughs]
Lewis: [laughs] Yeah, just a refresher. If anyone wants that explained in text, something that they can follow on and read at their own leisure, write into the show. We'll be happy to send it along to you. Anything before I let you go, Evan?
Niu: Nope. I'm ready for the weekend!
Lewis: Alright, me too. Listeners, that does it for this episode of Industry Focus. If you have any questions or if you just want to reach out and say hey, you can shoot us an email at [email protected], or you can tweet us @MFIndustryFocus. If you want more of our stuff, subscribe on iTunes or check out The Fool's family of shows over at fool.com/podcasts. As always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against stocks mentioned, so don't buy or sell anything based solely on what you hear. Thanks to Dan Boyd for all his work behind the glass today. For Evan Niu, I'm Dylan Lewis. Thanks for listening and Fool on!
John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool's board of directors. Dylan Lewis owns shares of Amazon, Apple, and Facebook. Evan Niu, CFA owns shares of Apple, Facebook, and Spotify Technology. The Motley Fool owns shares of and recommends Amazon, Apple, Facebook, Pandora Media, and Twitter. The Motley Fool has the following options: long January 2020 $150 calls on Apple and short January 2020 $155 calls on Apple. The Motley Fool has a disclosure policy.
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