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Yahoo! Inc. (YHOO), Facebook Inc (FB) & Billion Dollar Mistakes?

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Yahoo! Inc. (YHOO)The big news this week was Yahoo! Inc. (NASDAQ:YHOO)‘s $1.1 billion acquisition of micro-blogging site Tumblr. Tumblr has grown its user base rapidly since it was founded in 2006, and today the site has over 100 million registered blogs, which have posted a combined 50 billion blog posts. Web traffic is through the roof, with 184 million unique visitors per month and 12.1 billion page views. But there’s a problem – The Onion explains it well:

How do you monetize gifs of cats?

Tumblr is known for launching internet memes, pictures of cats, fan blogs dedicated to popular shows like Dr. Who, and an incredible amount of pornography. It doesn’t seem like an advertiser’s dream, especially with all of the alternative advertising platforms out there.

In 2012 Tumblr generated $13 million in revenue and has a goal of generating $100 million this year. The costs to run Tumblr in 2012 totaled $25 million, and this will obviously grow as the user base expands. If Tumblr had stayed independent my guess would be that the company would eventually run out of money and fail.

Yahoo has a history of big acquisitions that ultimately fail. In 1999 Yahoo paid $3.6 billion for Geocities, which at the time was a very popular site that allowed users to create their own websites. Geocities eventually lost popularity and the site was shut down.

What happens when people get annoyed by ads on Tumblr and move to another free service? That’s the problem with free services like Tumblr – the moment you try to monetize people get upset. Does Tumblr add $1.1 billion of value to Yahoo! Inc. (NASDAQ:YHOO)? I don’t think so. Tumblr may never actually turn a profit, and if it does it will likely be far too small to justify the price tag.

Following Facebook’s lead

This acquisition reminds me of Facebook Inc (NASDAQ:FB)‘s $1 billion purchase of photo sharing app Instagram. Instagram had no revenue, and still doesn’t, but Facebook Inc (NASDAQ:FB) will eventually introduce ads in an attempt to monetize the service. But can it possibly generate enough revenue to be worth $1 billion?

I don’t really like business models where a service is free and supported by ads. It requires maintaining a huge user base while preventing the ads from driving people away. This gets difficult when there are competing free services pulling some users who are sick of ads away. The service has to become so indispensable to the user, like Gmail for example, that people are unlikely to leave. Neither Tumblr nor Instagram has that kind of stickiness.

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