Understanding Facebook's $2 Billion Virtual Reality Bet

After a difficult start to the week, U.S. stocks rebounded on Tuesday, with the benchmark S&P 500 ended Monday's gaining 0.4%. The narrower Dow Jones Industrial Average rose 0.6%. The animal spirits are out there: Witness Facebook's latest acquisition, a $2 billion deal for virtual reality specialist Oculus -- it's been little more than a month since Facebook announced it was acquiring messaging application WhatsApp for $19 billion.

What does Oculus do?
Billing itself as a "the leader in immersive virtual reality technology," Oculus has yet to release a consumer product -- its virtual reality headset is still at the prototype stage; however, it has already received 75,000 development kits for the headset to games developers. The technology is genuine; in fact, judging by some of the following user reactions, it's very realistic, indeed. (Warning: the video contains some profanity.)

Is Oculus profitable?

Probably not. Facebook Chief Financial Officer David Ebersman told investors and analysts on a conference call today that the acquisition wouldn't have a material impact on Facebook's revenues, as one might have expected.

Speaking of profitability, how much is Facebook paying exactly?
The total deal consideration is roughly $2 billion, but only $400 million of that sum is in cash, with the rest in virtual money, er ... Facebook shares (23.1 million of them, to be exact). Finally, the acquisition agreement also provides for an additional $300 million earn-out in cash and stock contingent on achieving certain performance milestones.

What is the significance of the deal?
According to Facebook CEO Mark Zuckerberg, Oculus has the potential to be "the most social platform ever," or as as game developer Daniel Ratcliffe quipped on Twitter:

I'm with Zuckerberg though; there's nothing more social than sitting in a chair with a device on your head that blocks out all sensory input

— Daniel Ratcliffe (@DanTwoHundred) March 25, 2014

Indeed, this acquisition is a bit of a head-scratcher, at first glance -- the synergies between Facebook's social mission and Oculus' virtual worlds are far from obvious. However, the key to understanding the deal -- or at least understanding Facebook's rationale for doing it -- appears to lie with the concept of platform. For the social network, mobile is currently the key platform, having overtaken the PC, but Zuckerberg is looking ahead, trying to determine what the next dominant platform will be. He thinks that platform is virtual reality, ergo Facebook must shape development in this area. Buy or build? In this case, Facebook felt Oculus had a sufficient lead that it made more sense to buy.

By the way, Zuckerberg is clearly looking beyond gaming for applications of virtual reality technology, "including communications, media and entertainment, education, and other areas." All well and good, but this is a highly speculative acquisition, at least in terms of Facebook's "moon shot" ambitions. No-one knows what direction virtual reality will take or what sort of acceptance it will ultimately achieve, but Facebook/Zuckerberg are willing to place billion-dollar bets with long odds because they appear to have a something of a paranoia about missing the next big thing (in Facebook's business, that sort of paranoia can be useful).

As such, I think this acquisition ought to be allocated to Facebook's "experimental" budget and is comparable to that of robot maker Boston Dynamics by Google. In short, who knows whether it will ever pay off, but the technology is pretty cool and it could end up being huge -- do you really need a better reason to spend $2 billion?

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The article Understanding Facebook's $2 Billion Virtual Reality Bet originally appeared on Fool.com.

Alex Dumortier, CFA, has no position in any stocks mentioned. The Motley Fool recommends and owns shares of Amazon.com, Facebook, and Netflix. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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