I remember the hype going into the Facebook IPO and how people were literally drooling over what was to be the seminal event to reinvigorate our financial markets, create wealth for thousands and cement Facebook as the success story of this generation. Well two out of three ain't bad.
Many thought of this as a "must buy" and "can't miss" opportunity to make money. Some were focused on long term capital gains but others looked for the fast IPO flip. The reasoning for the latter was "if LinkedIn took flight the first day then I can't wait for Facebook! Its going to take off!"
But it didn't. Not even, close.
In fact the dirty little secret of the 3rd largest IPO and largest technology offering in the US is that Facebook is barely trading at the IPO price. Up less than 1% from the initial offering price.
While some are running victory laps over the "perfect pricing" of the IPO where supply was almost magically aligned to demand the truth, as it often seems to be, is neither as simple nor as rosy as what people generally want to hear.
An alternative and potentially more likely story is that Facebook perilously teeters on the edge of a failed IPO where it could quickly find its shares trading below its initial offering price.
Even more scandalous is the notion that lead banker Morgan Stanley is artificially supporting the IPO price of $38 as a floor to avoid the potential negative stigma of a broken IPO and the strained relationships with large money investors who would feel like they had been taken for a ride that made them car sick.
I am not the only person who cautioned against investing in Facebook at the IPO but I am one of them. Why should you care? Because I am not the only person who recognized and marveled at its potential and sought to buy Facebook over seven years ago but I am one of them (see The Facebook Effect). So while I have been a Facebook fan and supporter for several years I recently jumped off the bandwagon when it came down to the IPO.
To me there are significant issues in three major categories: (1) wall street (2) business prospects (3) sentiment
Let's start with wall street:
As I have been telling people for the past couple months there would be no large first day pop here. Some people agreed. Some thought I was crazy but I will share the rationale I was using at the time.
- Supply and demand isn't a theory - it's a law. The corollary is that scarcity creates value and there was none here because of the number of shares offered in the IPO. The idea is that the company offers the supply of shares and the bankers generate or at least locate the demand for the shares from institutions. While LinkedIn was noted for its conspicuously small offering of shares in its IPO Facebook in contrast provided shares in volumes that were of epic and historical proportions. In addition the shares were available almost everywhere even retail via E*TRADE. (http://business.time.com/2012/05/08/facebooks-ipo-is-now-available-for-e-trade-retail-investors/) and were owned and heavily traded prior to the IPO. (http://www.businessinsider.com/facebook-valuation-surges-past-100-billion-on-private-markets-2012-2) More on both of those points later. The simple point here is that shares are no different than any other commercial good - the more you control distribution the more you control price. Of course, I think the banks had little control over price because...
- IPOs are just sloppy seconds for Joe and Jane Public. The game is already set by the time the IPO becomes available because the big money is already playing months before the IPO. IPOs used to be the gatekeeper for big money hedge funds and mutual funds to access hot private companies. No longer. Big money doesn't have to wait to trade. With the advent of second market and sharespost private company stock trading platforms there is now a backdoor available to wealthy individuals and large institutions. These exchanges essentially allow the stock to trade before the public can access the shares because of accredited investor rules. Ironically, the fact that the shares had been trading privately for the past year in a range within 20% of its current public trading price (http://www.insideipo.com/2011/09/there%e2%80%99s-nothing-cooler-than-a-trillion-dollars/) suggests that the private market already signaled pricing to the public markets well in advance of the IPO so the banks had very little flexibility with pricing without facing sharp questions from either the company or the investors.
- When Joe and Jane Public get invited to the party it says something about the party. Big money is the only group that matters in IPOs and arguably in the stock market generally. These are the people the bankers and company brass fly around to visit on their "road show". These are the people who are allocated stock at the IPO price before the stock even trades. In essence, the model is built around the big money institutions. Everyone else is allowed to play but not on anything approaching equal footing or rules. When you see shares available to retail then for me this is another challenging sign unless there is a statement up front about desire to include Joe and Jane Public. Big institutions are not known for their altruism so if you are seeing invites sent to Joe and Jane Public then they may need help with the cover charge or better yet the bar tab...
- MOST IMPORTANT: The valuation is just plain ridiculous. So we are talking about a company where their revenue is about half of what McDonalds makes in profit but is worth more than the American icon known for its low cost meals of questionable nutritional value? We are talking about a trailing P/E ratio of 100x and forward north of 60x. So Apple and Google are trading at about a third to a fourth of that. Strike one. Respected researchers and analysts are saying the company is overvalued. (http://video.cnbc.com/gallery/?video=3000090705) Strike two. In addition, business prospects are not looking like the slam-dunk you would need to see to feel comfortable at this valuation...
So let's look at the business prospects
- Revenue growth is slowing. Facebook is a phenomenal business in terms of its reach. But its revenue growth story has been largely theoretical. In reality, the company is already facing slowing revenue growth quarter over quarter. (http://www.businessinsider.com/facebook-ipo-2012-4) This Company should still be in hyper growth mode like Google was at a similar stage of its evolution to justify its valuation. More important to consider is that high P/E companies are based on high growth.
- Advertising is the core but is still a question. GM very publicly assailed the quality of Facebook ads and withdrew $10 million in ad budget in a manner and timing that suggested extreme displeasure with the leading social company. (http://www.forbes.com/sites/joannmuller/2012/05/15/gm-says-facebook-ads-dont-work-pulls-10-million-account/ )Given that this represents the lion's share of the revenue there should be at least concern about the other shoe dropping with other firms reinforcing the well documented claim or actually pulling dollars out of the budget. This then reinforces the revenue growth challenge...
- International is the key to growth of users but the company makes significantly less per user (50-80% less). This is compounded by the fact that international access especially in Asia is increasingly oriented towards mobile and... ( http://articles.economictimes.indiatimes.com/2012-05-17/news/31749333_1_facebook-users-napoleon-biggs-mixi)
- Mobile is a question. The world is going mobile and Facebook recognizes that. Many view Instagram as much of a means to support the acquisition of Gowalla to plug the hole in mobile as it was to protect their core social franchise around photos and remove a critical question from the IPO. The fact that they had been trying to hire the creator for a while was a bonus prize. The challenge is that Facebook does not have a monetization plan that currently works for mobile and neither of these groups comes with one.
- X Factor: Facebook is now a public company. There are several unknowns that accompany this event. One key is that as they move from an innovation based growth strategy to an acquisition based growth strategy having the war chest of cash and public currency allows them to make some major moves. The key will be their ability to integrate and operate these acquisitions. Let's see how they manage the vicissitudes of the public market and the implications on employees wealth and morale. They have done a marvelous job heading into the IPO. Public is a different game.
So let's look at sentiment
- Zuckerberg is a rogue CEO (investor perspective). That's not necessarily a bad thing. Rupert is a rogue CEO and you get gems like FOX owned and operated stations, the NFL contract and MySpace (financially was brilliant given the Google contract to underwrite it - he just couldn't run it). Unfortunately you also get little jammies like the hacking scandal. By showing up to investor meetings in his hoodie Zuck is either demonstrating solidarity for the movement to support justice for Trayvon Martin or he is just saying screw you I'm doing things my way. Some people don't care how you interact with them as long as you make them money but for a lot of people with money they actually do care. Ever read the Big Short?
- Facebook is losing its cool and more importantly its trust. Survey after survey notes the latent discontent with the service and lack of trust in the service. Of course Microsoft had the same issues and that didn't end so badly for them... The challenge is that Microsoft challengers were always supported and people rooted for them. When was the last time someone rooted for someone competing with Apple? I like Facebook but its forced changes and lack of real innovation for at least a couple years has led me to root for Facebook competitors on a regular basis now. I mean they had to be dragged into some obvious future improvements by Google+. That's right. Google+. The same Google+ with lower average minutes per user than MySpace.
- Advertisers are looking at Facebook more as earned and owned media than paid. Brands recognize the power of the network but don't respect the value of the advertising medium. So they are doing it themselves. (http://www.forbes.com/sites/joannmuller/2012/05/15/gm-says-facebook-ads-dont-work-pulls-10-million-account/) (http://online.wsj.com/article/SB10001424052970204294504576613232804554362.html) Maybe this means Facebook will have to charge them access to the DIY spaces in the future but it is a chilling observation that I am sure the company does not want to become a trend. And while the GM episode was loud the DIY movement is very quiet. Understandably so. If they can get far enough along before Facebook flips the switch on charging them access then these brands may complain about abusing market power and Facebook finds itself in the Microsoft position in the late 90s because...
- X Factor: The regulatory target on the collective Facebook back is growing. Issues of privacy and security overseas will eventually become a nuisance. Nothing to make an investment decision around but definitely something to watch. Institutions of this size and worth draw the attention of the regulators and this is prime for such attention. At 900 million users, Facebook has gained the attention of the world so let's see how this plays out...
So what does this all mean? The numbers don't work for me as an investor.
I think the result in the near term will be continued pressure to the downside and I expect the stock to break below its IPO price of $38 by the end of the week although I am certain the underwriters will not allow it to stay there long. I expect that they will use the tricks of the trade to support the stock but that it will eventually break and that it will take less than a month to do so. I am not interested in this stock above $28. It is a real company with powerful assets but it isn't worth $100 billion. Not yet. Not now. Everything has to go right for this company to be worth such a lofty valuation and there are tons of basic questions about the core business. This was and still is a classic wait and see. Or as my friends from Missouri would say - show me.