Category Archives: Facebook

IPO arcana: underwriting vs. sales, and the over-allotment. Who knew?

May 24, 2012 By in Facebook, institutional salesperson, internet, Investment firms, preliminary and final prospectuses Tags: , , , , , , , , Leave a comment

As I mentioned in an earlier post about FB, it’s surprising to see how little the financial media understand about how IPOs work–whether it be newspaper reporters and their firms’ related blogs, or the talking heads on cable.

Two aspects:

the over-allotment

In the case of FB, it was 63.2 million shares (the number is on the front cover of FB’s registration statement).   As noted in the sentence that gives the over-allotment number, this amount of stock is not included in the 421.3 million share figure listed in bold.

What is it, then?

The over-allotment is a kind of insurance or safety precaution that the company issuing stock and the underwriters build into the offering.  The company agrees to sell a specified amount of extra stock to the underwriters at the IPO price if the underwriters ask for it.  In the FB case, it was 62.3 million shares.

When the underwriters divide the stock up and sell it to clients, they distribute the larger amount.  So the FB stock sold to the public amounted to a total of 483.6 million shares (421.3 + 62.3).

If the issue goes well and the stock stays at a price higher than the IPO level, the underwriters purchase the extra stock from the company and deliver it to clients.  That’s the usual case.  For FB, that would have meant an additional $2.4 billion from the IPO.

If, on the other hand, the issue goes badly, the underwriters can buy stock in the open market at the IPO price up to the amount of the over-allotment, without taking any financial risk themselves.  Don’t ask me why, but underwriters are legally allowed to do this for a short period after the IPO is launched.

The underwriters did this kind of intervention with FB just before noon and again during the final hour of trading on its first day.

How do we know?

The underwriters make no attempt to hide their identity or their intentions.  They want other traders to know they have a huge amount of buying power and intend to defend the IPO price.

How did I find out?  I looked at a chart of FB on my cellphone.  I saw the stock stopped its normal minute-to-minute gyrations just after 11:30 and flatlined–just like when someone dies on a TV medical drama.  That’s not natural.  Someone was making a statement about the $38 level.

In listening to hundreds and hundreds of IPO roadshows, I’ve never heard the over-allotment mentioned–ever.  Professionals know it’s there.  For the underwriters, it would be like a restaurant saying it had a great food-poisoning doctor on call.

underwriting group vs. sales syndicate

This is really arcane.  There’s no reason to read any further, except that this distinction may explain the bad treatment of some retail investors in the FB IPO.

The money that brokers charge in an IPO is for two slightly different functions.

–They have a percentage interest in an underwriting group.  Although I use underwriter and broker as synonyms in everything I write, that’s not precisely correct.  The underwriting group buys the stock from the company and then resells it. It’s paid a small amount for taking the “risk” that the members will be unable to resell the stock.  Remember, though, that the brokerage companies have firm–though not legally binding–commitments to buy the stock from clients who know they’ll never see another IPO allocation if they renege (legally, any client can return the stock and get his money back up until shortly after the final prospectus is issued.  See my post on preliminary and final prospectuses).

–the underwriting group employs a selling syndicate to distribute the shares it buys from the company.  It’s made up of the same firms that comprise the underwriting group, but possibly in different proportions, based on the size and strength of institutional and retail distribution networks.  Normally, the selling commissions are much higher than the underwriting fees.

Why write about this?  The accounts I’ve read mention only Morgan Stanley as a broker whose retail clients received much larger allocations of FB stock than they anticipated.  My guess is that Morgan Stanley carved out for itself an especially large piece of the selling syndicate pie.

Facebook (FB), looking back after three days of ugly trading

May 23, 2012 By in Facebook, internet, Private equity, Technical Analysis, Trading Tags: , , , , , , , , , 1 Comment

a failed IPO

The long-awaited IPO of FB has come and gone.

The stock opened late, due to a NASDAQ computer snafu.  It almost immediately gave up its initial gains.  It closed a mere 25¢ a share above its $38 offering price–and that only due to “stabilization” (read: price-fixing) efforts by the underwriters in the final hour of trading.

It’s been falling since.

a successful offering??

One interesting aspect of the fiasco is that many commentators–as well as many retail participants in the offering, and apparently also the CFO of Facebook–are basically clueless about how the IPO process is supposed to work.

In particular, I’ve heard media proponents of the tooth-and-claw school of capital markets trying to burnish their Darwinian credentials by claiming that Morgan Stanley actually did a good job with the offering.  Explicitly or implicitly, they point to the poor trading performance of FB as evidence that the bankers achieved the highest possible price for FB.

I think this is crazy talk.  When FB conjures up in investors minds words like “overpriced,” “disaster,” and “huge losses,” that’s not good.  Nor is it when retail investors feel they were tricked into buying more stock than they wanted   …or when the lead underwriter is being investigated for disclosing negative opinions about FB only to a few customers.  And, of course, none of the money from sales of extra shares went to FB itself.

An IPO is supposed to go up!  

Not necessarily by 100%, but maybe 20% or so.  Why?

Psychologically the company is associated with success when its stock rises.  Retail investors, who will buy/use the company’s products and loyally support management, feel good about themselves and the stock they own.  This positive association lays the groundwork for the market to absorb more stock when lockups expire and when employees want to cash in more of the stock that’s a key part of their compensation.

A failed IPO, in contrast, generates questions–well-founded or not–about the stability of the company and about the trustworthiness and competence of its management.

what went wrong?

As I see it, there were two separate problems:

1.  The main one is that FB issued too much stock all at once.  Up until a week ago, the plan had been to sell 388 million shares at a maximum price of $34 each.  That’s $13.2 billion.   Which is enough money to buy all of the stock of Sony or Omnicom or Applied Materials or Ralph Lauren or Limited Brands, at yesterday’s closing prices.

Last Wednesday the amount of stock was increased by 25% to 485 million shares and the offering price was upped to $38.  So the total take from the IPO went up by 40% to $18.4 billion.  That would be enough to buy Marathon Oil or Kellogg or Yahoo–or to pick up Whole Foods or Charles Schwab and have a couple of billion left over.

This decision had two negative effects:

–it took $5.2 billion out of investors’ pockets that might have gone into buying FB in the open market after the launch.

–worse, the underwriters were unable to find happy homes for all that extra stock.

In any “hot” IPO, institutions routinely place orders for many times the amount of stock they actually want, in the hope that this will influence the underwriters to give them larger allocations than they’d get otherwise.  You want 250,000 shares so you ask for a million.

I don’t think this tactic works, since the parties know one another very well.  But people do it anyway.  Maybe it makes them feel good.  Occasionally the move backfires and the institution gets more stock than it wants.  Maybe it gets 500,000 shares.

When this happens, the message is clear–the issue is in trouble.  The institution probably decides to stay on the sidelines rather than buy more.  Or it turns into a seller.

Lots of retail investors seem to have been playing the same game with FB.  Institutions have battle scars and regard being burned like this as a cost of doing business.  But for a retail investor, finding 5,000 share of FB in you account last Friday when you expected 500 must have come as an incredible shock.   That’s enough to turn you from a greedy buyer into a panicky seller.

2.  NASDAQ had a computer meltdown.  The details aren’t clear.  My broker, Fidelity says it still doesn’t have complete execution information on buy and sell orders it placed for clients during the first few hours of FB trading last Friday.  This doubtless raised the level of panic individuals have been feeling.

Just as important, I think the NASDAQ mess also had the effect of transferring some selling from last week into this–prolonging the period of trading turmoil.

who decided to up the offering size?

Normally it’s the underwriter, who, after all, is the one in continual contact with potential buyers.  If so, Morgan Stanley and the others had exceptionally tin ears.

In this case, my reading of stray media comments says that the Facebook CFO made the final decision.  At the very least, he seems to be the one being thrown under the bus.  I’ve never seen comments like this before.  My inclination is to say this means they’re true–and that the underwriters don’t like David Ebersman very much.  Let me amend that–they don’t think they’ll need to be doing business with him again.

who benefits from the pricing decision?

The underwriters, of course, whose fees are determined by the size of the offering.

Company officers other than Mark Zuckerberg are still listed as making no sales.  Mr. Zuckerberg remains as seller of 30 million chares, which he notes will go to pay taxes.

The largest chunk of extra stock, 54 million out of the 97 million added, is listed in a catch-all category of people who have given voting rights to Zuckerberg.  Their sales go from 71 million shares to 125 million.  The rest of the shares come from venture capital investors.

To me, this says the company FB had nothing to gain by raising the offering size.

what to do

This is still the same company, with the same prospects, as before.  If you liked it at $38, you’ve got to like it more at $32.  I don’t know the company well enough to have an investment opinion.  The stock does seem to be starting to trade more normally today, though.

Facebook: my take

May 11, 2012 By in Facebook, Industry Analysis, internet Tags: , , , , , , 3 Comments

how is FB describing itself to the financial community?

I think the roadshow video is very instructive.

First of all, it is very expertly and painstakingly scripted and filmed.  A great deal of time, energy and thought went into it, in my view.  Therefore, it should be taken seriously as saying how FB wants to position itself in the minds of investors.

What are the main messages?  I think there are three:

1. FB is as much a social cause as a company.  And, by implication, we all now have a chance to be a part of the movement by becoming owners.

Mark Zuckerberg says both in the video and in a letter in the prospectus that he didn’t initially intend for FB to be a company.  He created it (I think I see a slight change in his delivery as he says this on the video) because it needed to be done.

“Facebook was not originally created to be a company.  It was built to accomplish a social mission–to make the world more open and connected…There’s a huge need and a huge opportunity to get everyone in the world connected, to give everyone a voice and to help transform society for the future…We hope to strengthen how people relate to each other,” he writes.

2.  FB is in a unique position among internet companies. 

Everyone else has succeeded only in creating the “raw tools” that FB is cementing together into a comprehensive communications network.  Because of this unique position, future applications developers will doubtless build their products on the FB infrastructure, giving the company huge profit expansion potential.

3.  FB is only at the start of its “rewiring” of the way people communicate with one another.

There’s very little discussion of current operations in the video–despite the fact it’s a half-hour long.  You’ll see why below.  To me, the implication is that the concept of a possible future is much more important than the present.  It’s a sort of “If you build it, they will come” message.

what about current operations?

Here are the numbers I find most interesting:

users

As of March 31, 2012, FB had 901 million registered users worldwide who have interacted with Facebook in some fashion at least once over the prior month.

As of the same date, it was averaging 526 million registered users who have some interaction with Facebook on a given day.

Of monthly active users, 83 million use mobile devices exclusively to interact with Facebook; 405 million others use both computers and mobile devices.  This is a big change.  Mobile usage grew by 69% over the past year.  It contributed most of the gains shown in North America.

Overall user growth was 33%.

geography

FB breaks out active users into four geographical areas:  US and Canada, Europe, Asia, and Rest of World.

US/Canada

20.7% of all users

average quarterly revenue/user = $2.86, up 14% year on year

user growth was +91% two years ago, +46% last year, +15% this year

biggest boost to growth appears to have been through mobile devices

Europe

27.9% of all users

average quarterly revenue/user = $1.40, up 18% yoy

user growth +94% two years ago, +46% last year, +20% this year

Asia

25.5% of all users

average quarterly revenue/user =$.53, up 23% yoy

user growth +268% two years ago, +93% last year, +47% this year

RoW

26.9% of all users

average quarterly revenue/user = $.37, up 19% yoy

user growth +137% two years ago, +58% last year, +33% this year

what these figures mean

To me, they suggest that the North American market is maturing rapidly and that Europe may be only a year or so behind.  Not surprising, given that Facebook users in North America already outnumber non-users.

The two regions make up three-quarters of FB’s revenue.   So, if it isn’t already, emphasis in North America has got to shift away pretty soon from grabbing as many new users as possible (to prevent rivals like Google+ from snatching them us) to raising revenue per user.  How that will go is unclear (to me, anyway).

income statement

FB has two sources of revenue:  advertising and payments, the latter mostly generated by microtransactions in games. During calendar 2011, FB collected $3.154 billion in ad revenue and $557 million as its share of payments (the lion’s share of that from Zynga).  That was an 88% yoy gain.  Net income was up by 66%.

For the latest quarter, however, net was down yoy, despite a 45% yoy rise in revenue to $1.058 billion.  How so?

Expenses rose by 97% yoy during the period.  R&D was up by 168% to $153 million, marketing by 134% to $159 million, spending on infrastructure by 65% to $277 million.

I interpret this as FB’s recognition that to continue to grow it has to do so in a new way.  It either has to sign up a whole big bunch of low-revenue users outside the US and Europe, or find new ways to raise average revenue per user in its more affluent, but more mature markets in North America and Europe.

It’s conceivable that during this transition time, eps growth will be nothing to write home about.  It’s also not 100% clear FB will be successful, although it is in a very powerful position in the social networking arena.

conclusions

FB’s IPO materials tell two different stories.

–one, portrayed in the video, is of a unique company with boundless potential in an increasingly interconnected world.

–the other, from the numbers in management’s discussion of operations in the prospectus, is of a company that has already picked most of the low-hanging fruit and which is ramping up spending to fend off slowing revenue growth.  The price of this ramp may be lackluster profit growth for at least a while.

Which story to believe?

Here I have no strong opinion.

On the plus side,…

…good growth companies tend to reinvent themselves every few years.  For example:

–Microsoft was originally the PC operating system company.  Then it was the Windows graphical interface company.  Then it was the corporate Office productivity suite company.  Then, a dozen years ago, it stopped growing.

–Apple was the iPod company.  Then it was the “halo effect”/Apple Store company.  Then it was the iPhone company.  Now it’s the iPhone/iPad/iCloud company.

–Amazon, which I think FB resembles the most closely, was originally an Internet “concept” company that sold books in cyberspace and didn’t make much money.  Then it “pivoted”, expanded the range of products it sold itself and began to act as an online sales conduit for third parties.  Profits exploded.

What could go right in this fashion for FB?

Let’s say that corporate advertising on Facebook could double–I’m not sure whether this is an aggressive assumption or an underestimation–over the next two or three years, while FB maintains something like its current cost base.  If so, earnings would rise by about 150%.  Companies would arguably shift ad dollars to FB because it’s cheaper and because customer targeting is better.

Or something really good that’s unexpected by the investment community could develop, as happened in all the cases I’ve cited above.

On the minus side,...

…the valuation, based on current profit levels, is high at 96x earnings per share.  That’s not necessarily a deal-breaker.  LinkedIn, which I don’t think is as promising a company, trades at 686x.  Amazon trades at 186x, with a similar story of heavy investment in new product development.

Priceline.com, clearly a more mature company, trades at 30x.

An “old” warhorse like Apple, where the price earnings multiple has been contracting for the past several years, trades at 14x.

Microsoft, which hasn’t shown any innovative spark so far this century, trades at 11x.

what will professional investors do?

Value investors will hold onto their MSFT and not touch FB with a ten-foot pole.

Growth investors will probably take all the FB they can get in the IPO.  Knowing that the stock will very soon be part of the NASDAQ index, I think they’ll try to build their positions to the point they have only slight underweights and then await further developments.

For me, the stock would be a roll of the dice–something I try to avoid.  It’s not simply a question of valuation. If I thought FB’s earnings in three years would be close to triple the current level, as a doubling of revenue/user would achieve, I’d be very happy to buy it.  I don’t know the company well enough to have that conviction.  But I believe this is the key question potential investors should have an answer to.

Note:  Since I  wrote this post, two new pieces of information have come out:

–FB amended its prospectus to reflect what was apparently a management answer to a question posed during the roadshow.  FB said that some users were switching to accessing Facebook through mobile devices rather than through computers.  This has a negative effect on revenues, since FB runs fewer ads through mobile devices and advertisers pay less for them.

–apparently demand is strong enough for the issue that FB is talking about raising the IPO price to $34-$38.

Facebook: the IPO process

May 10, 2012 By in Facebook, Industry Analysis, internet, Stock ideas Tags: , , , , , Leave a comment

going public

Going public is a highly choreographed dance.  FB is in the middle of its own time on “Dancing with the Stars,” vying for a prize of close to $100 billion.

the sequence of events

When a company decides to have its stock publicly traded:

hiring Wall Street

1.  it hires a team of investment bankers

filing with the SEC

2. with the investment bankers’ help, it prepares and files a comprehensive registration statement with the SEC for that agency’s regulatory approval.  Called an S-1, it becomes the preliminary prospectus which is given to potential investors once the SEC gives its ok.  Like any other company’s, FB’s approved S-1 can be found on the SEC’s Edgar website, along with any earlier versions the SEC may have sent back for more work.

The S-1 is legally required to be accurate and complete disclosure of all material information relating to company’s business.

Note:  SEC approval means only that the document is procedurally correct.  The agency doesn’t guarantee that the S-1/prospectus is in fact accurate or complete disclosure.   Nor does it say whether it thinks the stock will be a good investment or not.

the roadshow

3.  it launches a marketing campaign, whose centerpiece is a management roadshow organized by the investment bankers.

The roadshow typically lasts a week or two.  It reaches all the major investment centers and all the important money management firms in the country.

If demand to see and hear the company is high, as it clearly is in this case, management will be broken up into two or more teams (the FB video suggests it may have as many as four).  One will normally be headed by the CEO, another by the CFO.

The schedule is brutal.  Each day begins with a breakfast meeting.  Private meetings–usually an hour long + travel time to the next one–with important money management firms follow.  Then there’s a lunch, often with large numbers of portfolio managers, analysts and the press, none influential enough (read: big enough commission payers) to justify a private meeting.  Then there are private meetings in the afternoon, followed by a dinner presentation–and then possibly a trip to the next city on the list.

Add it all up and management is telling the same story, over and over again, maybe 7x-8x a day.

Since the S-1 must contain all material information about the company, it’s important that management not say anything that’s not contained in it–especially if someone might later on construe this as important.  So the teams are highly scripted and drilled on how to answer questions commonly asked.

In a way, the teams are a bit like actors.  They’re supposed to–if they can–smile and signal to questioners their respect for his penetrating insights and the thought/wisdom behind the query.  All they while they may be thinking, “Not again!” and “Doesn’t anyone read the prospectus?  The information he wants is on the first couple of pages!”

the video

Facebook has made a very artful 30-minute video (my comments tomorrow), available on its website, which I gather it intended to play at every meeting.  Smart move.  It burns up half the meeting time.  It also provides a clear roadmap for predictable follow-up questions–responses to which can be cleared by the legal department and rehearsed in advance.  The WSJ says, however, the video wasn’t played during the big public lunch in Boston after heated complaints about it at the comparable affair in Manhattan.

pricing the offering/allocating stock

4. the investment bankers are gathering feedback from clients throughout this time.  They’re trying to gauge the level of investor interest so they can set final pricing and decide to divide up the IPO stock among investors who place orders.

At the same time, money managers will want to get a sense of how “hot” the offering is.  Usually that’s expressed in terms of how many times the books are covered–that is, by how many times the requests for stock exceed the shares available for sale.  FB is a relatively large offering, so 3x or 4x would be impressive.  My guess is that the number is already high than that.  Of course, this can be a self-reinforcing process.  When money managers believe an offering is “hot,” they may request double or triple (or more) the stock they really want, in the hope they’ll end up with a bigger allocation after everyone’s order is cut back.

More tomorrow.

 

Facebook (FB): preliminaries

May 9, 2012 By in Constructing a Portfolio, Facebook, Industry Analysis, internet, Stock ideas, Technology Tags: , , , , , Leave a comment

FB’s corporate structure

FB has two classes of common stock, A shares and B shares.  The two are identical, except for:

1.  A shares, which are the kind being sold in the public offering, have one vote each on matters of corporate policy

B shares, which are held by Mark Zuckerberg and other insiders, and which can’t be sold, have ten each.  This way insiders continue to control the company while raising money from outsiders.

2.  B shares are freely exchangeable into As, giving holders of the Bs a way to turn their holdings into cash.  But when insiders sell they don’t give “extra” votes to the buyer.

Any investor in internet companies–from Google to LinkedIn–is familiar with this structure.  It has been around a lot longer than that, though.  Hershey has a similar structure, for example, as do the New York Times and News Corp.

the offering

FB plans to sell 337, 415,352 shares in the offering.

Of that, 180 million will be new shares issued by the company.  The rest will come from employees cashing in stock grants they received as part of their compensation, and from venture capital investors cashing in stock they bought in private financing transactions.

Assuming the stock is sold at the mid-point of the announced pricing range of $28-$35 a share, the IPO will raise $10.6 billion and will imply that the entire company is worth just under $100 billion.

$5.6 billion of the proceeds will go to FB; the rest will go to selling shareholders–VCs and present/past employees.

overallotment

IPOs routinely line up commitments by sellers to provide an additional amount of stock for sale in the IPO if demand proves exceptionally strong.  In this case, FB has agreed to sell 6 million shares more, selling shareholders another 44.6 million.

why is FB going public?

In the Use of Proceeds section of the prospectus, FB says:  “…we do not currently have any specific uses of the net proceeds planned.”  The company also already has $3.9 billion of cash on the balance sheet.  So, why?  Two reasons:

–from Microsoft three decades ago, to Google, to Facebook and Linked In, tech companies have attracted highly talented workers despite relatively low salaries and the risky nature of any job with a startup.  In fact, prospective employees seek these companies out.  The financial motivation is the chance at a huge payout on stock options or restricted stock sold in a successful IPO.  The same holds true for venture capital investors.

So FB has an obligation–implied, or possibly specified in contracts with VCs–to have an IPO.

–ultimately the money will be spent on R&D, and to accelerate FB’s expansion to mobile devices and in markets outside North America.

expiring lockups

When they bought FB shares, venture capitalists may have agreed not to resell them until after the IPO.  Such agreements are called lockups. 

The selling shareholders have also made further lockup agreements with the underwriters not to sell more stock for specified periods after the IPO.

The clock starts ticking on them as soon as the IPO takes place.

–171.8 million shares become eligible for sale after 90 days

–another 137 million are freed up in the following three months

–another 235 million leave lockup in the six months after that.

The lockups mean holders can’t sell during the period the shares are restricted.  It doesn’t mean holders have to sell once the restrictions are lifted.

This is a glass-half-empty/glass-half-full sort of thing.  As long as the stock price is at least stable, history says few will feel rushed to sell once their lockup expires.

NASDAQ listing

Although Facebook picked a ticker symbol with two letters, something more closely associated with the NYSE (most NASDAQ stock symbols have four letters), it has chosen to list on NASDAQ.

One possible inducement for FB to choose NASDAQ–the exchange has just reduced the “seasoning” requirement for a new stock to enter the NASDAQ benchmark indices to a mere 90 days.  It seems to me that FB will become an index constituent as soon as possible.

This is important.  It means that every index mutual fund or ETF that tracks NASDAQ indices will be compelled to buy FB shares.  It also means that any active manager whose performance is measured using NASDAQ as a benchmark will have to think twice about “flipping” (immediately reselling) any shares garnered in the IPO.  In fact, if the manager takes a positive view on the stock, he may have to buy a lot more, in order to have a higher-than-benchmark weighting.

the IPO video

It’s part of the IPO roadshow.  Check it out.

More tomorrow.