has Facebook (FB) bottomed?

I think it has–at least in relative performance terms.  But I also think that FB’s conduct during its IPO has created an enduring credibility problem for it.

bottoming?

The biggest factor depressing FB stock during its debut, in my view, was the joint, last minute, decision by the FB chief financial officer and the lead underwriter to expand the dollar amount of an already large offering by 40%.  That left no buying demand for the aftermarket.  If you think the underwriters didn’t know precisely what they were doing, there’s a bridge connecting Manhattan and Brooklyn you might be interested in buying.

However, it has only recently come out that the NASDAQ trading problems on the first day were much larger than I had originally appreciated.  CNBC has reported that investment bank UBS alone may have racked up FB-related losses of $350 million.  How so?

If you remember, NASDAQ’s computer systems weren’t able to handle FB orders at all for the first several hours of trading.  Some retail investors didn’t know for the better part of a week how much FB stock they had bought or sold.  It turns out, though, that institutional problems were a lot bigger.

CNBC says an unnamed UBS trader entered a buy order for 1,000,000 shares of FB.  He didn’t get a confirmation from NASDAQ.  So he entered the order again   …and again   …and again   …and again.  Then, apparently, confirmations for all the orders came at once.  It’s unclear whether the confirms came on Friday, or during the following week.

CNBC also says UBS only liquidated some of the stock at below $30 a share.  Do the math.  If we say the UBS trader bought the stock at an average of $40 and sold at $30, that’s a $10 loss on each share.  If so, he pressed the “buy” button 35x!!!, without thinking about the possible consequences  (Welcome to the world of trading.).  

Presumably the UBS trader wasn’t the only one doing this.

Notice, too, that the FB price didn’t dip below $30 a share until almost two weeks after the IPO.  So it took UBS at least that long to trade out of its unwanted position.  Throughout all that time, FB was under unnatural selling pressure.

I think that’s over.

prospectus disclosure

The IPO materials suggest that FB wants to portray itself as carrying out an ethically good social mission.  Mark Zuckerberg says as much when he leads off the IPO video.  Thereby, I presume, it hopes to gain investor trust and support–and a higher PE.

FB has just released correspondence between it and the SEC about the prospectus.  Media analysis of the documents indicates that FB withheld from the first version of the prospectus two items of information that I regard as the two most important facts about company operations.  They are:

–the regional breakout of subscriber growth and profitability, and

–the effect on profits of the switch to mobile use of FB.

(Note:  I haven’t looked at the correspondence, which is contained in SEC filings by FB.  But every major news source I read has reported the same story.)

You might say that in the rough and tumble of economic life, the most prudent course for a company is to disclose as little as possible to potential competitors.  You might also say that the initial draft of the prospectus is intended solely to stake out a negotiating position with the SEC.  In one sense, that’s right.  But if you do this, I don’t think you can pitch yourself as being socially responsible or try to cultivate potential investors as partners in the noble cause you’ve embarked on.

Think of it this way:

A married couple.  One partner likes to gamble but always loses.  One day, that partner comes home late from work, after losing $500 playing poker.  The other partner says, “I see that look on your face.  You’ve been gambling again.  How much did you lose this time.”  The reply:  “$5.”

Is this last statement true?  I don’t think so.

Yes, it is factually correct.

But it’s also incomplete.

If the two people were commercial adversaries, maybe the statement would be okay.  But in a relationship where the partners have assumed an obligation to be fully and completely truthful with the other, the reply is a lie.

No, the prospectus isn’t a marriage proposal.  On the other hand, I don’t think that FB can invite us to become partners on a socially uplifting journey while stamping caveat emptor on all its disclosure to us.  We can’t be both trusted allies and sheep ready to be fleeced.

The “like me, trust me” route does generate a higher PE multiple, in my experience.  But to the degree that investors perceive a double standard, I think the stock’s PE multiple will be lower than if it clearly chose one approach or the other.

the strangest stuff about the Facebook IPO

Looking back on the FB IPO, I find several aspects of it strange. I don’t just mean that it was horribly bungled by the underwriters–and to an extent that almost defies comprehension. There’s more:

the last-minute prospectus additions

They concern the effect of increased mobile usage on FB results in the US. This trend appears to have been evident for a long time. It’s certainly material. At All Things D, Mary Meeker (more on her presentation in another post), the former Morgan Stanley internet analyst–she and Henry Blodget were the uncrowned Wall Street royalty of the late Nineties internet mania, said about half of US FB users do so via the less-lucrative mobile route. If so, why the only passing mention in the original prospectus?

subsequent rumor mill fodder

Over the past couple of weeks, stories have emerged that FB is going to:
–create its own branded cellphone
–acquire the Scandinavian browser company, Opera, and
–buy Research in Motion.
Who knows whether any of this is true. But if FB has plans on any of these fronts that are any more than idle musings, there should have been some mention in the prospectus.

no demographic information

Clearly, FB has transcended its original purpose of allowing college classmates to learn about each other more quickly. I’d be interested in knowing, for example, if the heaviest users are high school and college students–and if usage falls off sharply as they leave school and begin working. FB must know stuff like this. But, again, nothing in the prospectus.

the attitude of Morgan Stanley

The CEO is reported to have said in a cable TV interview that retail investors were “naive” and had participated in the IPO “under false pretenses,” if they expected FB shares to go up after the IPO. FB shares have set a world record for loss of market value by an IPO after its debut. That’s not normal. Arguing that investors should recognize that they are sheep to be fleeced whenever wool is needed–even if that’s what he really thinks–isn’t a great way to get new customers, or to keep current ones. He might have said he didn’t mean for this to happen and he was sorry.

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

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

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’s first day

I’m writing this at about 3pm, so the trading day isn’t over.  Several aspects to the FB IPO are already notable, though.

The stock opened at $43 and quickly reached a high of $45.  It then dropped to the IPO price of $38, where it met stiff resistance.  It now seems to be settling in at around $40 (note: I have a limit order in for today a tiny amount at $38.25).

1.  The day before yesterday the underwriters announced that the FB offering would be increased by 25% from an already hefty size.  This virtually always has the effect of tempering any first-day appreciation of the stock.

We should assume this was the main purpose of the move.

It isn’t clear if in this case the number two reason was:

–to accommodate holders chomping at the bit to sell or

–to ensure that the stock wouldn’t reach a crazy-high price in the first few days of trading and then collapse.

2.  The extra stock comes predominantly from selling shareholders, not from new shares issued by FB.  Normally that’s a bad thing, because the market argues (reasonably) that employees and venture capital investors know a lot more about the true worth of their firm than the rest of us do.

But the dynamics of this case aren’t so crystal clear.  The more new stock that’s issued by FB itself, the more Mark Zuckerberg’s margin of voting control over the company shrinks–and the less able he is to sell shares in the future and still maintain his voting majority.  This is not a worry for today or tomorrow, but Zuckerberg may have been quite happy to encourage employees or early investors to sell more.

3.  It’s not well-known, but underwriters have a short period of time in which they’re legally permitted to “stabilize” the price of a new issue (read:  step into the market and prop the stock up so it won’t fall below the IPO price).  That appears to have occurred with FB shortly before noon.

…not a great sign.  It raises the question of what will happen to FB next week, when the stabilization period expires and underwriters can’t stabilize anymore.

4.  The stock didn’t open until around 11am.  “So what,” you say.  That’s normal for a “hot” IPO.  Historically, that’s true.  But the brokerage industry trade association, FINRA, changed the IPO rules late last year so buyers can only place limit orders (that is, ones that specify a maximum price) before the first trade.  This eliminates market orders (ones where the buy price is open-ended) and should make the process of finding an initial market-clearing price much simpler. So a ninety-minute delay before opening is a lot.

5.  There are continuing reports of problems with trading in FB.  No one seems to know why.