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: my take

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

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

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.

book value in an intellectual property world: Facebook and others

the Facebook IPO

I’ve had a couple of requests to write about the upcoming Facebook IPO.  So I’m slogging through the preliminary prospectus.  I’m not sure I’m going to come out with a final conclusion, but I think I will be able to highlight important points. Today, book value.

In the prospectus, Facebook (NASDAQ ticker:  FB) makes what I regard as an unusually strong effort to point out that the company has very little tangible book value.  As of March 3, 2012, the figure is $2.85 per share.  The expected inflow of cash to the company from the IPO, calculated at a purchase price of $31.50 a share (the midpoint of the expected pricing range of $28-$35) will raise that to $5.15 a share.  So FB really wants buyers to be aware they are paying a little over 6x book for the stock.

What does this mean?

book value

Every investor looks for bargain stocks.  Techniques differ, though.  One of the main tools used by early 20th century securities analysts was looking for stocks that traded at steep discounts to the net asset value shown in the company’s official accounting records.

The measure is “net” in the sense that it is arrived at by subtracting the carrying value of everything the company owes to others (its liabilities) from the carrying value of all its assets.  The resulting number is also called book value, because it’s derived from the official accounting ledgers.

an example

The idea is simple:  say a firm starts with a single asset, $1 million in cash, and has 100,000 shares of stock outstanding.  Book value is $1,000,000/100,000 shares, or $10/share.  If the company spends all the money to buy land and build a cement plant, it still has book value of $10, but now it’s all in land and plant and equipment.

Suppose shortly after this, the stock market turns down–for whatever reason–and the company’s stock falls to $5 a share, or 50% of book value.

The plant is still there, however, and would still cost $1 million, or $10 a share, to duplicate.  So you can now buy $10 worth of assets for $5!!  How can you go wrong?  (You can, but that’s a story for another day.)  At the very least, the idea that the company holds valuable assets that can–at worst–be sold should act as a cushion against further declines.

One other thing about book value:  it also includes, as plusses, profits made and retained in the business, as well as losses, as minuses.  So for a successful company, book value gradually rises; for a consistent money-loser, it gradually falls.

Warren Buffett and intangibles

Fifty years or so ago, Warren Buffett had the idea that made his investing reputation.  He noticed, far ahead of his contemporaries, that some companies–Coca Cola, for example–had substantial advantages, like famous brand names, efficient distribution networks, a reputation for high quality, that were “intangible” in the sense that they weren’t reflected directly on the company’s accounting records at all.

Nevertheless, these intangible assets have a value.  They are predictors of longevity of a business and of higher than average profit margins.  Companies that possess them fetch high prices in mergers and acquisitions.  Buffett was the first one willing to pay a little bit extra for companies that had strong intangibles. Nowadays everyone does.

most IT is all about intangibles

In the early years of the computer industry, tech companies were allowed to “capitalize,” or list as assets on the balance sheet, the salaries and expenses of their research and development efforts, instead of subtracting them from current revenue in the income statement.  But by the time I arrived on the scene in the late 1970s, the practice had led to such horrible abuses (it made profits a lot higher than they should have been) that it was banned.

Like advertising expenditures, R&D is treated as an expense, and reduces income, even though, if successful, it creates an important competitive advantage for a firm.  The more R&D, the lower profits are–which means that book value doesn’t rise very quickly.  But the intellectual property is at the heart of what makes tech companies valuable.

the Facebook case

As the prospectus indicates, pre-offering, FB has book value of $2.85.  The largest chunk of that is cash, generated both by operations and prior sales of stock.  The book value of other assets is slightly over $1 a share.

In addition, the inflow of cash from the IPO will almost double that number, creating a tremendous benefit for pre-IPO shareholders.  An IPO participant’s $31.50 becomes a claim on company assets worth $5.15.  Prior owners will have their claim on book value of $2.85 boosted a lot.

significance?

1.  Unlike the cement company, in the FB case there’s no safety net of salable assets to fall back on if the company is unable to make money. In that sense, FB carries with it a large amount of risk.

2.  For FB, it’s all about intangibles–the brand name, the goodwill imbedded in the huge number (900 million) of users of the service, whatever patents the company may have.  Traditional accounting statements aren’t built to showcase these attributes.  So analysis of the statements may not get you very far in understanding the company or its potential.

What about other tech companies.  How do they trade versus their book values?

Here’s a sample:

Priceline.com      12x book value

LinkedIn     12x book

Amazon.com     11x

Netflix          7x

Microsoft      5x

Google     3x

eBay     2.5x

Yahoo     1.5x.

It’s hard to generalize from these instances.  For fast-growing firms, trading at huge premiums to book value doesn’t appear to be a problem.  On the other hand, Yahoo traded at 8x book in 2004, when its future appeared to be more promising–and 6x book when it turned down Microsoft’s takeover bid.  So the fact of a large premium to book doesn’t guarantee anything.

 

All in all, this implies to me that evaluation of FB will be a much more subjective, and difficult, process than for a typical IPO.\

More tomorrow.