GRPN, ZNGA, FB: what were the underwriters thinking?

I’ve been writing over the past couple of days about Groupon and Zynga, stocks I consider prime examples of the Greater Fool theory in action.  GF answers the question of why any investors, particularly professionals, would buy shares of either  offering, given the obvious flaws in their operating models.

Let’s take the other side of the coin today.

Why would anyone want to put his firm’s name on the red herring as a sponsor/seller of merchandise like this?

More than that, in both the GRPN and FB cases, the companies submitted initial S-1 registration statements to the SEC that the regulator rejected.  GRPN tried to define a new kind of operating “profit” that excluded major cost elements.  FB didn’t mention that its high-earning US and European businesses were being hurt dramatically by users’ shift from access by computer to smartphones.  Why would underwriters take the reputational damage that comes with encouraging/condoning such behavior?

The reason not to push these names, or to try to paper over problems, is obvious:

the stocks in question were arguably overpriced, with nowhere to go but down.  Money management clients would lose money by buying them.  This would make them unhappy, endanger their careers and generally weaken the bonds of trust that tie them to the underwriters.  The flow of commission money to the underwriters would decline.

Also, in my (long) experience, such anti-money manager behavior is highly unusual.  In fact, the only parallel I can come up with is the waning days of the 1980s junk bond market, when very weak offerings were the order of the day.  (To be clear, I don’t believe that anything like the unhealthy and unethically close relationship between Drexel and key junk bond fund managers exists today.)

So, why?

I have three thoughts:

1.  The underwriters–both the firms and the individual investment bankers–spent a lot of time and effort courting the companies.  Especially for the individual investment bankers, a payoff on this investment was much more important than maintaining good relations with money management clients.

2.  Their unusually anti-money manager behavior implies to be that creating successful (read: very high-priced) debuts for GRPN and ZNGA were do-or-die events for the fortunes of the tech bankers involved.  They apparently saw no percentage at all in considering how money managers–or individual investors–would be hurt by subscribing for the issues.  It was okay for the issues to crash and burn.  Therefore, no new social media IPOs are on the horizon.

3.  The bankers think the negative fallout on their business from these dud issues will be minimal.  Yes, some managers may lose their jobs.  So what,the bankers think  (read Liar’s Poker if you think this is too harsh).  The new guys won’t know what happened in late 2011.  Less starry-eyed portfolio managers will have short memories.  They won’t hold a grudge and will evaluate future issues on their merits, not on the present bad behavior.

 

Of these conclusions, I think the most interesting is the suggestion that social media IPOs are over for the foreseeable future.  But the series of dud offerings may also be harbingers of a more adversarial and confrontational attitude in the future between bankers and portfolio managers.

 

Greater Fool Theory (II): Zynga (ZNGA)

ZNGA

Zynga (ZNGA) is a maker of casual social games played principally on Facebook.  The most famous of them is FarmVille.

The company follows in the footsteps of the Korean smash hit Kart Rider, which showed how immensely profitable “free” casual online games can be if they charge money for items players need to succeed (microtransactions).

going public

ZNGA went public in mid-December 2011–before GRPN shares began to give up the ghost–at $10 a share.

Shareholders weren’t as lucky on day one as GRPN IPO participants, however.  The stock opened at $11 and rose to $11.50.  It then faded back to $9, before closing the day at $9.50–below the IPO price, despite presumably the best efforts of the underwriters to “stabilize” the price at $10.

The stock did have a brief renaissance in February, when it reached almost $16 a share, before beginning its downward journey to the current $2.78.

 ZNGA as a “greater fool” stock

two investment variables

To my mind, the most important investment issues surrounding ZNGA were/are:

–whether it could follow the success of Farmville with other, hopefully bigger, games, and

–its relationship with Facebook.

on the first count,

It’s pretty easy conceptually to figure how much a given game is worth.  Games have a lifecycle that’s a function of:

–how many users it has

–how often, and for how long in each session, they play

–how long the game remains at/near peak popularity before players become interested in something else and fade away.

The detailed data may be difficult to come, but this is a straightforward discounted cash flow problem.  Figure out the value of a game–let’s say $3 a share–and that tells you how many successful games are already being presupposed in a given stock price.

Long before the IPO, industry sources were indicating that ZNGA was having trouble finding a follow-up success to Farmville.  Its subsequent games were attracting fewer players–who were playing them less intensely than Farmville, and losing interest more quickly.  Therefore, on all DCF counts, they were (much) less profitable.

To my eyes, ZNGA had all the earmarks of a one-trick pony.  Yet, to me the $10 IPO price presumed a parade of new hits.

on the second point,

experience, common sense and basic microeconomics all suggest that symbiosis can be a fragile thing in the business world.

From FB’s perspective, the fact the ZNGA games were a significant source of its revenue had to start it looking for other game makers to feature.  That would hedge against the possibility that ZNGA was a flash in the pan.  And it would diminish the leverage ZNGA would otherwise be gaining over FB if the hits kept on coming.

From ZNGA’s perspective, the fastest way for it to grow would be to tap non-FB gamers by establishing a platform separate from FB.  That, of course, would be potentially bad for FB.

The issue has two facets:

1.  Was ZNGA successful because FB steered traffic to it?; or was FB successful, at least in part, because it had preferred access to ZNGA games?  The more important partner should get the lion’s share of any profits from the partnership.

2.  The FB/ZNGA relationship had become profitable enough that the question of the respective profit shares came up.

Here again, the issue was settled pretty decisively over a year before the IPO.  ZNGA is successful because of  FB, not the other way around.

why subscribe to this IPO?

What must the subscribers to the IPO have been thinking?    …all I can see is the thought that “greater fool” had worked once with GRPN, so it would likely work again.

And, if you flipped the stock into the early strength on the first trading day, it did.

Tomorrow:  what were the underwriters thinking?

the Greater Fool theory

a real life example of the Greater Fool theory:  Groupon (GRPN)

Groupon has been in the news again recently, as the stock makes fresh historic lows.  It closed yesterday at $4.72 a share.  The issue went public early last November at $20!

Anyone who bought in the IPO and held until now has made a loss of over 80%.  Ouch!!  Even worse, the S&P 500 is up almost 20% over that span.

what the company does

Groupon, of course, brokers mass discount coupon offers between companies and the public, in return for a (large) slice of the coupon proceeds.  The idea was/is that the Groupon offer publicity and the repeat business at full price it would generate would more than make up for the initial discount.

Sounded like a great idea.  The biggest problem, of course, is that there are no barriers to entry.  There is/was nothing stopping you or me from rounding up a bunch of relatives or friends and starting a local competitor.  And there was nothing stopping a behemoth like Google from doing the same.  In fact, serious competitors had begun to sprout up long before GRPN went public.

On top of that, GRPN had a lot of trouble creating financial statements that the SEC would approve.  Among other things, GRPN was losing a ton of money because of heavy marketing expenses, its largest cost.  The marketing was needed to get the very high revenue growth that was the firm’s main financial attraction.  But GRPN initially proposed to the SEC–unsuccessfully–that it should be able to show investors results before deducting marketing expense as its key measure of operating income.

Yes, this sounds crazy.  Apparently, though, this was the best way GRPN could see to make its financials look attractive–putting lipstick on a pig, as it were.  No surprise, then, that the company ran into problems producing accurate accounting statements even after it came public.

To sum GRPN up:

–dubious accounting (the surest sign I know of a toxic security),

–operating losses,

–a business concept that larger and better funded rivals could easily duplicate–and were already doing so.

Yikes!

Q:  Why would anyone be fool enough to buy this security?  (The underwriters had to have known all the unsavory details, but that’s another story.

A:  The buyer believes that there’s a “greater fool” out there that he can sell the stock to at a higher price.

the theory itself

That’s the essence of the Greater Fool theory.

Two parts:

1.  The buyer knows the security he’s buying isn’t worth the money he’s paying for it.  So he’s a fool to do so.

2.  But he believes he can find an even bigger fool to take it off his hands at a higher price.

GRPN trading

In the case of GRPN, as I mentioned above, the stock came public at $20.

The opening trade on 11/4/11 was $25.90.  That was the low for the day.

GRPN traded as high as $31.14, intraday, closing at $26.11.  The stock stayed above the $20 line until Thanksgiving.  And it fluctuated around $20 through early February–before starting south in earnest.

Any IPO participant who “flipped” the issue on day one made at least 29.5%.  A 50% gain was possible (although I haven’t checked the volume at the $30+ prices).

To me, the most interesting thing about GRPN is that there were plenty of warning signs of the trouble that was to come.  Any professional–especially the underwriters–would have seen this immediately.  So too would anyone who thought about Groupon for more than a minute or two.  But the offer was timed to come during a period of high speculative (read: irrational) interest in social networking stocks.  No surprise that Zynga, another obviously flawed company, came at the same time.