Tuesday, May 22, 2012

Facebook IPO: Letting the Air Out of the Bubble

The first thought that crossed my mind when the Facebook IPO failed to trade up on its first day and stepped into the abyss on its second day trading was that the market is acting rationally. The second thought that I had was that the underwriters and Nasdaq really screwed up. I confess that I am a bit of a skeptic when it comes to social networking and some of the related markets such as social gaming, picture sharing and so on. There seems to be more than a little bit of a fad element attached to it, and I can't seem to get completely comfortable with the notion that people will continue to willingly share all types of personal information with large personal networks and eventually the entire cyberworld when Facebook manages to sell every bit of personal information that is useful in targeted marketing, which is everything. I worry about the potential for massive loss of privacy for the generation of young people who are growing up with Facebook and other social networking sites. I am also concerned about the effect on social and intellectual development of children and teens who use Facebook as their primary communication and socialization channel. I do however, believe that the concept of social networking is powerful, and the myriad benefits it creates for both social interaction and data aggregation and analysis will ensure that it continues to evolve into an enduring business.

The fascinating, overhyped build up to Facebook's IPO generates a number of observations and potential issues.

1. Facebook was overvalued at its IPO price.  I know that free-market enthusiasts will always respond to this assertion that it was priced right, since the deal was oversubscribed at the $38 price, which was a significant increase over the previous range, especially considering that the deal size was also increased. But the aftermarket performance indicates that the lead underwriter may have overestimated the strength and stickiness of its book or the commitment of its institutional accounts, or they got a little too greedy, or all of the above. I simply do not believe that Facebook is deserving of a $111 billion valuation, which is what it was priced at. This puts it ahead of companies like HP, Cisco, Disney, Dow Chemical, Texas Instruments, GM, United Technologies and McDonald's, and it is close to companies like Intel and Oracle. I am not convinced that Facebook has the growth potential to justify its valuation, and that is clearly one of the factors spooking investors.

2. Can Facebook generate sufficient growth?  Growth is absolutely essential for highly value stocks. The instant investors get a whiff that growth is slowing or may not meet expectations, they abandon a stock like rats deserting a sinking ship. Many questions surround Facebook's ability to sustain growth. It's 900+ million subscribers will be difficult to grow at the rates it has enjoyed historically, and Facebook's has not convincingly demonstrated its ability to monetize its subscriber base. Most of its revenue comes from advertising and by capturing a 30% share of its partners' transaction revenue, such as Zynga, which is its largest customer at about 12% of total revenue. Facebook users have historically been very resistant to paying any sort of direct fees for premium services, and I am very skeptical that they will be willing to start now. Also, Facebook access is rapidly shifting to mobile platforms which generate lower ad revenue rates than traditional Internet connected PCs, which is one of the trends that forced Facebook into ridiculously overpaying for Instagram. GM's announcement that they were pulling their $10 million annual Facebook advertising account because they concluded that it did not create any benefits is ominous, and Facebook's amended S-1 showing a sequential sales decline in the first quarter is even more so. Add the Morgan Stanley analyst's cutting his estimates during the road show, and you have all the ingredients for real concern about Facebook's ability to generate the growth necessary to support its rich valuation, and if growth really slows down, or even turns negative, its fair valuation is a long way down from where the stock is today.

3. Lack of profit leverage. Facebook has outstanding profitability, with gross margin at around 75 - 80% and operating margin around 50%, but peak operating profit occurred in late 2010, and earnings have essentially tracked revenue since. It is hard to see the company doing better than EPS tracking revenue growth, and it is conceivable that EPS could lag revenue growth if some of the problems outlined in #2 become bigger issues. Earnings growth is mother's milk to growth investors, and Facebook may be facing an uphill struggle.

4. Management Capability and Governance. Mark Zuckerberg is obviously very bright and talented, and creating Facebook, growing it and keeping it independent is a remarkable accomplishment. But investors seem a little nervous about whether his skill set and demeanor is appropriate for running a highly visible public company. Showing up in New York for the first major road show meeting in a hoodie was poorly advised - it showed a lack of respect for the investors whose money was being asked for and appeared arrogant and immature. And his single-handed negotiation of the Instagram acquisition, buying a roughly 10 person company with no revenue and 30 million users for $1 billion looks absolutely horrible, even if you consider Facebook's need to strengthen its mobile presence. The decision on Instagram seems to have been made unilaterally by Zuckerberg and the board was notified by e-mail after the agreement was made, which seems to signal that the CEO believes he can act without the guidance and approval of his board and his investors - that is not going to endear him to public investors. The dual class voting stock which concentrates voting power in Zuckerberg's hands is not viewed favorably by public investors, and it is a concession they had to swallow in order to have access to the offering, as was the unusual 90 day lockup period. The abysmal corporate governance at Facebook may create confidence problems if investors perceive that the CEO is not the right person for the job.

5. Underwriter and Nasdaq fumbles. Morgan Stanley, the lead underwriter, either got too greedy or overestimated the strength of its book when it increased the size of the deal and the price to the top of the increased price range. This caused many institutions to immediately flip their allocations, and in some cases take short positions. The underwriters could not support the stock in the face of such massive volumes, and have had to step out of the way, causing further weakness in the stock. Nasdaq also stumbled in the way it managed the opening of trading and its inability to execute and confirm trades for hours after they were placed, which caused huge investor irritation and cost people a lot of money. While it wasn't the company's fault, it was just another aberration that affected investor confidence.

There has been a lot of chatter suggesting the massive valuations assigned to Facebook and other Web 2.0 companies is creating another valuation bubble reminiscent of the dot com bubble of the late 1990's. I believe that the valuation of many Web 2.0 companies is excessive and presents significant downside risk to investors, which meets the working definition of a bubble. However, it is nothing like the stock market bubble of the late 1990's, which peaked in 2000 and collapsed in dramatic fashion. The dot com bubble was much more widespread - not just dot com companies, but hardware companies, telecom and network companies, semiconductor companies, software companies, optical fiber companies, etc. all traded at absolutely ridiculous valuations that were rationalized by the mantra "the Internet is going to change the world and the stock market is forever changed." They were right on the first part and really, really wrong on the second part. The Nasdaq composite peaked at over 5000 in March 2000, and is around 2850 today. The valuation mania that has caused a valuation bubble among Web 2.0 companies is really confined to the Web 2.0 companies and hasn't spilled over to other business in the ecosystem.

Investor behavior is also very different this time around, as evidenced by Facebook's trading performance. There has been a wide variation in the post-IPO trading performance for different stocks. Companies like Linked In, Splunk, and Jive Software have performed very well since their IPO, while others such as Zynga, Groupon, Pandora, and Friend Finder have declined significantly. Investors are being selective - companies with credible performance, operating models and management are seeing their stocks perform well, and companies with flawed models and inconsistent results are being punished. This is very different than 1999, when every stock went up, sometimes by several times on the first day, and the market did not show any selectivity.

There will be some very successful companies that emerge from the current crop of IPO's and also some disasters. I fully believe that Facebook will be a very successful company and will figure out how to strengthen its position as the dominant social networking company, and hopefully will figure out how to create a stable, growing revenue stream from its massive user base. I just don't believe it deserves to be a $100 billion market cap company today. I hope the insiders take a lesson from Mark Cuban and put a collar on their stock to preserve today's value.


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