Facebook flop underscores questions over valuation
Nasdaq bungle costs firm dearly; investor concerns about ad revenue ‘short-sighted’
Facebook’s troubled arrival on Nasdaq on May 18 was a nasty reality check for the social media giant, after it had enjoyed months of hysterical hoopla. The 33-strong syndicate led by Morgan Stanley might like to paint the deal as a blowout. And, certainly, pricing at the top of the range with a massively increased deal size of $16 billion – the largest US tech offering in history and the third largest US float – is an achievement.
However, a lacklustre debut – gaining just 0.61% and even that thanks to a massive support effort by the lead underwriters – took the shine off an initial public offering (IPO) that seemed to become more tarnished with every day of marketing.
The stock ended its first full day of trading at $34 after opening at $36 and from an offering price of $38. Technical glitches and investor nervousness appear to have been the main causes of the slow start. But it is the former that some analysts say has had the most damage.
“When any company goes public, the first day is important for sentiment, and Nasdaq screwed that up with people putting in orders not knowing what they got or not knowing the price for hours,” says one trader. “Traders really need transparency to get comfortable and that wasn’t there.” It was supposed to be a coup for Nasdaq to be the platform of choice for Facebook but on the day, after a delayed start to trading of 30 minutes, and then due to glitches in the trading system, many buyers were left for two hours without knowing if their orders had been processed. In some cases, orders never went through at all.
“It was too risky that day and there was too much hype to be able to think clearly and trade,” adds another trader.
Some analysts say the slump in share price post-IPO was exacerbated by General Motors’ (GM) announcement to stop advertising with Facebook and concerns around whether Facebook’s advertising revenue would continue to grow. This has been one of the biggest challenges for Facebook – that of convincing investors it merits such a large valuation.
GM, for example, accounted for only 0.3% of Facebook’s ad revenue last year – revenue that grew at 60%. Jitters around the future of the social media monopoly seem to be based on the fact it has no real comparisons, and is evolving so quickly.
How did Facebook find itself in a position where television news networks worldwide led with stories that it was massively overvalued? After all, Facebook started off with possibly the best pre-IPO goodwill of any company in history. With more than 900 million active users worldwide – more than half of all internet users and around a seventh of the world’s population – the company has brand recognition that most firms can only dream of.
Moreover, Facebook’s growth from its origins in Harvard in 2004 is legendary. Indeed, its history, re-told in the film The Social Network, was nominated for eight Oscars and is credited by some with turning its CEO Mark Zuckerberg into a geek sex symbol. Slightly more credible observers – mainly anthropologists – have ventured that Facebook’s popularity is creating a new model of social interaction: it is changing how the human race functions.
With a backstory such as Facebook’s, what is amazing is not that the IPO was completed successfully – albeit against a backdrop of Greece edging closer to the abyss – but that it managed to arouse such hostility among many market observers.
Some believe that hostility came about because of a lack of restraint in how Facebook was valued and how the deal was increased in price and size. While laissez-faire purists argue that the underwriters’ duty is simply to deliver what investors want, others argue the recent past – including the dotcom bubble and the financial crisis – demonstrates the need for caution and responsibility: something conspicuously absent in Facebook’s float.
“Even a dotcom analysis requires heroic assumptions about future revenue growth to get near to the valuation ascribed to the company – before the price range was increased,” says Alan Patrick, co-founder of technology consultancy Broadsight. “There are so many unanswered questions: how to make money from mobile [the issue addressed in the supplement to the prospectus] being just one of them.”
Victor Basta, managing director of technology M&A advisory firm Magister Advisors, points out that Facebook will have to grow to $30 billion to $40 billion in revenue to justify its current valuation. “It can’t trade at 30 times revenue forever,” he says. “Where will that revenue come from? A seventh of the world might use Facebook, which theoretically gives it scope for subscriber growth. But much of the remainder of the world – especially in developing countries – doesn’t have a PC or a smartphone.
“Moreover, many of those people don’t have a life that takes them outside their village. They don’t need Facebook.”
However, Daryl Jones, head of research at Hedgeye Risk Management, points out: “Facebook created a new industry and has succeeded in monetizing it in just a few years from advertising but partly by collecting fees from app companies, specifically in the sale of virtual goods – again an industry that did not exist until recently.
“To value the firm on short-term metrics is short-sighted. Facebook will create new revenue streams like it did with apps. We just don’t know what those are yet and maybe nor do they. But with 500 million users a month and those user numbers increasing, Facebook doesn’t have to make a lot of money out of each customer to justify its roughly $100 billion valuation. Just creating some new products to sell to that massive user base will lead to exponential cash flow.”
Concerns about whether Facebook will be able to make money from the shift into mobile are also overplayed, says Jones. “The average Facebook user spends eight hours a month on it on their desktop,” he says. “The average Facebook user who uses both mobile and desktop spends 12 hours a month on the site. So, it may be harder to sell ads through mobile at the moment, as no one has worked it out yet, but the move to mobile also means Facebook has stickier clients – so an even stronger user base.”
Basta emphasizes that if Facebook is not going to fill its revenue gap through growth, it must fill it by getting more from existing users. “However, this model also presents challenges,” says Basta. “Facebook depends on partners to a far greater extent than Google, for example, did at a similar stage of its development.
“Google was much more of a silo company, whereas Facebook depends on its ecosystem of partners. Facebook has the advantage it can charge other companies for being on its platform. However, the flip side is that it has to give everyone a cut of its business.”
The excitement generated by Facebook’s IPO was understandable, but once stories emerged of parents punting their children’s college funds on the IPO, a social network bubble began to form, according to Patrick.
“The parallel is with 1995 and Netscape’s IPO: the dotcom madness hasn’t arrived but it’s on the way,” he says. “Other social network-type businesses will try to list and the wisdom of crowds will become the madness of crowds: people will just want to be part of the next big IPO.”
Given such a fever, it might have been responsible to stick to the original deal size and range, and let the aftermarket do its work. Instead, the underwriters increased the price and inflated the deal by a quarter: Goldman Sachs more than doubled the number of shares it planned to sell, from 13 million to 29 million, Silicon Valley investor Peter Thiel increased his sale from eight million to 17 million shares and hedge fund Tiger Global increased its sale from three million to 23 million shares.
Of course, Facebook might yet end up as the world’s most successful company and its valuation become fully justified. However, coming so soon after JPMorgan’s European credit-default-swap debacle demonstrated that recklessness is still rife at some of the world’s global banks, a touch more humility – and a bit less of a throwback to dotcom days – might have been welcome in bringing Facebook’s IPO to market.