Did facebook fool investors ?

Lot of experts have already written a lot about facebook IPO , the subsequent stock price fall and impact on the investor community. Investors have subsequently filed lawsuit against the underwriters and facebook for hiding information prior to IPO. The question is is the investors so naive that they could not look at the risks themselves and they had to bank on analysts and underwriters declaration. This is one of the classic case where company fundamentals were totally ignored and speculation and greed overshadowed. I got a chance to analyze this issue recently and below are just some thought processes which came across to my mind. 

Facebook is the most famous social networking site with 900+ million users and have made an IPO debut on 18th May 2012. Facebook was valued $104 billion with an offer price of $38 at the time of IPO , which made it one of the biggest company to go public in the US history. After the debut the share price saw a constant fall and is now (11th Oct end of day price) trading at close to $19.45, which is about 50% lower than the offer price. Although there was overwhelming responses from the investors oversubscribing the IPO by more than 10 times, there were few fundamental risks involved in the company which investors overlooked . Few of those risk factors which probably investors overlooked :

Future Growth 

Facebook revenue stream is generated fundamentally by advertising which contributes to 85% of the revenues. The cash flow is tied to just one vertical and any fluctuation will have an impact in the company valuation. In terms of user base facebook has saturated some of its key first world markets in terms of user counts. It’s very difficult for facebook keep increasing the user base as what it has done in the last couple of years. 

The ad revenues are directly linked to the number of users clicking the ad banners and with markets getting saturated the ad revenues may remain constant or slide in the event facebook is not able to bring new well received products and unable to balance the user experience with the ads. Moreover almost half of the advertisers see that ad dollars spent on facebook is “experimental” and as a result the ad revenues have gone down by 6% in the Q2. General Motors Co has pulled out $10 m ads from facebook at the time of its IPO and more and more advertisers are following suit. 

Mobile Users 

Almost about half of 900m user’s user mobile channel to access facebook and its mobile sites do not show ads of any kind. Facebook has not been able to successfully monetize its mobile user base. Moreover facebook do not own any proprietary mobile device or OS. Facebook competitors Google give preference to Google+ and iOS provides twitter as its identity provider and native sharing options. Google and Apple control the native in-app payment systems could effectively box facebook out of the mobile app market. 

Competition 

Facebook faces a significant amount of competition from the likes of Google, Microsoft and Twitter, as well as other social networks from around the world. Facebook's competitors may acquire and engage users at the expense of growth or engagement of their user base, which would negatively impact Facebook's business and financial results. Acquisitions or consolidation within Facebook's industry may result in more formidable competitors. 

Government Censorship and Privacy Regulation 

Facebook is an international business; it is available in more than 70 languages and has offices or centers in more than 20 different countries. Facebook are subject to a variety of risks inherent to businesses operating internationally like: 

• Social, political or economic instability. 
• Potential damage to Facebook's brand reputation due to compliance with local laws, including potential censorship. 
• Facebook face risks relating to the legal and regulatory environment in foreign jurisdictions. 

Facebook has attempted to give users more control about how much of their information can be made public, but the company never revealed clearly how they are using the data internally. Investors realize that the personal information which facebook holds is the single biggest selling points to its ad customers. In the event of misuse of data, public backlash or government sanctions the revenues will nosedive. 

Management Team 

Facebook is a two headed company , CEO Mark Zukerberg who makes products and CIO Cheryl Sandberg who is responsible for making money. They have unconventional way of running the business , not much of discussions and no formal approach before deciding on the investment. Mark Zukerberg is just one person who have authoritarian rule over facebook. He even spent $1b in instagram without consulting anyone. The business is not run in a corporate style and in the event something tragic happens to Mark , or he makes a big mistake the whole company will be in jeopardy.

Do investors have legitimate claim for compensation?

The basis of the lawsuits against facebook and its underwriters is the accusation that "underwrites disclosed the change in analyst’s forecasts selectively and have made a fraud in sizing up the offer price". As per SEC regulation facebook has highlighted the risk factors and gave enough indications in the IPO prospectus. Facebook has clearly mentioned the risk factors on -competition, worries about slowing of advertisement revenues and also acknowledged that revenue is not going to grow at the same rate. Specific disclosures include that revenue fell by 6% and profit by 32%. There were other warning for investors too, General Motors pulling out the advertisement and facebook itself acknowledging that there is lot advertisers have shown skepticism and they consider the site experimental. 

On May 15th the price was boosted to $38 and news was already out that insiders were selling 84 million more shares. Pricing the stocks at high end range and cashing out on the investor interest is not wrong as per the law. It may be termed as greed or short shortsightedness but not illegal. At the time of trading the price to earnings ratio is close to 120, which by any means it’s too high and leaves zero margin of safety .Seasoned investors is expected to know this basic fundamental that issue is overpriced and use their judgement while subscribing. 

Most of the investors have ignored the risk factors, and the fact that offer price is high end, but still they have gone ahead to investment on a hope to get a return on the first day of the trading. Most of the investors have subscribed to the IPO not on the hope that it has long term prospect, but rather to make money on the first day of the trading. Although there was glitch in the NASDAQ system because of which the matching price was not done correctly and because of which some of the investors lost money. But it’s a zero sum game, some may have gained and some lost. Investors may claim that money lost due to incorrect matching prices and underwriters or NASDAQ may compensate for that .But legally there is isn't much merit for investors to sue facebook. 

The writing was there on the wall and it was more of investor’s greed to cash out of the first day of the trading and over-subscription and investor interest cannot be attributed directly attributed to the valuation or disclosure. SEC rules states that ,analyst’s forecasts and views need not necessarily be included in the prospectus, so there is not much merit to sue facebook. . My view is that , as long as the rules of listing are followed, facebook and underwriters have not broken any law. So it is unlikely that the investors will get any  compensation for trading losses.

Looking from facebook perspective , was this IPO a success?

There are two ways to look at it, one from the investor’s perspective and one from the facebook and its underwriters. On the first day of the trading , intraday stock price rose to $42 and closed at 23 cents above the issue price of $38. Most of the first day cashers would have recovered their investments (ignoring cost of investment) , but overall the performance did not live up-to the expectation of investors. 

From the facebook and its underwriters perspective the deal was pretty good. The company and underwriters did not leave much money ( actually no money) on the table. The social media giant raised a hefty $104 billion, much of which will go into the company coffers. It also created a host of newly minted billionaires and millionaires, from its 28-year-old founder/CEO Mark Zuckerberg, down to most of Facebook’s 3,500 employees. Why I say underwriters did a damn good job is - the IPO was done in a time when the broader market was declining. 

It is important to remember that IPO is to raise capital and raise it as much as possible. The reasons for raising capital vary from supporting a business' growth to insiders cashing out, among others. Facebook managed to raise about $104 billion, the high end of its desired range. By this measure, the Facebook IPO was a smashing success. 

The fundamental issue in the IPO were- i) "quantum of shares" floated in the IPO and ii) facebook clearly misjudged the demand for the shares. Probably the market did not have that kind of appetite. Underwriters have dual role to play, one not to leave too much money on the table and another to leave some room for the investors to make money and this equilibrium creates the initial market is created. Underwriter’s maximized the price for facebook but failed to read the investors sentiments. 

Conclusion
Best investments are determined over months and years and not in hours and days. The long term investors may not be too unhappy as the company has got plenty of capital to take on the competitors ,and may come out with innovative products and new ways to make more money. Anyone investing in an IPO  and looking for a day one “pop” is trying to speculate the short term market behavior. Long-term success of a company isn't predicted by the initial trading of its shares but on a much longer term. Any company that controls online distribution for nine hundred million people and counting has the potential and long term investors are looking forward to that. It’s possible that many of the IPO investors are holding on to the stocks and bullish on facebook’s future.

Conclusion is - facebook and underwriter’s failed to judge the demand and the fact that offer price was at a higher end.Just considering the IPO , I think it was a success as the primary motive of raising capital was hugely successful. The company ended up a winner, although the short term investors and speculators (who predicted price rise) might not have.