Facebook's flop

The Facebook float flop has triggered a wave of post-mortems around the globe as analysts try to understand what went wrong. The answer is actually pretty straightforward: the float was over-hyped and over-priced.

It didn't help that NASDAQ went into meltdown under the pressure from the float, with traders unable to confirm their trades until mid-afternoon, but the fundamental reason Facebook shares ended yesterday at $US34.03 against the IPO price of $US38 was that the promoters sold too many shares at a price that stretched even the most optimistic of valuations.

When the float strategy was first unveiled Facebook was looking to sell about 10 per cent of its capital at between $US25 and $US35 a share, raising up to about $US10 billion and valuing the company at between about $US77 billion and $US96 billion.

With the roadshows triggering a near hysterical reaction, however, Morgan Stanley lifted the price range to between $US34 and $US38 a share and decided to make $US16 billion of shares available. At the top of that new range – which is where the float was ultimately priced – Facebook was valued at $US104 billion.

Given that Facebook earned only $US1 billion last year, that's a rather fancy price. It looks even more inflated when in the lead-up to the offering, Facebook's first quarter sales and earnings were lower than the fourth quarter last year, confirming that its growth rate has been decelerating. It has also turned cash negative.

The flickers of concern generated by those quarterly numbers, which Facebook said were affected by seasonal factors, were fanned when, mid-roadshow, Facebook filed a supplementary prospectus with the US Securities and Exchange Commission in which it acknowledged concern about its revenue growth because of the accelerating shift in its users towards mobile devices.

With more than half Facebook's users accessing the network through mobile devices, and Facebook itself declaring that it generates minimal revenue from mobile users and has yet to develop a way of monetising that usage, that wasn't quite a material restatement.

There are also unconfirmed reports that Morgan Stanley's own consumer internet analysts downgraded his revenue forecasts during the roadshow, which would be highly unusual, although consistent with the SEC filing.

Then, of course, General Motors pulled its advertising from Facebook, saying its advertising wasn't effective.

So, in the face of a number of recent negative developments, Morgan Stanley went ahead an increased the price to the top of the range and maxed out the number of shares it sold.

It is normal in ‘'hot'' floats for investors to ask for more shares than they expect to get, which appears to have happened in the Facebook IPO. In the event, it appears there wasn't any meaningful scaling back of applications, which meant some investors ended up with more shares than they wanted and therefore an over-hang in the stock once a market opened.

The Facebook debut, while somewhat embarrassing for the company and the investment banks associated with the offering, does mean that where conventionally there is some transfer of value from the original investors in the company being floated to new investors (and quick ‘'stag'' profits for those who immediately on-sell) this time the value went in the other direction.

The increased volume of shares that were made available came from insiders, so they profited from the inflated price. That's not an unfair outcome and ultimately the promoters of the offering were effectively working for those insiders.

Mark Zuckerberg and his executives might actually be privately pleased that they have rewarded the insiders (including themselves) handsomely while the fall in the share price lowers the performance bar for them slightly, although the stock still closed on a multiple of 93 times last year's earnings.

Had the listing followed convention and traded at a solid premium to the offer price, it might have been closer to 120 times. It might also have sucked in a lot more mum and dad punters in the aftermarket, with far bloodier and brand-damaging consequences.

The value of Facebook isn't something that can be readily or precisely calculated. In one sense whatever valuation is attributed to the company is a demonstration of faith in Zuckerberg's ability to find ways to monetise the vast user base – more than 900 million of them – more effectively. The sharemarket, even at the lower levels, is capitalising a lot of blue sky into Facebook's value.

In particular, Zuckerberg has to devise some way to extract revenue from those troublesome mobile users and do so quickly before the growth in their numbers completely undermines his average revenues per user and his margins.

The problem for investors, even at $US34 a share, is that Zuckerberg has been quite open in saying that he is more interested in improving his users' experience than in profiting from them.

So, those who subscribed to the IPO and still hold their shares have stock in a $US93 billion company with a CEO who is more interested in a social experiment and mission than in making money. Given the heroic leaps in profit the stock market price assumes, that's an uneasy combination.