Facebook's Wall St disconnect

Hype clouded common sense during the Facebook IPO, with reports now confirming that the bankers and analysts involved had lofty expectations of the company and little understanding of its challenges.

Facebook Inc may be having trouble connecting with Wall Street.

The financial houses behind Silicon Valley's largest-ever coming-out party kicked off formal coverage of the company on Wednesday by warning about an uncertain business model, margin pressures and a difficult transition to mobile technology.

The reports, released by banks involved in the IPO after a 40-day quiet period expired, represent Wall Street's broadest assessment of the first US company to debut with a market value of more than $US100 billion.

Morgan Stanley and other major brokerages that handled the blockbuster IPO said it remained unclear how Facebook plans to make money from a growing number of users logging on to the No. 1 social network via smartphones and tablets. That helped send its shares down three per cent.

Of the 17 brokerages that handled the blockbuster IPO and kicked off coverage of the social networking company on Wednesday, eight recommended against buying into the shares. Two of Facebook's three lead underwriters - Goldman Sachs and JP Morgan - were most bullish, targeting Facebook shares at $US45 and $US42, respectively.

Morgan Stanley, which has come under scrutiny for its role in driving a $US38 IPO price that now appears lofty to some, stuck to a price target that matched its debut level and "overweight" recommendation.

The average of target prices cited on Wednesday was $US37.64 - a tad below Facebook's stock market debut price.

Facebook's IPO was to have been the culmination of years of breakneck growth for a company that became a social and cultural phenomenon. Instead, it was marred by a series of trading glitches on its debut, and the company and its underwriters subsequently faced accusations of pumping up the price and inadequate disclosure.

Wednesday's panoply of neutral or equivalent ratings is notable because Wall Street research analysts have a reputation for favoring "buy" ratings, particularly in the high-profile Internet industry where "buy" or equivalent recommendations far outnumber "hold" or lower ratings.

The US internet sector's 110 companies sport a collective 561 "buy" recommendations or better, versus 352 "hold" or "sell" ratings or their equivalent, according to Thomson Reuters StarMine.

"It says there are real questions out there about the strength of this business model, the fundamental strength of this company, together with its valuation," said Tim Ghriskey, a portfolio manager at Solaris Asset Management.

"We're not buying right now, that's for sure."

How lofty?

Banks are required to keep their employees handling IPOs apart from analysts recommending stocks in order to avoid conflicts of interest.

In the IPO, banks sold their clients shares of eight-year-old Facebook, started by Mark Zuckerberg in his Harvard dorm room, at a price equivalent to a whopping 100 times 2011 net income per share. That compares with Apple Inc's current multiple of 20.6 and Google Inc's 18.9.

"I respect that a Chinese wall exists, but I think it feeds into the cynicism that Main Street has for Wall Street - that one side of the business was telling them to buy at $US38 and the other side of the business now at $US32 says we shouldn't buy it," said Steve Birenberg, a portfolio manager at North Lake Capital in Winnetka, Illinois.

Most analysts expect Facebook's large user base to help it corner a substantial share of the Internet advertising market in the long term. But half of the ratings released on Wednesday were "hold" and its equivalent or lower - despite the shares trading sharply down from their $38 IPO price.

Eight slapped top ratings - "buy," "outperform" or "overweight" - on the social networking company.

BMO Capital Markets' Daniel Salmon began his coverage with an "underperform" recommendation and a $25 target, translating into a nearly 25 percent slide from current levels.

"Slowing user growth is one of our primary concerns for Facebook's current valuation," said Salmon, the only analyst giving Facebook a negative rating on Wednesday. He estimated Facebook's annual user growth would be 22 per cent next year and 16 per cent the year after, much slower than expansion in the past.

The 33 banks that participated in the stock listing were required by securities regulations to wait until 40 days after the first day of trading on May 18 before publishing their views, limiting the research on Facebook until now to a handful of analysts.

Scott Devitt at lead underwriter Morgan Stanley, who told the firm's major clients that he had cut his revenue estimates on Facebook just days before the IPO, said he expects Facebook's ability to turn its mobile features into profit to be a challenge for the next several quarters to several years.

He expects revenue to climb 31 per cent in 2012, down sharply from the 88 per cent growth in 2011.

"No one is debating the potential opportunity in front of Facebook," said Channing Smith, a portfolio manager at Capital Advisors. "However, there is disagreement in the analyst community on the trajectory of the earnings and revenue growth in the coming years. The assumptions analysts are making are guesswork at this point."

Topsy-turvy IPO

Analysts at JP Morgan set a price target of $US45 for the stock, suggesting a rise of 36 per cent compared with its close of $US33.10 on Tuesday. Facebook shares were down 3.1  per cent at $US32.07 on Wednesday afternoon.

Goldman Sachs set a target price of $US42, less aggressive than Morgan Stanley's $US38 target.

The company's stock offering, one of the most highly anticipated in history, was marred by a series of technical glitches at the Nasdaq exchange.

Facebook's decision to increase the size of the offering by 25 per cent just days ahead of the IPO, as well as concerns about decelerating revenue, also weighed on the stock, which traded as low as $US25.52 before regaining some ground to trade in a $US31-$US33 range in recent days.

RBC said it expected Facebook's stock to hit $US40. BofA Merrill Lynch and Morgan Stanley pegged the shares at $US38, while Citi and Barclays opted for $US35.

The rush of research comes ahead of Facebook's second-quarter results, expected sometime in mid-to-late July.

With about 900 million users, Facebook has become one of the web's top destinations, challenging established players such as Google Inc and Yahoo Inc.

Even so, revenue growth from ads and other services is slowing. The company, which last year was more than doubling the amount of money collected every quarter compared with a year earlier, reported growth of 45 per cent in the first three months of 2012, and revenue declined from the preceding quarter.

General Motors Co' announcement a few days before the IPO that it would stop advertising on Facebook has added to the concerns about Facebook's ability to generate business from advertising.

Despite $US4.8 billion in expected revenue in 2012, the average amount of money that Facebook makes through each user is still relatively low, said BofA Merrill Lynch, which expects new advertising formats to accelerate revenue growth in the second half of the year.

In recent weeks, Facebook has unveiled a string of enhancements to its advertising service, allowing marketers to target ads to users on the mobile version of Facebook and to show Facebook users ads based on previous websites that they have visited.

"The company is in the midst of a mobile usage transition and we are cautious on Facebook's revenue trends until new mobile ad revenue models start driving the top line," the analysts at BofA Merrill Lynch wrote.

Several analysts working for the underwriters, including Morgan Stanley and Goldman Sachs, cut financial forecasts for Facebook days before the IPO, after the company cautioned about revenue growth due to a rapid shift of users to mobile devices, where Facebook is less effective at generating revenue.

The analysts briefed some institutional clients about their revised forecasts, sources have previously told Reuters, but retail investors were left in the dark. That revelation has resulted in lawsuits alleging the banks and Facebook failed to fully disclose the company's weakened financial outlook ahead of its IPO.

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