There was plenty of commentary over the weekend that the Facebook IPO was a big flop because the underwriters had to support the price, but that says more about the modern game of investment banking, where investor clients are usually given quick profits in IPOs at the expense of vendors, because vendors are not usually repeat clients.
Also, last week was not the best time to be bringing a high-risk company to market, let’s face(book) it.
Fact is Mark Zuckerberg and friends sold 15 per cent of their 4-year-old start-up for $16 billion, valuing a business that made $1 billion profit last year at $105 billion, a PE ratio of 105 times. The stock closed its first day at $38.23, slightly ahead of the IPO price of $38 per share, but only thanks to buying from the underwriters.
According to a company filing after the market closed, the three underwriters all had to spend a lot of money to keep the price above $38: Morgan Stanley, the lead adviser, ended the day with 162 million shares for $6.16 billion, while Goldman Sachs spent $2.4 billion and JP Morgan $3.2 billion.
Total fees were $176 million, so if they lose 50 cents a share the fees are wiped out.
They won’t be able to keep supporting the stock next week, so presumably both they and the IPO investors will soon be nursing a nasty loss. Everyone will then firmly describe Facebook as a great long-term investment.
Is it? Well, it will have to be quite long term because there remains a vast stock overhang. Only 421 million shares were sold out of 2.7 billion created, which makes it one of the smallest free floats in the world. And the dual voting structure, which gives the tradable shares no votes, means they carry no loyalty either, so any time the stock goes up there’s likely to be some big sell orders.
The price multiple assumes spectacular growth, but no one is entirely sure how, or even whether, the business model will work. Actually, amend that – the business model clearly works; it’s just a question of to what extent it works.
The hype around Facebook and the big valuation it got in the IPO, is all to do with this number: 845 million monthly active users as at December 31st, 2011. This was up 39 per cent on the previous year, which was in turn up 69 per cent on the year before that.
The business model is simple: display advertising on web pages that are created at no cost to the company by those 845 million users.
Contrast that with Business Spectator’s business model, which is based on display advertising placed on pages that all cost us something to create. We are in the new world of online media, but the model is traditional – you pay journalists to write stuff that you hope enough people will read to generate an audience that advertisers will pay for. Each page has a cost, and most of them cost more than they earn.
Facebook’s model is the same, except it doesn’t pay anyone to create the content. The problem with the model is the same as it is with all media that relies on display advertising: the advertising intrudes into what the user is doing; it tries to divert their attention and make them click on an ad.
Facebook’s click through rate (CTR – it’s rate at which users click on ads) is 0.051 per cent, which is not much. That’s because social media users are doing something that is very far removed from consuming products – they’re dealing with friends.
Journalism is often closer to the messages the advertisers are trying to get across, and sometimes it is directly related (stories about travel and cars for example), so the CTRs can be much higher. Google’s CTR is phenomenal because people are actively searching for something – Google isn’t trying to divert them, it’s just harvesting existing consumption.
Facebook’s revenue growth can only come from increasing the CTR, increasing the number of users, or charging more for its ads (which is mostly a function of the first two metrics).
User growth in the US last year was 16 per cent, compared with the global growth of 39 per cent. The number of monthly active users (MAUs) in Brazil increased 268 per cent last year. In India the increase was 132 per cent. Just eyeballing charts of MUAs in the various regions it is clear that the growth in users in the US and Europe is flattening but is staying strong in Asia and Latin America.
So it’s fair to say that buying Facebook shares at $38 is a bet that it will be able to sell ads in the developing world – where its growth is – at the same sort of yields that it has been getting in the US and Europe.
And then there’s the question of whether Mark Zuckerberg’s company – that he controls more absolutely than Rupert Murdoch has ever controlled News Corporation – will be able to manage that growth.
American IPO documents are filled with bum-covering negative statements, but even for them this was an arresting statement buried deep in Facebook’s S-1 filing:
“We cannot assure you that we will effectively manage our growth.
In the event of continued growth of our operations or in the number of our third-party relationships, our information technology systems or our internal controls and procedures may not be adequate to support our operations. In addition, some members of our management do not have significant experience managing a large global business operation, so our management may not be able to manage such growth effectively.
To effectively manage our growth, we must continue to improve our operational, financial, and management processes and systems and to effectively expand, train, and manage our employee base.
As our organisation continues to grow, and we are required to implement more complex organisational management structures, we may find it increasingly difficult to maintain the benefits of our corporate culture, including our ability to quickly develop and launch new and innovative products. This could negatively affect our business performance.”