Facebook IPO: What It Is And What It Isn't

May.17.12 | About: Facebook (FB)

The Facebook (NASDAQ:FB) IPO has the most retail interest of any IPO, pretty much ever. Multiple specials are being run on the major TV networks documenting the history of the company and its future prospects, conveniently days ahead of the IPO. The IPO is going to be the largest in history, so it is obviously newsworthy, but some of the consequences of heavy retail interest are just now coming to the surface.

Facebook: Basic Arithmetic

Which company is a better deal, Stock A priced at $10 with 100 million traded shares or Stock B priced at $100 with 10 million traded shares?

If you answered either one, you're doing it wrong.

Each company is worth the same amount. Just going by share price alone, some would say that Stock A is cheaper, but you are getting a correspondingly smaller ownership stake in the company. 10 shares of A is the same percentage of the company as one share of B.

Every tweet, story, article or post that I see that refers to the Facebook IPO range of $34-$38 as "cheap" solely due to Apple (NASDAQ:AAPL) being at $650+ or Google (NASDAQ:GOOG) at $600+ makes me cringe. Blame it on inexperience, poor financial literacy, greed, etc. the fact is some people are going to get into the IPO thinking that LinkedIn (NYSE:LNKD) was just a preview of what is to come for Facebook. Calls for $50, $75, $100 and even $200 or $300 are being thrown around for where Facebook will end up after the IPO based entirely on the face value of other prominent stocks.

Will it see a pop above the current IPO range? Definitely. Almost guaranteed. Too many people with vested interests in this IPO being successful have put too much money on the line for it to be anything other than an astounding launch.

A case can definitely be made to get in to the pre-IPO trading vehicles [Firsthand Technology Value Fund (NASDAQ:SVVC), GSV Capital Corp. (NASDAQ:GSVC), Naspers (OTCPK:NPSNY)] for the initial pop and an exit immediately afterwards. It's possible that it is too obvious to work but sometimes the obvious play ends up being the most profitable.

In an effort to determine what the Facebook IPO actually is, let's look at some of the IPOs to which it is being compared.

LNKD: An IPO Case Study and Comparison

LNKD Post IPO Performance

LinkedIn IPO'ed to much fanfare on May 19, 2011 and is likely the model that all those playing the Facebook IPO are hoping for. The LinkedIn IPO was announced at $32-$35, priced at $45, started trading at $83 and spiked all the way to $122 before heading back down. Anyone who was able to get shares at the IPO price made a substantial return simply by winning the IPO allocation lottery.

If LNKD is the model for the upcoming FB IPO, we could see shares that started at $28-$35 price at $38, open at $70 and peak at $103. Maybe those calls for $100 are not so crazy after all.

The problem with the belief that FB will see the same surge in demand that was seen in LNKD comes in a few disappointing flavors.

LNKD came to the market with an extremely small float compared with what we are seeing with FB. LNKD started trading with just 7.84 million shares available. Compare that with the 420 million that Facebook will be offering with the just announced increased float. Sure, there is more demand for shares of Facebook, but is there 53x the demand? There will be substantially more shares available for trading and that should put a damper on any hopes of seeing the same post-IPO heights that LNKD achieved.

Facebook is also selling more of itself than LKND did on the IPO. With the recent increase in shares offered, Facebook is going to be selling 19.6% of its shares to the public, double the percentage of shares that LinkedIn offered at its IPO.

LNKD also IPO'ed at a time when people were rushing for exposure to "social" no matter the price point. The demand for LNKD shares was increased by being an opportunity to front run the eventual Facebook IPO, to catch lightning a bottle. Well, the lightning is here now and the bottle is not as shiny as it was before.

Facebook is growing much slower than LNKD, simply because it is a more mature company. Facebook already claims almost a billion users of its products. What is the ceiling? 2 billion? Is the majority of the world's population, living in rural poverty, going to be rushing to consume ads on Facebook?

Growth will not necessarily stop or reverse but the rule of large numbers is going to significantly limit their ability to grow the user base. It can try to actively monetize the user base through targeted ads or restructuring the user experience but any changes will be met with customers abandoning the site and moving to the alternatives that exist. Facebook may see improved revenue per user (currently at $0.23 per user per year) but will suffer from a slow bleed of users that reject its efforts to monetize membership. I'm not saying Facebook = MySpace, just that any efforts to further monetize the user base will more than likely result in a reduction in the user base.

With the larger number of shares being offered, the larger percentage of the company being sold, the significantly different market environment and the lower growth prospects I don't see Facebook achieving the $100 or higher price targets that some are claiming for the IPO.

Facebook, as a company, is closer in its business life cycle to Google than the younger LinkedIn, so let's take a look at the GOOG IPO and see if that can give us any insight.

GOOG: An IPO Case Study and Comparison

GOOG Post-IPO Performance

Google came to the market with its IPO in August 2004. Initially priced at $85 with 19.5 million shares offered, the stock started trading at $100 and within 3 months had already doubled. At the time of the IPO, Google was growing revenue by over 100%, net income by almost 148% and was only valued at ~$24B. In contrast, Facebook coming into the IPO is offering 21x the number of shares, growing revenue at 45%, net income at ~30% and a market value of $100B.

Simply put, Facebook is coming to market after the hyper growth phase is already done. Anyone expecting it to post a matching performance to GOOG is ignoring the reality of the mature business Facebook has become.

GOOG came to market with massive growth rates that stayed massive. The IPO price to revenue multiple of GOOG at 24x was high, but GOOG was able to maintain its growth rate and grew into its valuation. FB is coming to market with the same price/sales multiple with growth rates that are 50% to 67% lower than GOOG at its IPO.

Anyone expecting FB to mirror the post IPO performance of GOOG or LNKD is going to be sadly disappointed as the company, already priced aggressively at $38, is not going to be standing on a firm foundation if it is vaulted higher on hope and a retail buying frenzy.

What's The Play?

It's not too late to pick up some SVVC, GSVC or NPSNY to play the initial hype and retail frenzy. I would recommend selling if the IPO pops much above $50 and "Sell, Mortimer, Sell!" if it gets any higher. While SVVC has the upcoming Twitter IPO to look forward to and NPSNY has Tencent to provide additional momentum, I feel that you will be able to get the same shares for much less than you sold them for a week or two after the IPO.

Facebook is a fine company that is still growing substantially with tons of opportunity ahead of it. I simply disagree with all of the comparisons being made to the previous mega-IPOs as Facebook is coming to market well past the hyper growth stage while being priced as if it was just starting it.

I am unsurprised to hear stories of retail investors that are normally unable to obtain IPO shares suddenly having FB shares from their broker. There are simply a ton of shares being sold at this IPO and many ill-informed investors looking at the share prices of GOOG, AAPL, LNKD and PCLN and saying "Man, these FB shares sure do look cheap!"

Anyone even contemplating that should consider this:

FB shares outstanding - 2.1B

AAPL shares outstanding - 935M

GOOG shares outstanding - 326M

Does FB still look "cheap" when using AAPL's share count ($85) or GOOG's ($245)?

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.