We are now one week on from one of the most significant, feverishly anticipated, and, as it turns out, vexatious IPOs in history: on Friday May 18th, Facebook (FB) debuted in the public equity market and managed to pile on to the controversial valuation of the social media platform shepherded into our collective lives by its equally controversial founder a controversy surrounding the IPO itself. In the Sturm und Drang that has followed, two basic questions-related but distinct-have emerged:
- Did Mark Zuckerberg and his banker buddies deliberately hose retail investors on behalf of institutional insiders?
- Is Facebook, given its exorbitant valuation, even a good investment to begin with?
As to the first question, much will probably hinge on the "deliberately" part. As usual in cases of potential shenanigans in the upper echelons of finance, the bankers and their client will argue that despite certain regrettable circumstances in the execution of the IPO, they (technically) followed SEC regulations, while Facebook's benighted new shareholders, crying from the wilderness of plain dealing and good faith, will demand justice for what in any normal ethical system would clearly pass for outright fraud. It is something of an irony that the SEC regulations themselves, designed to protect individual investors from enthusiastic analysts, are at least partly to blame for the unfair and hamfisted manner in which IPOs in general are conducted. But the SEC is hardly as clever as the banks, anyway, and if its various mandates haven't been massaged into pliability by the banks' lobbying efforts to begin with, ways can almost always be found to circumvent them. The fact that this particular IPO was unprecedentedly hamfisted, from the mid-roadshow guidance revisions to NASDAQ's bungling of the opening day, merely throws into sharp relief the structure of a financial system which facilities and encourages these sorts of dubious, "technically not illegal" activities. Lawsuits may abound in the coming days, but they will likely do very little other than threaten to temporarily dilute the valuations of Facebook and its underwriters (and not by much) while lining the pockets of eager-to-litigate attorneys.
If you're extremely optimistic, you might believe the whole affair will bring needed changes to the culture of Wall Street. Arguably, something must be done to protect small investors from the ravenous appetite of the big money men for their every last dollar-cost-averaged cent. But increased oversight in an environment of cheap capital will only further discourage companies from bothering with public markets at all. Dual-class share structures and private equity exchanges are only the beginning. Once the majority of individual investors have been stripped of whatever meaningful, excess wealth they have left (and their retreat from the markets has already begun), innovative companies will simply go elsewhere to raise money without the hassle of having to answer to a motley of short-sighted, irascible, and irreconcilable shareholders.
Whatever the actual motives of Zuck and Co., the Facebook IPO was simply a highly visible symptom of a financial system that is increasingly making muppets of us all. Smart investors, in my opinion, shouldn't get too worked up about what went on last week and whether or not it was a deliberate conspiracy of some kind, because the effect is the same regardless: a whole bunch of people not in the know joined a feeding frenzy of frothy over-exuberance and (as usual) lost money. In all likelihood, it was more complicated than a simple scam and less innocent than mere incompetence. And there was every possibility that things could have gone differently. Play the game or don't. Either way, you have to protect yourself. The banks are not on your side, and Wall Street always wins. That doesn't mean you can't win, too, but it pays to be modest when facing up to those odds. Unfortunately, despite the naïveté of small investors and true blue believers in the supposed free market, it has ever been thus. It's just that, in previous IPOs, you didn't mistake the issuing company for your "friend."
Which brings me to the second question: is Facebook a good investment? In reading through the blizzard of articles written on this subject over the past week, the conclusions are not surprising. They are yes, it is worth it, because Facebook has managed to attract an enormous user base that its clever techies will undoubtedly find some way to monetize, because techies can do anything (especially for money) and hey even Steve Wozniak is buying in while Tim Cook paid them a rare compliment; and no, it is way overvalued, their revenues are falling, the real money has already been made by Bono on SecondMarket, and the barriers to entry in the social networking domain are too low to expect Facebook to maintain a competitive advantage that justifies its insane P/E ratio. As in almost every investment decision, numbers are helpful, but one ultimately has to either have confidence in a business's future prospects or not. Everyone who invests in this company or even has a Facebook account (I have one friend who doesn't) should ask themselves, do I really have faith in Mark Zuckerberg's creepy smile?
But let's look at some of the concrete information available. First, the share price: the IPO was set at $38. This price was higher than the top end of the original estimated range the stock would start trading at, and it was decided on after Facebook's executives revised their forward earnings downward. Unfair? Ridiculous? Outrageous? Not if people were willing to pay for it. The underwriters, on behalf of their client, were incentivized to sell as much stock for as much money as they could get. The whole point of an IPO, after all, is to raise money for the company (and possibly give the VCs a glorious send-off), not satisfy the frankly embarrassing greed of the secondary market. If investors really thought Facebook's valuation was justified because of its future earnings potential or impressive brand value, they should still think so now. Despite frequent talk of fundamentals, a stock's value is largely a matter of perception. There's no reason Facebook shouldn't be worth $38 or even $100. For that matter, why isn't Google (GOOG) worth $1000 already? Probably just because that seems expensive, but it would still be cheaper than Facebook. I think part of our brains makes us forget sometimes that stocks are priced according to supply and demand, and demand for Facebook was huge. So its valuation is huge. Does it make sense?
Here are some companies you may have heard of with valuations around the same as Facebook's at or after the IPO: Altria (MO), American Express (AXP), Citigroup (C), ConocoPhillips (COP), Kraft (KFT), McDonald's (MCD), Mitsubishi (MTU), Siemens (SI), Home Depot (HD), Walt Disney (DIS), Unilever (UN, UL), United Parcel Service (UPS). These are fast and loose comparisons, but it's certainly something to think about when blue chip fixtures are suddenly joined in the highest ranks of American corporatehood by a college student's side project.
As for assigning the stock a more conventional valuation, Henry Blodget thinks it belongs somewhere between $16 and $24. MarketWatch's Mark Hulbert calculates a fair price of $13.80. Those numbers were arrived at by careful analyses of the data, but I think they miss the point. An investment in Facebook is never going to be about value. There's just too much hype surrounding this highly-visible company that such an enormous chunk of humanity has such a highly-personal relationship with for its valuation to ever be sane. It is also likely to be volatile for this and many other reasons. Value investors should certainly stay away (I'm sure they have), but anyone else who truly believes in the transformative, disruptive potential of this company-and there's no reason not to occupy that side of the fence-should feel fine investing at any price. You're buying into an idea, after all, not just a company. But that said, will Facebook actually succeed at monetizing its user base? These guys think so but with very little evidence except their belief in the ability of smart computer geeks to exploit the enormous platform of users they have brought into being (without, I surmise, making them feel exploited?). If you believe that, too, then buy in, ignore all the noise, and you may one day get your own Wall Street Journal wealth-o-meter.
But before you do, please familiarize yourself with these choice excepts from their prospectus:
We have two classes of common stock, Class A common stock and Class B common stock. The rights of the holders of Class A common stock and Class B common stock are identical, except voting and conversion rights. Each share of Class A common stock is entitled to one vote. Each share of Class B common stock is entitled to ten votes and is convertible at any time into one share of Class A common stock. The holders of our outstanding shares of Class B common stock will hold approximately 95.9% of the voting power of our outstanding capital stock following this offering, and our founder, Chairman, and CEO, Mark Zuckerberg, will hold or have the ability to control approximately 55.8% of the voting power of our outstanding capital stock following this offering.
This is no problem if you trust Zuck's vision for the company, perhaps, but don't forget: his vision is not necessarily to make you or anyone else rich. In case you haven't seen The Social Network, he is uniquely monomaniacal for the CEO of one of the 50 largest companies in the world. And his mania has nothing to do with shareholder interests or even, quite possibly, making money (he has plenty and doesn't seem to have much interest in spending it). With that in mind, the prospectus identifies a key conflict of interest every potential investor in this idiosyncratic company should bear in mind:
As a board member and officer, Mr. Zuckerberg owes a fiduciary duty to our stockholders and must act in good faith in a manner he reasonably believes to be in the best interests of our stockholders. As a stockholder, even a controlling stockholder, Mr. Zuckerberg is entitled to vote his shares, and shares over which he has voting control as a result of voting agreements, in his own interests, which may not always be in the interests of our stockholders generally.
This basic fact about Facebook's corporate organization is also listed as one of the many risk factors associated with purchasing shares in the company. Here are a few others, about which much has already been blogged:
We generate a substantial majority of our revenue from advertising. The loss of advertisers, or reduction in spending by advertisers with Facebook, could seriously harm our business
Growth in use of Facebook through our mobile products, where our ability to monetize is unproven, as a substitute for use on personal computers may negatively affect our revenue and financial results
I'm sure everyone at Facebook is extremely clever and that at least every other Red Bull-fueled, all-night hackathon is devoted to figuring out ways to milk their users of cash, but their first public statements as regards the platform monetization that the regular sort of bulls are prognosticating are basically variations of "we don't know what we're going to do." This is also in the prospectus in the paragraph that explains why they have decided to go public and how they intend to invest the proceeds in order to grow their business:
We intend to use the net proceeds to us from our initial public offering for working capital and other general corporate purposes; however we do not have any specific uses of the net proceeds planned.
My favorite line, however, is a neat riposte to every stock-pumping fanatic that believes Facebook still has enormous room to expand:
We expect our rates of growth will decline in the future.
Does that mean next year or sometime after 2050? Or just next quarter? I suppose it's hard to make too much out of what must be a truism for every economic entity that has ever existed.
So are Facebook IPO investors muppets or mavericks? Only hindsight knows for sure. If I were one of them, I would probably deploy some sort of options hedging strategy rather than buy shares outright. Shares that carry no dividend and only nominal voting rights are not in their own right a very attractive investment (to me). On the other hand, volatility in Facebook's stock is probably going to make the options fairly expensive, too (with any luck, trading volume will at least keep the spreads within reason).
If Zuck really wanted to shake things up, if he really wanted to follow through to its logical conclusion the open, transparent, democratic, and socially-connected world he envisions and espouses, why didn't he just offer to sell shares directly to his users, through Facebook itself? I'm sure someone at FB HQ could have put together a brokerage app of some kind. With so many devoted users of his service, the shares would have been pretty easy to sell at auction, too. Had the company gone that route, the creators of Facebook's real content and the generators of whatever value it has now or in the future truly would have had a chance to become its owners, and Mark Zuckerberg would truly have done something to challenge the hegemony of Wall Street on behalf of his users, who are basically that part of humanity that is consistently screwed over by Wall Street. Instead, he ended up looking like yet another narcissistic Silicon Valley billionaire whose words and deeds misalign when it comes to sharing wealth and power (more useful things to "share" than anything on Facebook), his demotic hoodie notwithstanding. But all that's pie in the sky. It was far easier for Facebook to go the boring, traditional route, and perhaps the most likely outcome of the whole Facebook IPO fiasco is that a once innovative company will soon enough become just another boring, traditional ticker symbol: fodder for analysts, flash traders, institutional price manipulators, and all their other "friends."
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.