Facebook Fully Diluted - In Search Of Equilibrium

Aug. 7.12 | About: Facebook (FB)

Recently, we were investigating the possible counterintuitive bullish scenario for Facebook (FB) given the dramatic fall in its stock price since its IPO priced at $38 per share in May 2012. We are of the opinion that Facebook is here to stay. In fact, Stephan Paternot explains eloquently the power and reach of FB in this recent interview.

We then started digging into the issues highlighted by the media on the differing opinions on why the stock was falling. They are numerous, and if you are reading this, you probably have read them all as well.

Here are a five we recommend:

1.Facebook: Change or Die by Dan Newman

2.Dear Facebook, It Really Could Be This Simple by Alexia Tsotsis

3.Facebook Is More Valuable Than You Think By Henry Blodget

4.Traders Bearish As Facebook Lockup Expiration Looms WSJ

5.83M Facebook Accounts Are Fakes And Dupes CNN

A telling indicator in any stock drop or pop is the short interest, which is officially reported by Nasdaq in the middle and end of each month on a historical basis. The latest report shows a 56.7M shares short interest on 7/13 which dropped from 60.1M shares short on 6/29. We have checked on the availability on the borrow from some different brokerage houses and have seen the availability of shares to borrow in order to sell short started to get tighter. One brokerage house didn't have any availability, but they are involved in litigation with Nasdaq on the Facebook IPO saga. Most show it available with a negative rebate (equivalent to annual interest charge) of 1.5%. This is up from no charge at the beginning of the week.

We believe that Facebook is going to figure out the growth formula to appease its critics. The fake accounts and bots issue will also be worked out. The most difficult situation for FB is the dilution issue that the company faces from Restricted Stock Units "RSU" and Incentive Stock Options "ISO". The Facebook S-1 shows that a fully diluted share count is 2.714 Billion shares. Most sites report the total share count at 2.1 Billion. The actual fully diluted share count is approximately 30% higher which is the theory that short sellers are using to short the stock at these levels. With the lockup period ending in mid August, it seems that the current price needs an adjustment to account for the absorption of these new shares coming into the float. Has the price been adjusted to the proper level? The real question an investor has to ask themselves when trying to find the right entry point into the stock is whether the short interest of 13%, roughly 260 million shares according to Factset, is enough to accommodate the coming dilution. Using simple arithmetic, that is 1/3 of the additional coming shares, so the price drop from $26 price level to the current $21 level is approximately 30%. Is this price drop fully adjusted with a short interest increase of 200 million shares? Wedbush Morgan has reported that the support level is $16.50 or another 17.5% from current levels. We think the spike in shares Friday was in sympathy with the good numbers posted by "specialty" Social Network LinkedIn (LNKD), which surged $15 or 16%. We think that the "specialty" Social Networks may eventually be more compelling to power users, making this correlation an future inverse relationship.

We believe that the borrow availability is starting to get tighter and as this continues to accommodate the coming share count increase. At some point in the next fourteen days, the share price will reach its equilibrium at a price most likely lower than its current level.

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