Why You Shouldn’t Buy Facebook: Part-3

It’s ironic that last week when I wrote the initial draft for this series, I could barely come up with 10 reasons why an investor shouldn’t buy Facebook (FB). That was before Facebook’s IPO on May 18th. In light of all that is happened since then, it is hard to understand why anyone would want to buy Facebook at this point. There has been an indication of earnings being lower than reported, an overvalued stock price, and a myriad of law suits against Facebook and its underwriters within the first two days of trading. Even more surprising is that investors didn’t sell their shares last week in light of such news. Facebook shares closed Friday at $31.91 per share, down
-16% from the $38 IPO price.

This is the final post to this series on the Facebook IPO. If you missed the previous posts, Part-1 and Part-2, be sure to check them out. ;)

The Honeymoon for Facebook is Over  

Chan and Zuckerberg Wedding photoThings are not looking good for Facebook or for its main underwriter Morgan Stanley. It also looks like the honeymoon plans for Facebook CEO and recent newlywed Mark Zuckerberg, will soon be over as well. On the third day of trading, the main underwriter Morgan Stanley, the subsidiary underwriters, and Mark Zuckerberg of Facebook have already had several class action lawsuits filed against them from investors.  You can view the press releases for Facebook on the Globe and Mail site, to see the firms that have already filed suit, and many more are likely to follow. The U.S. Senate Banking Committee has also expressed interest in the Facebook IPO.

The lawsuits aren’t just about the fact that retail investors lost money, which they did, rather the potential for known information which was not disclosed to all investors in a proper manner. Since 420 million shares were issued at a $38 IPO price, there are billions of dollars which were lost to retail investors, primarily within the first day of trading.

As the Glancy Binkow & Goldberg lawsuit points out, “the complaints allege that Facebook, certain of the Company’s executive officers and directors and the underwriters of the IPO failed to disclose… and cut their earnings forecasts and that news of the estimate cut was passed on only to a handful of large investor clients, and not to the public.” Many investors who purchased shares from Friday to Tuesday were not aware of the alleged reports of lower earnings by analysts, being different from the reported earnings in the IPO prospectus. If substantiated, it implies that retail investors were not privy to the same information as a handful of other investors, and that revenue was misrepresented.

However, as a recent Globe and Mail article points out, pertaining to disclosure of the Facebook IPO “… it’s perfectly legal for a securities firm to disclose analyst research to only some classes of clients and not to others -so long as the research process is untainted by interference from the investment bankers involved in the underwriting .” Regardless, whether it may be legal practice or not, or even ethical, full disclosure to all investors and the process of disclosure appears to be in question.

The Top 10 Reasons (continued…)

Here are the Top 10 Reasons why you shouldn’t even consider buying Facebook, continued: 

7. Costs from legal proceedings of the IPO

Regardless of the outcome, as an investor in Facebook you are picking up the tab for all the current legal fees surrounding these allegations and lawsuits around the Facebook IPO. Many of these lawsuits could drag on for months if not years, with mounting costs. More importantly, if Facebook should be found guilty or agrees to a settlement, billions of dollars will have to be paid back to investors. That money will come out of any profits on top of all the ongoing legal fees.

8. Accountability and privacy issues

Putting aside the recent legal issues surrounding the Facebook IPO, there are other legal issues that could potentially surface for Facebook in the months to follow. Facebook has a sketchy past with privacy policies.

Zuckerberg’s first prototype for Facebook was called Facemash which he launched in October 2003 while at Harvard. To populate the content for the site, Zuckerberg hacked into Harvard’s security network and copied the student ID images used by dormitories and used them to populate Facemash, according to wikipedia.  The site was shut down a few days later by the Harvard administration, who also laid charges against Zuckerberg for violating security, copyrights, and individual privacy. The charges were later dropped, but shortly thereafter in January 2004, Zuckerberg then went on to build Thefacebook. This was the predecessor to today’s Facebook which was incorporated in 2004.

A few years later in the summer of 2009, Facebook came under pressure from the federal privacy commission over privacy concerns. The Canadian government was concerned the social networking website was violating Canadian privacy law, by keeping people’s personal information indefinitely. Facebook was also criticized for sharing users’ files with nearly one million third-party software developers. On July 16th, 2009, Facebook was given 30 days to comply with then Privacy Commissioner Jennifer Stoddart’s recommendations.

[easyazon-image-link asin="B00835T9D8" alt="Buy This Book Before You Buy Facebook: A PandoDaily Expert Guide To The Internet's Biggest IPO" src="http://ecx.images-amazon.com/images/I/51Q6ilzDMsL._SL500_.jpg" align="right" width="187" height="250"]

In fact, even if you deactivate your Facebook account, Facebook still stores all your personal information unless you delete it. But therein lays the dark secret behind Facebook, which is really more of a data-mining company through apps and personal profiles, than a real advertising company. Next to Google, Facebook probably has the largest amount of personal information about people on the web – maybe even more. This information is likely more valuable to Facebook for marketing than displaying a billion Bing or Facebook ads. The recent addition of Facebook’s timeline is a scary lesson on just how much information Facebook has about you. The recent time-line not only encouraged me to deactivate my personal Facebook account, but to actually delete it!

At some point Facebook will come under more public and legal scrutiny regarding its privacy policies, now that it is a publically traded company – you can count on it. ;)

(PS If you want to permanently delete your Facebook account, and not just deactivate it, you can do it here. Facebook will give you 14 days from the day you request to delete it, before they actually do.)

9. The Groupon Effect

Groupon (GRPN) was another large internet company that went public in November 2011. From the onset, Groupon was plagued with legal issues surrounding its IPO, with questions surrounding its accounting and revenue practices. Some analysts compared Groupon’s IPO to a Ponzi scheme, and others criticized Groupon’s decision to pay out over $940 million of its venture capital it to its founders and early backers (from wikipedia, see initial public offering filing). It was estimated that Groupon was losing $100 million dollars per quarter.

Groupon (GRPN)

Groupon (GRPN) one year chart

It’s been a long steady decline for those who bought Groupon on IPO day at $20, or more per share. Although Groupon shares increased some 30% shortly after the IPO, legal issues surrounding its accounting and revenue practices surfaced early on, hammering the stock price. The stock price hit lows of $9.63 per share in May 2012. Today, Groupon now trades at $12.05 dollars per share, -39.7% below its IPO price.

Facebook is already dealing with the legal issues surrounding its IPO, and there may indeed be more questions about its advertising revenue, stock valuation, and profit margins. Like Groupon, although for different reasons, Facebook is already wrangling in legal issues as newly traded company. As an investor, that is not a good sign.

10. Other reasons not to invest 

There are other reasons why you shouldn’t invest in Facebook. (1) A recent Globe and Mail article points to Facebook’s intrinsic value which also indicates an overvalued stock price. In that article many analysts give Facebook a share price between $9.69 and $29 per share based on what is termed intrinsic value, and the latter is assuming “Google like growth”.  (2) Facebook has a Price to Earnings Ratio of 81, meaning the price of the stock is valued 81 times above its earnings. Investors will often invest in stocks with higher PE ratios of 15 to 20, but 81 is simply dangerous. (3) Zuckerberg is the majority shareholder, with a 57% stake control of voting shares as of the IPO. This means that retail investors have no say in company policy or voting control.

Conclusion

Although Facebook is the second most used website behind Google, it doesn’t necessarily mean it’s a great investment as a shareholder.  Facebook may indeed be a worthwhile investment a year down the road, but buying an IPO always has inherent risk. Within the first few days of trading, there are already class action lawsuits against the company and underwriters. Many are already questioning the facebook IPO, lofty stock valuation, and potential for future revenue and earnings. Considering the Facebook IPO has been the largest in history, and there is more room for concern, there is also more room for downside than upside.

If you already own Facebook and your nursing a loss, then consider selling and get out before the real problems hit the fan. These are real considerations, such as: (1) revenue and profit that appears to be misrepresented to retail investors, (2) potentially lower than expected revenue come Q1 reports,  (3) a stock valuation that is now confirmed as overvalued, and (4) the beginning of numerous class-action legal suits against the company and its underwriters, which will cost the company money.

Even if you really believe in the facebook business model, you should wait until these major issues are resolved before you buy in.  Facebook may follow in the steps of Groupon, with a long declining share price amid legal wrangling, and lower than expected earnings and revenues. Time will tell.

Readers, what’s your take?

If you missed the previous posts, Part-1 and Part-2, be sure to check them out. ;)

21 Responses to “Why You Shouldn’t Buy Facebook: Part-3”

  1. Rob

    May 27. 2012

    Hi Ninja,

    Great set of posts. Very well throught out and presented. There’s one part in particular in Part 3 that I really liked, “The recent time-line not only encouraged me to deactivate my personal Facebook account, but to actually delete it!” I did exactly the same thing, as have many of my friends. When you see every detail of your life laid out in a string you realize how much personal information they actually have on you. It’s scary, to say the least, and I wasn’t even a heavy user.

    I think with identity theft one the rise in Canada (and most everywhere else) people will start being much more carefuly about what infomation they let out. Or at least I hope they do. And that can’t be good for companies like FB who’s near sole purpose seems to be data collection.

    • The Dividend Ninja

      May 31. 2012

      Rob, thanx so much for dropping by and the late response here. ;) I’m glad you picked up on the points I brought up about privacy issues – many people seem unconcerned, but they shouldn’t be. What facebook tracks through its timeline now is human behaviour – probably for marketing purposes.

      Yes I deactivated my personal Facebook account, as well as my personal Linkedin and twitter accounts. To be honest, most people are more interested in connecting to be seen by others, than simply connecting. I am also becoming much more concerned with my online information and how it is being used. This will be another blog post – my personal rant against social media!

      Cheers

  2. Sunny

    May 27. 2012

    Great article.

    But Groupon is more like a coupon company and from what I know, they only have that as business. On the other hand, Facebook is a bit different as they have or going to acquire a company that do business in photography or something like that, I don’t quite remember. Just for that, Facebook is more diversified. They had made or are about to make some major acquisitions.

    Also, Facebook is the only way I know for people to keep in touch on the Web. Are the millions of Facebook users going to stop to use Facebook overnight? Kind of no. I wanted some Facebook stocks to be part of the moment, but my purchase order never go through. It seem to be a good thing, especially at this time since the stock value is under the $38 mark. However, its going to be interesting to see how Facebook will do on the market over the long term. It will be interesting to watch.

    I love Facebook anyway, such vibe and sooooo bright. I would have love to have a bit of that in my portfolio see.

    • The Dividend Ninja

      May 31. 2012

      Hi Sunny,

      Nice to see you over here again, so thanks for taking the time to drop by. ;)

      Yah I completely understand the differences between Groupon and Facebook, though both companies had massive legal suits agaisnt them after their IPO. I personally believe like Groupon, Facebook shares will decline substantially over the first year amid a sea of lawsuits. That was my point about comparing them.

      Facebook is also the second most used website in the world – so obviously as you mention it isn’t going anywhere. However just because you like facebook and are familiair with it, doesnot mean its a safe investment. Using a company product or service, and investing in a company are two seperate things. As I’ve pointed out in this three-part series, I don’t think facebook is a good investment or a safe investment.

      Here is the positive side of it. You weren’t able to buy in at $38 which is a good thing since you haven’t lost any money. Be patient and you can probably buy Facebook for $10 or even less sometime down the road – it will be a bargain by then.

      Cheers!

  3. unbalanced

    May 28. 2012

    Great article as usual. There are alot of unhappy people who bought Facebook. Did someone put a gun to their head and force them to buy. Have you, or would you consider to write an article on preferred shares or the pros and cons of seggrated funds. Thanks in advance. I have been reading you for over a year and have learnt alot of info from you and other bloggers.

    • The Dividend Ninja

      May 31. 2012

      Unbalanced nice to hear from you again! I really appreciate the positive feedback, it’s remarkable to me people have been following my blog for over a year.

      No one put a gun to anyone’s head to buy Facebook, it’s called greed pure and simple. In this case retail investors thought they could make a quick buck – turns out after the fact they weren’t given all the facts in the first place! It’s all a fools game.

      I have an article here on Preferred Shares I wrote over a year ago. But keep in mind the yields are lower now on most PF shares, so they are not neccessarily as attractive to purchase:

      http://www.dividendninja.com/the-power-of-preferred-shares

      Cheers

  4. TM @ Young and Thrifty

    May 30. 2012

    *slow clap

    I was spouting the same stuff to my buddies explaining that how many users FB has was a very small part of what it was actually worth. Looks like the numbers are backing you up big time buddy! At this point (now that people have started looking at the profit numbers) I wonder how far the stock can slip? It’s so difficult to really place a valuation on this one, but what better example do we need of a bubble caused by media and our own inability to detect pure hype?

    • The Dividend Ninja

      May 31. 2012

      TM, thanx for the awesome comment! Get your buddies to read Parts 1 and 2 as well. ;)

      FB was so obviously a hyped stock, without the substance behind it (i.e. earnings and revenue). And it turned out right on IPO day big investors were given different information of lower earnings – not a good sign. It’s ironic that I wrote this series a week before the IPO, and felt I was stretching my points of valuation etc. That’s turned out after the fact to be bang on. Right now the stock is being heavily shorted.

      Cheers!

  5. Eddie

    May 31. 2012

    Another great post Avrom!
    And I’ll join in to YTs *slow clap* (imagine the Wisers commercial) :)
    The Groupon example you used in #9 was a great example of what I think will happen to FB. Oddly enough FB has taken a very similar approach that Groupon took prior to going public.

  6. My Own Advisor

    Jun 01. 2012

    Great article, very solid series!

    I suspect there are many unhappy investors with FB.

    I wonder how many people will make the same mistakes again, jumping into the next tech. IPO?

    People have a very short memory. To each their own though! :)

    Cheers,
    Mark

    • The Dividend Ninja

      Jun 02. 2012

      Mark, Cheers! Unfortunately we will see history repeat itself… Many people still think Facebook as a great investment – Arrrrg.

  7. farcodev

    Jun 05. 2012

    I though that with 2008 and 2009 people would stop to take the first speculative bandwagon when they see one, but apparently it’s not the case.
    Great 3rd part, thanks for this critical analysis :)

    Thumbs up !

  8. Let's Learn Finance

    Jun 14. 2012

    Just finished reading this 3-part series, excellent display of reasoning! I didn’t and wouldn’t have bought any FB shares at its IPO nor any preceding days – for only 4 out of the 10 reasons you’ve mentioned. You’ve just given me 6 more reasons to justify my initial thought process :P

    Hopefully, this’ll be something they can bounce back from and perhaps take a more “stable” position in the market. I don’t think the company deserve to transcend into a infinite decline because it really brought something to society and revolutionized its market. Or maybe that’s the inner FB addict speaking out loud?

    Either way, it was an insightful and accessible read. You might see me around snooping around the comments more often :P Keep it up, Ninja!

    • The Dividend Ninja

      Jun 14. 2012

      Hey, delighted to have you drop by and feel free to snoop around more often. ;) Glad you liked the series, I had a lot of fun writing it as well. Which were your four reasons?

      btw
      I love your site, lots of great info!!

      Cheers

      • Let's Learn Finance

        Jun 14. 2012

        I’ve got a handful of blogs that I’ve stumbled across in the past couple of weeks that I’m eager to sit down and read over in fine detail – your blog is one of them! ;)

        I’m just waiting till my exams are finished to get into it haha, so you’ll see me then!

        My four were;
        1. IPOs Are Risky Investments – This one was obvious. I’m too risk averse :P

        5. What is the business model? – THIS. It’s one thing to evolve the face of your product to keep the consumer interested and engaged, but its rare that one business model will fit perfectly for the entire life of the company. Unfortunately, there’s no evidence that Zuck and the team evolved with the company’s growth. They do have a model -> bring lots of people together, put ads on the side and get some clicks. It’s the same model I had when I launched my first niche website when I was 11 years old..

        7. Costs from legal proceedings of the IPO – Also obvious, the legal costs would be staggering and these will negatively transgress just the share valuation of the company.

        9. The Groupon Effect – This happened around the same time when I first took an interest in the Stock market. A negatively criticised IPO has quite a snowballing effect, I’ve come to realise.

        Also, thank you for the compliments, Ninja! It’s a little project I’ve started recently to work with my fellow colleagues in the Finance subjects I undertake. I’m pretty excited about it pushing forward because I’ve got a few lecturers behind it too! :)

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